Futures contract

A futures contract is a standardized legal agreement used in finance. It involves a buyer and a seller agreeing to trade an asset at a specific price. This price is called the forward price or delivery price. The trade does not happen immediately. Instead, the exchange of the asset and the payment occurs on a set delivery date. Because the value of the contract comes from an underlying asset, it is known as a derivative.

There are two main roles in these transactions. The buyer of the contractual right is called the long position holder. The person selling the contract is the short position holder. These parties often use futures for two different reasons: hedging or speculation. Hedging is used to manage price risk. For example, a person might use a contract to fix a currency rate. This protects them from unfavorable price movements before they receive a payment. Speculators, however, trade to profit from price changes. They try to predict if a price will rise or fall. If their prediction is correct, they earn a profit. This can even help distribute commodities like food more effectively during times of surplus or need.

To make sure both parties follow the rules, they must use a margin. A margin is a security deposit of money held by a trusted third party. This deposit acts as a performance bond to prevent a party from reneging on the deal. For example, gold futures trading might require a margin between 2% and 20% of the contract value. This amount depends on the volatility of the spot market. The exchange also uses a process called marking to market. This means the contract is re-evaluated every day based on current prices. The difference between the agreed price and the daily price is settled daily. This is known as the variation margin. If an account balance falls too low, the exchange issues a margin call. The owner must then add more money to the account.

To further reduce risk, regulated exchanges use a clearing house. The clearing house acts as the buyer to every seller and the seller to every buyer. This ensures that if one person fails to pay, the clearing house assumes the risk. This system allows traders to transact without needing to perform deep research on the person they are trading with. Some traders, like hedgers with physical ownership of a commodity, may have certain margin requirements waived or reduced. Other types of margins exist, such as the initial margin used to start a position. The exchange sets this amount based on estimated daily price changes. There is also a maintenance margin, which is the minimum amount a customer must keep in their account.

Futures markets have a long and interesting history. Some consider the Dōjima Rice Exchange in Osaka, Japan, to be the first futures exchange. It was established in 1697 to help samurai. They were paid in rice and needed a stable way to convert it into coin after bad harvests. Later, the Chicago Board of Trade (CBOT) listed the first standardized exchange-traded contracts in 1864. These were based on grain trading. By 1875, cotton futures were being traded in Bombay, India. This led to trades in oilseeds, jute, and bullion. In the 1930s, wheat accounted for two-thirds of all futures trading.

The market changed significantly in the 20th century. In 1972, the Chicago Mercantile Exchange created the International Monetary Market (IMM). This was the world's first financial futures exchange. It launched currency futures, which allowed for trading different types of money. In 1976, the IMM added interest rate futures for US treasury bills. By 1982, they added stock market index futures. A stock future is a cash-settled contract based on the value of a market index. These are considered high-risk instruments. They are also used as indicators to help people understand market sentiment.

Contracts eventually reach a point called expiry or expiration. This is the day a specific delivery month stops trading. On this day, the final settlement price is determined. For many index and interest rate futures, this happens on the third Friday of certain months. During this time, traders may "roll over" their positions to the next contract. There are two ways to finish a contract: physical delivery or cash settlement. In physical delivery, the seller actually provides the specified amount of the asset. In other cases, the contract is settled through payments. Even unique ideas have been suggested, such as organ futures to help increase the supply of transplant organs.