Introduction to futures

In section 7.2 we covered forward contracts that allowed a company to remove exchange-rate risk by agreeing a price now for delivery (or receipt) in the future. These contracts are traded over the counter and are a private transaction between the company and the bank. Now imagine if a company had agreed to buy a currency at a certain price and the exchange rate had moved in an advantageous direction. The forward contract could be considered to have value, but it is impossible to release this value. Futures contracts solve this problem.

A futures contract is a “marketable” forward contract, with marketability provided through futures exchanges that list hundreds of standardised contracts, establish trading rules, and provide clearing houses to guarantee and intermediate contracts. Futures contracts, like forward contracts, are a binding agreement to buy or sell an underlying asset at a specified date in the future. However, they primarily differ from forward contracts in that (i) the agreement can be sold and (ii) futures contracts are available on a much wider array of assets.

Futures contracts are traded on a centrally regulated exchange, with every negotiated price being “heard” by other traders. Traditionally, futures were traded via open outcry but more recently there has been a shift to electronic trading. In fact, on 2 July 2015, the leading futures exchange in the world, the Chicago Mercantile Exchange (CME), switched exclusively to electronic trading as a consequence of open outcry futures volumes declining to 1 per cent of daily futures volume.

Futures positions

In a long futures position, you agree to buy the contract's underlying asset at a specified price, with payment and delivery to occur on the expiration date (also referred to as the delivery date). In a short position, you agree to sell an asset at a specific price, with delivery and payment occurring at expiration. Thus far this sounds very similar to a forward contract. However, the real attraction of futures contracts over forward contracts is the ease of closing out a position. In order to close out a futures position, you simply need to do the reverse of whatever you did to get in to it.