A market that enables buyers and sellers to exchange contracts for the future delivery of commodities or financial instruments. If a commodity producer wishes to sell a commodity in the future, he can assure his ability to do so by selling a futures contract today. Alternatively, if a commodity user needs to buy a commodity in the future, he or she can make certain that he may do so by buying a futures contract today. Futures markets, therefore, make it possible for producers and consumers to act today to make sure that they will be able to do what they want to do in the future. Futures markets arose from the need to reduce price risk in commodity trading.
In the early part of the last century, it was common in the United States for farmers to bring their products to market at a set time of the year. Often this resulted in a glut during market season, and farmers found prices very depressed when they came to sell their products. At other times, prices could be very high because of shortages. Some farmers and merchants began to make contracts for future delivery, assuring the farmers at least a minimum price for their crops.
After the Civil War, there evolved the formal practice of futures trading at commodity exchanges like the Chicago Board of Trade and elsewhere, as traders began to exchange contracts for future delivery that were standardized as to grade, size, and time of delivery. Standardization was important to the growth of futures trading because it made on futures contract for a specific commodity identical and thus interchangeable with other contracts for delivery of the same commodity during the same time period.
It is contract standardization that distinguishes a futures contract from a forward contract. A forward contract is tailored to the needs of the individual buyer and seller, and is an agreement between the two of them directly. A futures contract is a standardized agreement that takes place under rules prescribed by the futures exchange on which the contract is traded. Each buyer or seller deals through the exchange clearing house, and each is insured against default by the exchange itself.
Today organized futures markets for the exchange of standardized contracts for future delivery exist for a large number of items, including grains and feeds (wheat, corn, soybeans), livestock (cattle, hogs, porkbellies), metals (copper, silver, gold), lumber, and financial assets (foreign currencies, stocks, and debt instruments). The prices of futures contracts for these items are published daily in the Wall Street Journal and elsewhere. The appended table shows a set of quotations for futures contracts traded during a typical day. The exchange where the contracts are traded is shown in parentheses next to the name of the commodity or financial instrument. Each row of price quotes reflects the day's trading in a particular futures contract. The delivery date of the contracts is listed as the first item on each row. for example, July corn traded on the Chicago Board of Trade (CBT) or gold for delivery in August sold on the Commodity Exchange in New York (CMX).
The open price is that of the first transaction during the day. The high and low are the highest and lowest prices during the day. And the settlement price is an average of the high and low prices during the "closing period" as defined by the exchange, usually the last two minutes of trading.
The open interest reflects the number of outstanding contracts at the end of the previous day's trading. For each commodity or financial instrument, the Journal also reports the total volume of trading (number of contracts exchanged) on the day in question and on the previous trading day.
Holders of outstanding contracts must ultimately settle their positions either by liquidation through offsetting purchases or sales, or by receiving or delivering the physical commodity against the contract. The great majority of futures contracts are settled by offset. Only 3% of all contracts result in delivery of the actual goods.
Interest rate futures are based on long and short-term, fixed-income financial debt instruments with prices that vary inversely to their interest rates. The term "interest rate futures" refers to specific contracts for interest sensitive financial instruments. Stock index futures are based on the performance of a group of stocks; these futures allow investors to protect a portfolio of stock from a decline in value. Stock index futures contracts are based on cash settlement, rather than delivery of a commodity or financial instrument. The use of futures markets by financial institutions is regulated by the guidelines of regulatory agencies. The guidelines vary across regulators. The Comptroller of the Currency, which regulates national banks, allows the use of financial futures for activities deemed to be "incidental to banking." The Comptroller's policy allows hedging to reduce a bank's overall interest rate exposure. The Federal Home Loan Bank Board, regulator of federal savings and loan associations, allows associations to hedge when the hedging is used to reduce overall interest rate exposure.
The FINANCIAL ACCOUNTING STANDARDS BOARD (FASB) provides guidelines for accounting for futures contract in Statement of Financial Accounting Standards No. 80, Accounting for futures contracts, Statement of Financial Accounting Standards, August 1984. The rules allow the use of deferral accounting for futures transactions that meet the following hedge criteria. First, the asset of liability to be hedged exposes the institution to price or interest rate risk. Second, the futures contract selected reduces the interest rate exposure of the institution, is specifically designated as a hedge, and its price is highly correlated with the cash item being hedged. Futures transactions not meeting these criteria will be accounted for by marking-to-market.
TEWELES, R.J., and JONES, FRANK J. The Futures Game, 1987.
This book has an extensive bibliography covering the following areas:
HERBST, A.F. Commodity Futures: Markets, Methods of Analysis and Management of Risk, 1986.
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