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In Finance , a futures contract is a standardized Contract , traded on a Futures Exchange , to buy or sell a certain Underlying Instrument at a certain date in the future, at a specified price. The future date is called the '''delivery date''' or '''final settlement date'''. The pre-set price is called the '''futures price'''. The price of the underlying asset on the delivery date is called the '''settlement price'''. A futures contract gives the holder ''the obligation'' to buy or sell, which differs from an Options Contract , which gives the holder ''the right, but not the obligation''. In other words, the owner of an options contract may exercise the contract. Both parties of a "futures contract" '''must''' fulfill the contract on the settlement date. The seller delivers the commodity to the buyer, or, if it is a cash-settled future, then cash is transferred from the futures trader who sustained a loss to the one who made a profit. To exit the commitment prior to the settlement date, the holder of a futures Position has to offset his position by either selling a Long Position or buying back a Short Position , effectively closing out the futures position and its contract obligations. ''Futures contracts'', or simply ''futures'', are Exchange Traded Derivatives . The exchange's Clearinghouse acts as Counterparty on all contracts, sets Margin requirements, etc. FUTURES VS. FORWARDS While futures and Forward Contract s are both a contract to deliver a commodity on a future date at a prearranged price, they are different in several respects:
STANDARDIZATION ''Futures contracts'' ensure their Liquid ity by being highly standardized, usually by specifying:
MARGIN To minimize Credit Risk to the exchange, traders must post Margin or a Performance Bond , typically 5%-15% of the contract's value. Margin requirements are waived or reduced in some cases for Hedgers who have physical ownership of the covered commodity or Spread Trader s who have offsetting contracts balancing the position. Initial margin is paid by both buyer and seller. It represents the loss on that contract, as determined by historical price changes, that is not likely to be exceeded on a usual day's trading. A futures account is marked to market daily. If the margin drops below the margin maintenance requirement established by the exchange listing the futures, a margin call will be issued to bring the account back up to the required level. Margin-equity ratio is a term used by Speculator s, representing the amount of their trading capital that is being held as margin at any particular time. The low margin requirements of futures results in substantial leverage of the investment. However, the exchanges require a minimum amount that varies depending on the contract and the trader. The broker may set the requirement higher, but may not set it lower. A trader, of course, can set it above that, if he doesn't want to be subject to margin calls. Return on margin (ROM) is often used to judge performance because it represents the gain or loss compared to the exchange’s perceived risk as reflected in required margin. ROM may be calculated (realized return) / (initial margin). The Annualized ROM is equal to (ROM+1)(year/trade_duration)-1. For example if a trader earns 10% on margin in two months, that would be about 77% annualized. SETTLEMENT Settlement is the act of consummating the contract, and can be done in one of two ways, as specified per type of futures contract:
PRICING The situation where the price of a commodity for future delivery is higher than the spot price, or where a far future delivery price is higher than a nearer future delivery, is known as Contango . The reverse, where the price of a commodity for future delivery is lower than the spot price, or where a far future delivery price is lower than a nearer future delivery, is known as Backwardation . When the deliverable asset exists in plentiful supply, or may be freely created, then the price of a future is determined via Arbitrage arguments. The forward price represents the expected future value of the underlying Discount ed at the Risk Free Rate —as any deviation from the theoretical price will afford investors a riskless profit opportunity and should be arbitraged away; see Rational Pricing Of Futures . Thus, for a simple, non-dividend paying asset, the value of the future/forward, ''F(t)'', will be found by compounding the present value ''S(t)'' at time ''t'' to maturity ''T'' by the rate of risk-free return ''r''. : or, with ''continuous compounding'' : This relationship may be modified for storage costs, dividends, dividend yields, and convenience yields. In a perfect market the relationship between futures and spot prices depends only on the above variables; in practice there are various market imperfections (transaction costs, differential borrowing and lending rates, restrictions on short selling) that prevent complete arbitrage. Thus, the futures price in fact varies within arbitrage boundaries around the theoretical price. The above relationship, therefore, is typical for stock index futures, treasury bond futures, and futures on physical commodities when they are in supply (e.g. on corn after the harvest). However, when the deliverable commodity is not in plentiful supply or when it does not yet exist, for example on wheat before the harvest or on Eurodollar Futures or Federal Funds Rate futures (in which the supposed underlying instrument is to be created upon the delivery date), the futures price cannot be fixed by arbitrage. In this scenario there is only one force setting the price, which is simple supply and demand for the future asset, as expressed by supply and demand for the futures contract. In a deep and liquid market, this supply and demand would be expected to balance out at a price which represents an unbiased expectation of the future price of the actual asset and so be given by the simple relationship :. In fact, this relationship will hold in a no-arbitrage setting when we take expectations with respect to the with respect to the risk-neutral probability. With this pricing rule, a speculator is expected to break even when the futures market fairly prices the deliverable commodity. In a shallow and illiquid market, or in a market in which large quantities of the deliverable asset have been deliberately withheld from market participants (an illegal action known as Cornering The Market ), the market clearing price for the future may still represent the balance between supply and demand but the relationship between this price and the expected future price of the asset can break down. FUTURES CONTRACTS AND EXCHANGES There are many different kinds of futures contracts, reflecting the many different kinds of tradable assets of which they are Derivative s. For information on futures markets in specific underlying Commodity Markets , follow the links. Trading on Commodities began in Japan in the 18th century with the trading of rice and silk, and similarly in Holland with tulip bulbs. Trading in the US began in the mid 19th century, when central grain markets were established and a marketplace was created for farmers to bring their commodities and sell them either for immediate delivery (also called spot or cash market) or for forward delivery. These forward contracts were private contracts between buyers and sellers and became the forerunner to today's exchange-traded futures contracts. Although contract trading began with traditional commodities such grains, meat and livestock, exchange trading has expanded to include metals, energy, currency and currency indexes, equities and equity indexes, government interest rates and private interest rates. Contracts on financial instruments was introduced in the 1970s by the Chicago Mercantile Exchange (CME) and these instruments became hugely successful and quickly overtook commodities futures in terms of trading volume and global accessibility to the markets. This innovation led to the introduction of many new futures exchanges worldwide, such as the London International Financial Futures Exchange in 1982 (now Euronext.liffe ), Deutsche Terminbörse (now Eurex ) and the Tokyo Commodity Exchange (TOCOM). Today, there are more than 75 futures and futures options exchanges worldwide trading to include:
WHO TRADES FUTURES? Futures traders are traditionally placed in one of two groups: Hedger s, who have an interest in the underlying commodity and are seeking to ''hedge out'' the risk of price changes; and Speculator s, who seek to make a profit by predicting market moves and buying a commodity "on paper" for which they have no practical use. Hedgers typically include producers and Consumer s of a commodity. For example, in traditional Commodities Market s, Farmer s often sell futures contracts for the crops and livestock they produce to guarantee a certain price, making it easier for them to plan. Similarly, livestock producers often purchase futures to cover their feed costs, so that they can plan on a fixed cost for feed. In modern (financial) markets, "producers" of interest rate swaps or Equity Derivative products will use financial futures or equity index futures to reduce or remove the risk on the swap. The social utility of futures markets is considered to be mainly in the transfer of risk, and increase liquidity between traders with different risk and time preferences, from a hedger to a speculator for example. OPTIONS ON FUTURES In many cases, '' Options '' are traded on futures. A Put is the option to sell a futures contract, and a Call is the option to buy a futures contract. For both, the option Strike Price is the specified futures price at which the future is traded if the option is exercised. See the Black Model , which is the most popular method for pricing these option contracts. FUTURES CONTRACT REGULATIONS All futures transactions in the United States are regulated by the Commodity Futures Trading Commission (CFTC), an Independent Agency of the United States Government . The Commission has the right to hand out Fines and other punishments for an individual or company who breaks any rule. Although by Law the commission regulates all transactions, each exchange can have its own rule, and under contract can fine companies for different things or extend the fine that the CFTC hands out. The CFTC publishes weekly reports containing details of the open interest of market participants for each market-segment, which has more than 20 participants. These reports are released every Friday (including data from the previous Tuesday) and contain data on open interest split by reportable and non-reportable open interest as well as commercial and non-commercial open interest. This type of report is referred to as 'Commitments-Of-Traders'-Report, COT-Report or simply COTR. SEE ALSO
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FUTURES EXCHANGES & REGULATORS
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