What is a Futures Contract?

The incredible growth in the use of derivatives and the sporadic controversy they stimulate make it important to understand their role in the financial markets.

A futures contract is a standardized contract that obliges the owner of the contract to buy or sell the underlying asset, which may be a physical commodity or a financial instrument (stock, or bond), at certain future date (delivery date) at a certain price (settlement price). The agreement is between (1) the party who agrees to sell the underlying asset for the agreed upon price (short position) and (2) the party who agrees to buy the underlying asset for the agreed upon price (long position).

To illustrate how a futures contract works, we assume that, in February, a producer of wheat wants to lock a selling price for next season's crop, and a bread maker wants to lock a buying price to determine the quantity of bread produced and the potential profit. These two parties may enter a futures contract agreeing the delivery of 4,000 bushels of grain to the bread maker (long position) in May at a price of $5 per bushel. By entering into a futures contract, both parties secure a price that they agree to pay and receive in May.

Futures contracts are traded on a futures exchange, the quantity and quality of the commodity are specified, the price per unit is specified, the delivery date, location and method of delivery are specified, they are settled daily, and the position is closed prior to maturity.

Futures contracts have virtually no liquidity risk because they are traded on major future exchanges. Also, because of their standardized terms and conditions, such as the quality and quantity of the underlying asset and expiration dates, are allowed to be traded (bought and sold) in secondary markets. Therefore, the owner of a futures contract can buy or sell the contract and offset his position by trading an identical type of contract in the secondary market.

Futures contracts have virtually no credit risk because they are settled daily. Buyers and sellers of futures contracts are required to deposit the initial margin in a margin account, which is typically 3 percent to 6 percent of the value of the contract. Funds are added of deducted form the margin account after each trading session reflecting the daily price changes in the futures contract and this is how the settlement price is determined. Therefore, as futures contracts are settled daily, if the margin account becomes too low, the maintenance margin limit is reached and the investor is required to put additional funds in the account or to close his position.

Through this process, the futures exchange becomes a counterpart to all transactions and if an investor defaults, the exchange covers all losses. In any case though, the daily settlement of the account and the maintenance margin requirements help to spread the risk over the daily cash flows of the futures contract until maturity thus preventing an investor's deficit from increasing.

Futures markets are regulated by the Commodity Futures Trading Commission (CFTC), which oversees the exchanges and approves new contracts for trading. When a contract expires, cash or assets may be exchanged between the counterparties.