Futures Contracts

Futures contracts - What they are

A futures contract is an agreement between two parties to make an exchange of a commodity on an agreed date in the future but the price is agreed today.

These are standardised contracts. This means that individual futures contracts are defined by the contract specifications. The specifications detail the contract size (amount being traded), exactly what is being traded, how the settlement price is determined and the date when settlement or delivery is to be made. This standardisation is a key part of futures. Both the buyer and seller know exactly what they are dealing in.

Futures exist in commodity markets, foreign exchange, bonds, short term interest rates and equities. They aren’t new. The Chicago Board of Trade opened in 1865 trading grain futures. More recently the Chicago Mercantile Exchange started trading financial contracts in 1972.

Key features

As mentioned above a key aspect is the standardisation of contracts. There are further important features. These include the following.

There is a central exchange: This is where buyers and sellers orders are matched. Traditionally this has been conducted in trading pits but with improvements in technology many contracts are traded electronically using a central order book to match buyers and sellers. Because transactions go through an exchange they are subject to the rules of the exchange.

Trade data, in particular the price at which transactions are done is recorded and made available to market participants. It is therefore argued that pricing is transparent because you can see exactly where trades are done and where the next bid and offer prices are.

Once a trade is done the deal is “given-up” or novated to a clearing house. The buyer and seller therefore have a contract with the clearing house rather than with each other. Crucially this leads to a reduction in counterparty credit risk.

There is margining: Clearing houses are made up of members. Members must post collateral by way of Initial Margin (IM) and Variation Margin (VM). Members clear trades on behalf of clients so these clients are ultimately responsible for maintaining their own margin calls. IM is collateral, normally cash, that is posted before trading can start.

It is there to make sure that the buyer or seller has sufficient funds in order to cover any losses incurred over a short period of time. Over and above the IM is the VM. This is a daily or intra-day collateral call. Individual futures trades are valued or marked-to-market using the exchange price. Losses incurred by the futures trader must then be made whole by the transfer of VM. This is normally cash. Dealers with positive valuations receive VM.

This regular marking to market means that losses must be monetised. It prevents a dealer building up a large loss and then finding out that he has insufficient resources to meet this loss. The requirements for IM and VM vary by exchange and include algorithms that permit the offset of positions in order to create a net valuation.

Failure by a dealer to pay margin will mean that his trades are closed out and losses are deducted from the IM. If the IM is insufficient the clearing members are responsible. The key features of margining, centralisation and transparency have long been held as the main advantages of using futures.

Some Disadvantages

Despite their advantages futures are not always the best solution for trading and risk management. The fact that the contracts are limited by their specifications means that a dealer has no flexibility over the terms of the contact. If the dealer wishes to trade or hedge specific risks there may be no suitable futures contracts or those that do exist may not precisely match what he wants to do. This is why OTC markets like swaps have thrived. They allow dealers to tailor make transactions to suit their needs and also those of clients. OTC markets have also introduced collateral management which although operationally intensive is akin to margining and is used to mitigate credit risk.

Futures Prices

In theory the futures price is dictated by the spot price adjusted for the benefits and costs that accrue over the time period from today to the expiry date of the futures contract.

Here is a simple example:

If the spot price of grain is $10 and the cost of storage is $2 then the futures price will be $12:

If the futures price was higher or lower an arbitrage opportunity would exist. If you could buy gain spot at $12, store it for $2 and sell futures for $12.50 a riskless profit of $0.50 would occur:

Riskless profits like this would not last long as supply and demand would bring the market back to equilibrium. As mentioned above this is the theory and largely the futures price will reflect the spot rate and cost of carry however in real markets nuances mean that imperfections exist. Some of these are complex and can be exploited by traders. The scope is beyond this basic document.

The difference between the futures price and the spot price is called the basis by futures traders. Basis traders attempt to exploit opportunities where the basis is greater or less than expected.

Short Term Interest Rate Futures

There are a number of contracts based on short term interest rates (LIBOR) for the main currencies including USD, EUR, GBP, YEN and CHF. Indeed the USD contract, known as the Eurodollar contract is the most widely traded futures contract. The specifications for this contract are:

The unit of trading:         $1,000,000

Quotation:                          100 minus the interest rate

Min. price move:              0.005, ($12.50)

Delivery months:             March, June, September, and December

These contracts are quoted at three month intervals (March, June, September and December) for a period of ten years although greatest liquidity is in the near month contracts.

Traders in this contract are trading the three month forward interest rate based on LIBOR (interbank deposit rates) for the relevant delivery month. (Settlement is on the third Wednesday of the contract month with the Libor fixing two days beforehand). The quotation means that a futures price of 99.23 implies a forward rate of 100-99.23 = 0.77%

The relationship between these futures prices and forward rates means that as interest rates rise futures prices fall and vice versa:

Let’s suppose you expected interest rates to fall and wanted to speculate using these contracts. You buy one September contract at 99.23 (0.77%). Tomorrow the price is 99.24 (0.76%). Your gain is 99.24 – 99.23 = 0.01

The contract is based on a notional amount of $1,000,000 and the interest rate thereon for three months.

Your profit will therefore be:

$1,000,000 x 0.01% x ¼ = $25

This is sometimes referred to as the contract’s “tick value”.

In this case you have gained $25 and this you would receive as VM. Had the market gone in the opposite direction you would have lost money and would pay VM.

Speculation is not the only thing that futures can be used for. Many traders use them for hedging. Here is a simplified example. A bank agrees to lend money from a date starting in the future at a fixed rate of 0.77%. The bank sells a futures contract to hedge against rising interest rates:

If interest rates rise (in this example by 0.10%) the bank lends money at a rate below its funding cost. The loss incurred is offset by a gain on the futures contract of 10 basis points:

Had interest rates fallen the bank would have funded itself at a rate lower than the rate on the loan to the customer thus creating a profit. But this would have been mirrored by a loss on the futures position:

This example ignores all other related margins and risks but clearly shows that these futures contracts are instrumental in hedging short term interest rate risks.

A key aspect of short term interest rate contracts like the Eurodollar future is that it is a contract for difference. This means that when you reach the contract’s expiry date the futures price will converge with the spot price (LIBOR) and any profits or losses will have been fully reflected in the VM. No delivery of a bank deposit actually occurs.

Bond Futures

By way of contrast bond futures are contracts that allow the trading of bonds (longer term interest rates). They also permit delivery of a deliverable grade bond by the seller of the futures contract to the buyer. This occurs during a delivery window between the expiry and the settlement date.

Futures prices are directly linked to the underlying bond market. The mechanism is complicated by there being several different bonds that qualify as being of deliverable quality. The idea is that this helps to prevent a disorderly market where there is a scramble to buy just one bond for delivery.

Deliverable bonds will have different maturity dates and coupons. In order to make sure that the correct sum of money is paid to the seller by the buyer a conversion factor is used. Full discussion is beyond the scope of this document suffice to say that it acts to equate deliverable bonds so that higher coupon bonds have a higher invoice price. Normally at any one time one bond will be favoured for delivery because it has the lowest delivery cost (purchase price + cost of carry). The futures contract will therefore behave and be linked to this cheapest to deliver bond.

An example of a bond future is the US Treasury Bond contract traded by the Chicago Mercantile Exchange.  The specifications are as follows:

Amount: $100,000 face value

Deliverable: A US Treasury Bond 15-25 years in maturity

Conversion factor: using 6% yield

Price quotes: in 1/32nds

Settlement: March, June, September, and December

Suppose you buy one September contract trading at a price of 135.14. Tomorrow the price is 135.24. You have therefore made a profit of 10/32nds. How much is this?

The contract size $100,000

$100,000 x 1% = $1,000

$1,000 x 1/32 = $31.25

We have made 10/32nds

10 x $31.25 = £312.50

This has happened because bond prices have risen (interest rates have fallen).

You can therefore see that this contract could be used to speculate on and hedge against interest rate risk particularly for medium and longer dated exposures.

First Published by Barbican Consulting Limited 2014