Introduction to Futures Contracts

Futures contacts can be viewed as modifications on forward contracts, but is imperative to understand the differences.

Futures cover either commodities or financial instruments.

Like forward contracts, futures contracts are priced based on an arbitrage relationship.

NOTE: Futures contracts for commodities can incorporate additional variables related to storing the underlying asset.

Futures Contract Characteristics

• Futures are traded on regulated exchanges (not over the counter).

• Contract terms are standardized with respect to the: deliverable, contract size, settlement date, and method of settlement (alternatively, forwards are customized).

• A clearinghouse guarantees contract performance, which eliminates counter-party credit risk; alternatively forward contract participants face the risk that the counter-party will not perform on the contract.

• Counterparties post margin with the clearinghouse in order to help ensure contract performance.

• The value of a futures contract is reset to zero daily, as the daily gain/loss on the contract is netted against the margin posted by the counter parties.

• The mechanics of a futures trade is standardized.

Closing a Futures Contract – 3 ways

1. Enter an offsetting position before contract expiration.
2. Deliver the underlying asset at expiration.
3. Settle in cash at expiration.

For some contracts on financial assets, physical delivery is not allowed and cash settlement is required.

Value of a Futures Contract

Forward contracts can accrue significant positive or negative value during their life.

Because the daily gain or loss on a futures contract is netted against the margin posted by the counterparties, the value of a futures contract remains approximately zero during the contract term.