Futures market

[From Wikipedia]

futures exchange or futures market is a central financial exchange where people can trade standardized futures contracts; that is, a contract to buy specific quantities of a commodity or financial instrument at a specified price with delivery set at a specified time in the future. These types of contracts fall into the category of derivatives. Such instruments are priced according to the movement of the underlying asset (stock, physical commodity, index, etc.). The aforementioned category is named “derivatives” because the value of these instruments is derived from another asset class.

History of futures exchanges

One of the earliest written records of futures trading is in Aristotle‘s book Politics. He tells the story of Thales, a poor philosopher from Miletus who developed a “financial device, which involves a principle of universal application”. Thales used his skill in forecasting and predicted that the olive harvest would be exceptionally good the next autumn. Confident in his prediction, he made agreements with local olive-press owners to deposit his money with them to guarantee him exclusive use of their olive presses when the harvest was ready. Thales successfully negotiated low prices because the harvest was in the future and no one knew whether the harvest would be plentiful or pathetic and because the olive-press owners were willing to hedge against the possibility of a poor yield. When the harvest-time came, and a sharp increase in demand for the use of the olive presses outstripped supply, he sold his future use contracts of the olive presses at a rate of his choosing, and made a large quantity of money. It should be noted, however, that this is a very loose example of futures trading and, in fact, more closely resembles an Option contract, given that Thales was not obliged to use the olive presses if the yield was poor.

The first modern organized futures exchange began in 1710 at the Dojima Rice Exchange in Osaka, Japan.

The United States followed in the early 19th century. Chicago is located at the base of the Great Lakes, close to the farmlands and cattle country of the U.S. Midwest, making it a natural center for transportation, distribution and trading of agricultural produce. Gluts and shortages of these products caused chaotic fluctuations in price, and this led to the development of a market enabling grain merchants, processors, and agriculture companies to trade in “to arrive” or “cash forward” contracts to insulate them from the risk of adverse price change and enable them to hedge.

Forward contracts were standard at the time. However, most forward contracts weren’t honored by both the buyer and the seller. For instance, if the buyer of a corn forward contract made an agreement to buy corn, and at the time of delivery the price of corn differed dramatically from the original contract price, either the buyer or the seller would back out. Additionally, the forward contracts market was very illiquid and an exchange was needed that would bring together a market to find potential buyers and sellers of a commodity instead of making people bear the burden of finding a buyer or seller.

In 1848, the Chicago Board of Trade (CBOT–) was formed. Trading was originally in forward contracts; the first contract (on corn) was written on March 13, 1851. In 1865, standardized futures contracts were introduced.

The Chicago Produce Exchange was established in 1874, renamed the Chicago Butter and Egg Board in 1898 and then reorganised into the Chicago Mercantile Exchange (CME) in 1919. In 1972 the International Monetary Market (IMM), a division of the CME, was formed to offer futures contracts in foreign currencies: British poundCanadian dollarGerman markJapanese yenMexican peso, and Swiss franc.

In 1881, a regional market was founded in Minneapolis, Minnesota and in 1883 introduced futures for the first time. Trading continuously since then, today the Minneapolis Grain Exchange (MGEX) is the only exchange for hard red spring wheat futures and options.

The 1970s saw the development of the financial futures contracts, which allowed trading in the future value of interest rates. These (in particular the 90-day Eurodollar contract introduced in 1981) had an enormous impact on the development of the interest rate swap market.

Today, the futures markets have far outgrown their agricultural origins. With the addition of the New York Mercantile Exchange (NYMEX) the trading andhedging of financial products using futures dwarfs the traditional commodity markets, and plays a major role in the global financial system, trading over 1.5 trillion U.S. dollars per day in 2005.

The recent history of these exchanges (Aug 2006) finds the Chicago Mercantile Exchange trading more than 70% of its Futures contracts on its “Globex” trading platform and this trend is rising daily. It counts for over 45.5 Billion dollars of nominal trade (over 1 million contracts) every single day in “electronic trading” as opposed to open outcry trading of Futures, Options and Derivatives.

In June 2001, ICE (IntercontinentalExchange) acquired the International Petroleum Exchange (IPE), now ICE Futures, which operated Europe’s leading open-outcry energy futures exchange. Since 2003, ICE has partnered with the Chicago Climate Exchange (CCX) to host its electronic marketplace. In April 2005, the entire ICE portfolio of energy futures became fully electronic.

In 2006, the New York Stock Exchange teamed up with the Amsterdam-Brussels-Lisbon-Paris Exchanges “Euronext” electronic exchange to form the first transcontinental Futures and Options Exchange. These two developments as well as the sharp growth of internet Futures trading platforms developed by a number of trading companies clearly points to a race to total internet trading of Futures and Options in the coming years.

In terms of trading volume, the National Stock Exchange of India in Mumbai is the largest stock futures trading exchange in the world, followed by JSE Limited in Sandton, Gauteng,South Africa.

Nature of contracts

For more details on this topic, see Futures contract.

Exchange-traded contracts are standardized by the exchanges where they trade. The contract details what asset is to be bought or sold, and how, when, where and in what quantity it is to be delivered. The terms also specify the currency in which the contract will trade, minimum tick value, and the last trading day and expiry or delivery month. Standardized commodity futures contracts may also contain provisions for adjusting the contracted price based on deviations from the “standard” commodity, for example, a contract might specify delivery of heavier USDA Number 1 oats at par value but permit delivery of Number 2 oats for a certain seller’s penalty per bushel.

Before the market opens on the first day of trading a new futures contract, there is a specification but no actual contracts exist. Futures contracts are not issued like other securities, but are “created” whenever Open interest increases; that is, when one party first buys (goes long) a contract from another party (who goes short). Contracts are also “destroyed” in the opposite manner whenever Open interest decreases because traders resell to reduce their long positions or rebuy to reduce their short positions.

Speculators on futures price fluctuations who do not intend to make or take ultimate delivery must take care to “zero their positions” prior to the contract’s expiry. After expiry, each contract will be settled , either by physical delivery (typically for commodity underlyings) or by a cash settlement (typically for financial underlyings). The contracts ultimately are not between the original buyer and the original seller, but between the holders at expiry and the exchange. Because a contract may pass through many hands after it is created by its initial purchase and sale, or even be liquidated, settling parties do not know with whom they have ultimately traded.

Compare this with other securities, in which there is a primary market when an issuer issues the security, and a secondary market where the security is later traded independently of the issuer. Legally, the security represents an obligation of the issuer rather than the buyer and seller; even if the issuer buys back some securities, they still exist. Only if they are legally cancelled they can disappear.

[From Wikipedia]

Futures contract

In finance, a futures contract is a standardized contract between two parties to exchange a specified asset of standardized quantity and quality for a price agreed today (the futures price or the strike price) with delivery occurring at a specified future date, the delivery date. The contracts are traded on a futures exchange. The party agreeing to buy the underlying asset in the future, the “buyer” of the contract, is said to be “long“, and the party agreeing to sell the asset in the future, the “seller” of the contract, is said to be “short“. The terminology reflects the expectations of the parties — the buyer hopes or expects that the asset price is going to increase, while the seller hopes or expects that it will decrease. Note that the contract itself costs nothing to enter; the buy/sell terminology is a linguistic convenience reflecting the position each party is taking (long or short).

In many cases, the underlying asset to a futures contract may not be traditional commodities at all – that is, for financial futures the underlying asset or item can be currencies,securities or financial instruments and intangible assets or referenced items such as stock indexes and interest rates.

While the futures contract specifies a trade taking place in the future, the purpose of the futures exchange institution is to act as intermediary and minimize the risk of default by either party. Thus the exchange requires both parties to put up an initial amount of cash, the margin. Additionally, since the futures price will generally change daily, the difference in the prior agreed-upon price and the daily futures price is settled daily also. The exchange will draw money out of one party’s margin account and put it into the other’s so that each party has the appropriate daily loss or profit. If the margin account goes below a certain value, then a margin call is made and the account owner must replenish the margin account. This process is known as marking to market. Thus on the delivery date, the amount exchanged is not the specified price on the contract but the spot value (since any gain or loss has already been previously settled by marking to market).

A closely related contract is a forward contract. A forward is like a futures in that it specifies the exchange of goods for a specified price at a specified future date. However, a forward is not traded on an exchange and thus does not have the interim partial payments due to marking to market. Nor is the contract standardized, as on the exchange.

Unlike an option, both parties of a futures contract must fulfill the contract on the delivery date. The seller delivers the underlying asset to the buyer, or, if it is a cash-settled futures contract, 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 can close out its contract obligations by taking the opposite position on another futures contract on the same asset and settlement date. The difference in futures prices is then a profit or loss.

Standardization

Futures contracts ensure their liquidity by being highly standardized, usually by specifying:

  • The underlying asset or instrument. This could be anything from a barrel of crude oil to a short term interest rate.
  • The type of settlement, either cash settlement or physical settlement.
  • The amount and units of the underlying asset per contract. This can be the notional amount of bonds, a fixed number of barrels of oil, units of foreign currency, the notional amount of the deposit over which the short term interest rate is traded, etc.
  • The currency in which the futures contract is quoted.
  • The grade of the deliverable. In the case of bonds, this specifies which bonds can be delivered. In the case of physical commodities, this specifies not only the quality of the underlying goods but also the manner and location of delivery. For example, the NYMEX Light Sweet Crude Oil contract specifies the acceptable sulphur content and API specific gravity, as well as the pricing point — the location where delivery must be made.
  • The delivery month.
  • The last trading date.
  • Other details such as the commodity tick, the minimum permissible price fluctuation.
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