Futures Contracts: a Brief Primer

At the Expert Level of the CIPM curriculum, candidates are required to deal with return calculations of portfolios with futures contracts, as well as attribution analysis.  A good number of candidates, however, have little to no background on futures contracts, and the curriculum readings do not touch on this subject.

Thus, I write this blog post as a quick primer to give candidates some basic information on these instruments.  This is not meant to be comprehensive, but it should give candidates enough information to understand the basics of futures, and the concepts in the CIPM curriculum readings.

What is a futures contract?

A futures contract is, essentially, a "standardized" forward contract.

Forward contracts

 A forward contract always involves a contract initiated at one time and performance in accordance with the terms of that contract at a future point in time.  The contract always involves an exchange of one asset for another.  The price at which the exchange occurs is set at the time of the initial contracting, and actual payment and delivery of the good occur in the future.

For example:  a person wanting a puppy agrees to purchase a puppy from a breeder at the time that the mother gives birth to the litter.  The breeder and the buyer agree to a price now, although the actual exchange will not occur until the puppy is weaned.  This is an example of an everyday forward contract.

The buyer is said to have a long position, while the seller has a short position. The act of buying is called going long, while the act of selling is called going short.

 

How are futures contracts standardized forwards?

The main distinctions between futures and forward contracts are:

1.  Futures trade on organized exchanges.

2.  Futures contracts have standardized contract terms.

3.  Futures exchanges have associated clearinghouses to guarantee fulfillment of obligations

4.  Futures trading requires margin payments and daily settlement.

5.  Futures positions can be closed easily.

6.  Futures markets are regulated by identifiable agencies; forward markets are self-regulating.

Terms that are typically standardized in the contract include:

• Quantity traded
• Quality of the underlying commodity
• Expiration date
• Delivery terms and dates
• Minimum price fluctuations (tick size) and daily price limits 
• Trading days and times

The clearinghouse effectively removes counterparty default risk in the futures markets.  The clearinghouse is able to ensure that traders honor their obligations by taking the position of buyer to each seller, and seller to each buyer.  Because of this, every trader has obligations not to other traders, but to the clearinghouse, and will expect that the clearinghouse will maintain its side of the trade.  Effectively, the trader must only have trust in the credibility of the clearinghouse, rather than another trader.  


Besides the security of the clearinghouse, the primary safeguard against default is the requirement of margin and daily settlement.  Before trading a futures contract, the trader must deposit funds with a broker.  These funds serve as a good-faith deposit and are referred to as margin.  The margin can be in the form of cash, a bank letter-of-credit (LOC), or in short-term United States Treasury instruments (bills or notes).  While these funds are on margin the trader retains the title.

There are three types of margin.  When a trader deposits funds prior to trading, that is called initial margin.  The initial margin approximately equals the maximum daily price fluctuation permitted for the contract being traded.  The trader earns the interest accrued on any securities serving as margin.  For most contracts, the initial margin may be 5 percent or less of the underlying commodity value.

The initial margin can be so small in relation to the contract value because of the system of daily settlement or marking-to-market.   In futures markets,  it is required that traders realize any losses on the day they occur.  This means that the contract is marked-to-the-market.  When the funds on deposit with the broker reach a level called the maintenance margin, the trader must replenish the margin to its initial level.  This request for more margin is called a margin call.  The margin that is added is called the variation margin.  

 If a trader suffers a loss such that a margin call is made and the trader does not post the required additional margin, then the broker is empowered to close the futures position by deducting the loss from the trader's initial margin and returning the balance, less commission costs, to the trader.  In such a situation the broker would close the trader's entire brokerage account, since this is a violation of the trader's agreement with the broker.  Because the initial margin can cover any daily losses, there is no risk for the clearinghouse.


There are three ways to close a futures position:  delivery, offset, or an exchange-for-physicals (EFP).

Futures contracts may be based on a variety of underlying goods, including:  physical commodities (e.g., oil, sugar, cotton), currencies, interest-earning securities or instruments, and individual stocks. 

 

Futures markets meet the needs of three groups of users:  those who wish to discover information about the future prices of commodities, those who speculate, and those who hedge. Price discovery is the determination of future market prices via the futures market.  There is a relation ship between the futures price and the price that can be expected to prevail for the commodity at the contract delivery date.  Hedging with futures involves using a futures contract as a substitute for a market transaction. Speculation involves trying to capitalize on the change in value of contracts over time.


Investors may use futures contracts to achieve a desired exposure in a simple, typically transaction-cost-efficient fashion.  For example, if one desires an exposure of $2,000,000 USD to the 500 stocks in the Standard & Poor's 500 Index, one could achieve this in a couple of different ways:

• The investor could purchase all 500 stocks at allocations that match the weights in the S&P 500.  Doing this requires the investor spend $2,000,000 in cash, plus the transaction costs associated with doing each trade.
• The investor could open a long position in a S&P 500 futures contract for $2,000,000.  This requires only one transaction, would have negligible transaction expenses, and does not require $2,000,000 in cash be spent.  Rather than spending actual cash, the investor obligates himself/herself to pay a cash obligation of $2,000,000 by the contract's expiration date and receive the value of $2,000,000 in stocks.

Most futures contracts of speculators are closed by offsetting trade.  Thus, as the value of the contract has changed over time, when the investor would offset the contract at the value at the time of closing, and the investor has captured a realized gain/loss equal to the difference in value at closing of the position vs when it was opened.  This realized gain/loss has been paid to the investor over time through the daily settlement (mark to market) process.