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Futures and Forwards

Of all the securities dealt with in this book, the one that readers will most likely benefit from a primer is derivatives. When it comes to derivatives, the general incomprehension surrounding those instruments was nicely captured by a member of US Congress when he said: “What is a derivative? I wouldn’t know one if it hit me in the face”.[1] It is best to begin our primer with the most basic derivative instrument: the futures contract. This consists of the obligation to either buy or sell a specified amount of an underlying asset at a specified point in the future. The price, however, is set at the time the contract is initiated. As such, the party that buys a futures contract—who is said to go long—agrees to take delivery of the underlying asset at the stipulated date and price. Conversely, the party that sells a futures contract—who is said to go short—agrees to make delivery of the underlying asset at the stipulated date and price.

To illustrate this, consider gold. Futures on the yellow metal are most actively traded on the Commodity Exchange Inc. (COMEX) division of the New York Mercantile Exchange (NYMEX). Each gold futures contract represents 100 troy ounces. At any one time, there will be a series of contracts available for different delivery months. Now imagine that it is late 2015 and that the December 2016 gold is trading at $1070 per ounce. Anyone, then, who buys that gold futures contract assumes the obligation to pay $1070 per ounce for 100 ounces of gold when December 2016 arrives (the exact date is defined by the exchange) to the seller of the contract. The latter, in turn, assumes the obligation to come up with the precious metal and deliver the stipulated amount at the initially agreed price.

Hence, a future contract—and this is the same with every derivative instrument—is effectively created out of thin air by two traders willing to take opposing sides of a prospective exchange. Unlike a stock or a bond, there is usually no organization, such as a company or governmental body, which originates the security and ultimately grounds its value over time. With derivatives, the distinction between the primary market (where organizations issue securities to investors) and the secondary market (where investors trade securities among themselves) disappears. It is replaced by that between the futures and spot market. The latter is where the asset underlying a derivative, like gold, is traded for immediate delivery. Arbitrage tends to keep the spot and futures prices of the asset aligned, with the difference between the two reflecting the risk-free interest foregone in fully paying for the asset now in addition to the cost of carrying it in terms of storage and any other payments associated with holding it.6

Despite the arbitrage link that ties futures to their respective spot markets, very few who trade these derivatives instruments end up taking part in the delivery process. Indeed, some futures contracts, those on stock indices for instance, entirely dispense with the delivery requirement. These are settled on a cash basis via a payment of the difference in the value of the underlying asset between the initially set price and that at the expiration of the futures contract. Even where settlement ultimately involves delivery, anyone with a futures contract is able, prior to maturity, to transfer their delivery obligations to someone else. Where they have been long, they would sell their contracts; where they have been short, they would buy them. When the party on the opposing side of such a trade is also liquidating their position, the result is that both sets of obligations to engage in a subsequent spot transaction are canceled. The futures contract literally disappears. When it comes time for delivery, the only parties typically left with a position are those who have a direct commercial interest in the underlying asset. In our gold example, these would include miners of the precious metal and jewelry makers.

So where does the huge leverage involved with futures trading come from? Since the vast majority of market participants avoid delivery, brokerage firms are under no pressure to demand that future traders demonstrate ownership of the underlying asset on entering a short position. Similarly for those entering a long position. Brokers do not need assurance that buyers of futures contracts have the money needed to purchase the underlying asset. Instead, futures traders are expected to make a margin deposit in opening a trade, enough to cover adverse changes in the value of the

John Hall, Options, Futures, and other Derivatives, (Upper Saddle River, NJ: 2009), 118.

deliverable good throughout the duration of the position. While this is open, trades are marked to market on a daily basis. Hence, whenever the futures price has risen, the brokerage accounts of the longs are credited by the daily appreciated value of their positions, while the shorts are equivalently debited—and the opposite whenever the futures price has declined for the day. The initial margin requirement to cover the entry into a futures trade is usually less than 10 % of the value of the underlying asset and, indeed, is often in the 2-5 % range. If one considers that the margin for stocks in the USA is typically 50 %, one can begin to grasp where the huge leverage in futures comes from. To continue with our gold example, the initial margin required on the COMEX was $3750 per contract in late 2015, which works out to 3.5 % of the $107,000 which 100 ounces of gold were worth at the time. If someone buys a gold futures contact at $1070 per ounce and then, a month later, sells it at $1170, the profit is $10,000 ($100 price change X 100 ounces) less commissions. The trader more than doubles their initial investment. Had they simply bought the same amount of actual gold in the spot market, and then sold it at the same price a month afterwards as well, the profit would still be around $10,000. But the initial outlay would have been higher at $107,000. The percentage rate of return would only have been 9.3 %, instead of being 167 %. Needless to say, if gold had gone down $100, rather than up, then the futures trader would have lost their entire margin deposit plus an additional $6250. By contrast, the spot market participant would have only lost 9.3 % of their investment.

Forwards are structurally similar to futures. They also comprise obligations to either buy or sell a certain asset at a presently agreed upon price with delivery set for a later date. The difference is that forwards are not standardized in the way that futures are by the exchanges with respect to the quantity and nature of the underlying asset as well as the scheduled delivery time. Forward contacts thus have the advantage of being customizable to fit user needs. If a mining company needs gold delivery set for a month for which the exchange does not offer a liquid contract, then it is best off going to the forward market. Another difference is that futures prices and transactional volumes are more transparent to the public than those negotiated in the forwards markets. There, data availability tends to be confined to private dealer networks. But the most significant distinction between the two—precisely where recent proposals to regulate derivatives have been directed—is that a clearing house guarantees that the required cash disbursements are made on futures contracts. With forwards, there is no such third party. In that market, traders must rely on the good faith and financial resources of their counterparties, whereas futures eliminate the risks of non-compliance entailed by this dependence.

The first recorded instance of a forward contract occurred in Mesopotamia during the nineteenth century BC. Wood was the underlying asset of this maiden derivative trade. The terms of the trade were written down on a tablet, involving someone named Ashak-shemi promising to deliver 30 planks to a Damqanin at an unspecified future date.[2] Later, the ancient Greeks legally proscribed derivatives, which suggests at the very least that these were being illicitly transacted. Still, they tolerated forwards in grain to facilitate imports of this key commodity from Egypt. While following the Greeks in initially prohibiting derivatives, the Romans eventually allowed contracts for future delivery.[3] [4] Later in the medieval era, forward contracts were commonly negotiated at fairs and in the carry trade.8 Such contracts featured prominently in the Tulipmania of 1636-1637, becoming the main vehicle by which speculation was conducted on tulip bulbs.[5] [6] Around the same time, futures contracts on rice with standardized terms began to be traded in Japan. In the USA, the Chicago Board of Trade (CBOT), founded in 1848, introduced grain futures in 1865. It was soon followed by the Chicago Produce Exchange in 1874 specializing in butter and eggs. Out of this organization, a splinter group formed the Chicago Butter and Egg Board before becoming the Chicago Mercantile Exchange (CME) in 1919.1 1 Agricultural products continued to dominate futures trading until the 1970s when the derivatives market was revolutionized by the CME’s introduction of currency futures in 1972. Soon afterwards, a flurry of additional contracts based on financial instruments was inaugurated, such as Treasury bill futures in 1975, bond futures in 1979, equity index futures in 1982, and Eurodollar futures in 1983. [7] Besides the CME, other leading trading marts today include the Swiss-German based EUREX, London International Financial Futures Exchange (LIFFE), and London Metals Exchange.

Anyone first coming across the list of available futures contracts cannot help but be impressed by the diversity of the assets traded. The agricultural segment that historically grounds the futures markets encompasses contracts on corn, wheat, soybeans, sugar, orange juice, cotton, rice, milk, live cattle, and lean hogs. Pork bellies, long a symbol in the popular mind of the oddball activity that takes place on futures exchanges, was discontinued in 2011. Then there is the metals category, embracing gold, silver, platinum, steel, zinc, aluminum, and copper. Crude oil futures, in both its West Texas Intermediate and Brent variants, lead the energy sector that came to the fore beginning in the 1980s, a sector which also includes contracts on natural gas, heating oil, and gasoline. The most actively traded area of all, though, are the financial futures, with the most significant contracts there being those on the S&P 500 index, Eurodollars, US ten-year Treasury notes, and Euro currency. In the forward markets, the financials also reign. Beyond these four major sectors, the futures exchanges have been inventive of late, devising contracts based, not on an asset but on events. Thus, there are futures on the weather in which payoffs can depend on the temperature in a specified place, or the occurrence of rain, snow, frost, and hurricanes.

  • [1] Quote from Luke Zubrod, “Four Years Later: Dodd-Frank and Derivatives”, UnconventionalWisdom (August 1, 2014), at
  • [2] Ernst Juerg Weber, “A Short History of Derivative Security Markets”. In Vinzenz Bronzin’sOption Pricing Models'. Exposition and Appraisal, eds. Wolfgang Hafner and HeinzZimmerman (Berlin: Springer, 2009), 434.
  • [3] Ernst Juerg Weber, “A Short History of Derivative Security Markets”. In Vinzenz Bronzin’sOption Pricing Models'. Exposition and Appraisal (Springer, 2009), 436-437.
  • [4] Edward J. Swan, Building the Global Market. A 4000 Year History of Derivatives (London:Kluwer, 2000), 113-126.
  • [5] Charles Mackay, Extraordinary Popular Delusions and the Madness of Crowds, 95-96; Fora discussion of futures and forward trading beyond tulips that took place in Amsterdam, seeOscar Gelderblom and Joost Jenker, “Amsterdam as the Cradle of Modern Futures andOptions Trading, 1550-1650”, in The Origins of Value: The Financial Innovations ThatCreated Modern Capital Markets, eds. William N. Goetzmann and K. Geert Rouwenhorst,189-206, (Oxford: Oxford University Press, 2005).
  • [6] Donald Spence, Introduction to Futures and Options, (Cambridge, UK: WoodheadPublishing, 1997), 24-26.
  • [7] Franklin Allen and Douglas Gale, Financial Innovation and Risk Sharing (Cambridge:MIT Press, 1994), 27.
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