E-496 RM2-1.0 01-09 Risk Management Introduction To Futures Markets James Mintert and Mark Welch* Futures trading has a long history, both in the (CME) was formed in 1874 when the Chicago U.S. and around the world. Futures trading on Product Exchange was organized to trade butter. a formal futures exchange in the U.S. originated In each case the exchanges were formed because with the formation of the Chicago Board of commercial dealers in corn, wheat and butter Trade (CBOT) in the middle of the 19th Century. needed a way to reduce some of their price risk, Grain dealers in Illinois were having trouble which hampered the day-to-day management financing their grain inventories. The risk of of their businesses. Sellers wanted to rid them- grain prices falling after harvest made lenders selves of the price risk associated with owning reluctant to extend grain dealers credit to pur- inventories of grain or butter and buyers wanted chase grain for subsequent sale in Chicago. To to establish prices for these products in advance reduce their risk exposure, grain dealers began of delivery. In recent years futures contracts have selling “To Arrive” contracts, which specified proliferated, particularly in the financial arena, the future date (usually the month) a speci- as businesses become more aware of the price fied quantity of grain would be delivered to a risks they face and seek ways to reduce them. particular location at a price identified in the contract. Fixing the price in advance of deliv- What Is A Futures Contract? ery reduced the grain dealer’s risk and made it easier to obtain credit to finance grain purchas- A futures contract is a binding agreement be- es from farmers. The “To Arrive” contracts were tween a seller and a buyer to make (seller) and to a forerunner of the futures contracts traded take (buyer) delivery of the underlying commod- today. Although dealers found it advantageous ity (or financial instrument) at a specified future to trade what essentially were forward cash con- date with agreed upon payment terms. Most tracts in various commodities, they soon found futures contracts don’t actually result in delivery these forward cash contract markets inadequate of the underlying commodity. Instead, most trad- and formed futures exchanges. ers find it advantageous to settle their futures The first U.S. futures exchange was the Chi- market obligation by selling the contract (in the cago Board of Trade (CBOT), formed in 1848. case of a contract that was purchased initially) or Other U.S. exchanges also began in the last by buying it back (in the case of a contract that half of the 1800s. For example, the Kansas City was sold initially). The trader then completes the Board of Trade (KCBT) traces its roots to January actual cash transaction in his or her local cash 1876 when a precursor to today’s hard red wheat market. futures contract was first traded. Similarly, a Futures contracts are standardized with forerunner of the Chicago Mercantile Exchange respect to the delivery month; the commodity’s quantity, quality, and delivery location; and the *Professor and Extension Agricultural Economist, Kansas State University Agricultural Experiment Station and Cooperative Extension Service, and Assistant Professor and Extension Economist–Grain Marketing, The Texas A&M System. payment terms. The fact that the terms of futures Changes in a Futures contracts are standardized is important because it enables traders to focus their attention on one Contract’s Value variable, price. Standardization also makes it A futures contract’s value is simply the num- possible for traders anywhere in the world to ber of units (bushels, hundredweight, etc.) in trade in these markets and know exactly what each contract times the current price. Each con- they are trading. This is in sharp contrast to the tract specifies the volume of grain or livestock it cash forward contract market, in which changes covers. Both Chicago and Kansas City Board of in specifications from one contract to another Trade grain and oilseed futures contracts cover might cause price changes from one transac- 5,000 bushels. The CME’s live cattle futures con- tion to another. One reason futures markets are tract covers 40,000 pounds (400 hundredweight) considered a good source of commodity price of live weight steers. The lean hogs futures con- information is because price changes are attrib- tract covers 40,000 pounds (400 hundredweight) utable to changes in the commodity’s price level, of carcass weight pork and the feeder cattle not changes in contract terms. futures contract covers 50,000 pounds (500 hun- Unlike the forward cash contract market, dredweight) of feeder steers. To determine both futures exchanges provide: contract value and changes in contract value, • Rules of conduct that traders must follow examine the July KCBT wheat futures contract or risk expulsion on a day when the settlement price is $6.00 per • An organized market place with estab- bushel. The total contract value would simply be lished trading hours by which traders 5,000 bushels times $6.00 or $30,000. If the July must abide KCBT wheat futures price changes to $6.10 per • Standardized trading through rigid con- bushel the next day, the new contract value is tract specifications, which ensure that 5,000 bushels times $6.10 or $30,500. The change the commodity being traded in every in contract value is $30,500 minus $30,000, or contract is virtually identical $500. Alternatively, you can compute the change • A focal point for the collection and in contract value by simply multiplying the price dissemination of information about change per unit ($6.10-$6.00=$0.10/bushel) times the commodity’s supply and demand, the number of units in the contract ($0.10/bushel which helps ensure all traders have x 5,000 bushels= $500). equal access to information The effect of a change in contract value de- • A mechanism for settling disputes pends on whether you previously sold or pur- among traders without resorting to the chased a futures contract. A decrease in contract costly and often slow U.S. court system value (a price decline) is a loss to anyone who • Guaranteed settlement of contractual previously purchased a futures contract, but a and financial obligations via the ex- gain for a trader who previously sold a futures change clearinghouse contract. Conversely, an increase in contract value (a price increase) is a gain to anyone who The Purpose of Futures Markets previously purchased a futures contract (i.e., is long), but is a loss for a trader who previously Futures markets serve two primary purposes. sold a futures contract (i.e., is short). One trader’s The first is price discovery. Futures markets loss is another trader’s gain. For example, in the provide a central market place where buyers previous wheat futures example, a trader who and sellers from all over the world can interact purchased July KCBT wheat futures at $6.00/ to determine prices. The second purpose is to bushel saw the value of his futures market ac- transfer price risk. Futures give buyers and sell- count increase by $500 when the price rose to ers of commodities the opportunity to establish $6.10; a trader who sold a futures contract at prices for future delivery. This price risk transfer $6.00/bushel saw the value of his futures market process is called hedging. 2 account decline by $500. The $500 gain earned contract (typically less than 5 percent of contract by the futures contract buyer came from the fu- value), traders of futures contracts are relieved of tures contract seller’s $500 loss via the exchange the responsibility of worrying that the trader on clearinghouse, as outlined in Figure 1. the other side of the contract will default on his Futures contract performance is guaranteed or her financial obligations by the mark-to-mar- by the exchange through an institution known ket margin system and by a series of checks and as the exchange clearinghouse, which tracks balances put in place by the exchange to ensure the value of each trader’s position and ensures that sufficient funds are available to cover each that sufficient funds are available to cover each account’s risk exposure. trader’s obligations. The exchange clearing- house requires that traders (via the futures Futures Trading Terminology Figure 1. Marking-to-Market Buyer and Seller Accounts To trade futures contracts you must become at Exchange Clearinghouse. familiar with the terminology used in the trade. Buyer (Long) Here are some terms and definitions. Date Action Price Long A buyer of a futures contract. Someone Day 1 Buy at $6.00/bu who buys a futures contract is often referred to as being long that particular Day 2 No action (but $6.10/bu contract. price increases) Short A seller of a futures contract. Someone who $0.10/bu gain sells a futures contract is often referred to x 5,000 bu as being short that particular contract. $500 gain Bull A person who expects a commodity’s price from day 1 to increase. If you are bullish about wheat Seller (Short) prices you expect them to increase. Date Action Price Bear A person who expects a commodity’s price to decline. If you are bearish about wheat Day 1 Sell at $6.00/bu prices you expect them to decline. Day 2 No action (but $6.10/bu Market An order to buy or sell a futures contract at price increases) order the best available price. A market order is executed by the broker immediately.