The best way to learn math and computer science.
Log in with Google
Log in with FacebookLog in with email
Join using Google
Join using FacebookJoin using email
Reset password New user? Sign up
Existing user? Log in
Sign up with Facebook or Sign up manually
Already have an account? Log in here.
Calvin Lin and Jimin Khim contributed
This is an introductory page in Options. If you are unfamiliar with any of the terms, you can refer to the Options Glossary.
A futures contract (future) is a standardized contract between two parties, to trade an asset at a specified price at a specified future date. The seller will deliver the underlying and the buyer will take delivery of the underlying and pay the agreed-upon price. The price that is agreed on is known as the future price or the delivery price and is determined when the contract is entered into. Since the price of the future is dependent on the price of the asset, this is a derivative instrument.
A futures contract is very similar to a forward contract. However, the futures market evolved to reduce the illiquidity and counter-party risk of the forward contract. A clearing house acts as the middleman, which performs the trade with both the buyer and seller. Clearinghouses overcome the potential credit risk by requiring the participants to put up an initial amount of cash, known as the initial margin. Futures positions are marked to market, and if there are insufficient funds, the exchange will require an additional maintenance margin, or is allowed to immediately liquidate the position.
True False
True or False?
A futures contract has very low counter-party risk.
Contents
- Features of a Future
- Payoff Diagrams
- Pricing Futures Contracts
Features of a Future
Each contract is standardized. The following information has already been determined.
The underlying asset, including its quality:
The amount and quality of the underlying asset. For example, 1000 bushels of Grade 4 corn.The time of maturity \( T: \)
The date at which the underlying is to be delivered. This could be a specific date or a time range.The place of delivery for physical underlying:
The place(s) at which the underlying is to be delivered. This is often a centralized location that is close to the place of production or transport.
Some futures contract are cash settled, which means that the seller of the future transfers the associated payoff in cash. This avoids having to deal with delivery or transportation concerns.The initial margin and margin maintenance amount:
This is determined by the exchange. Typically, the initial margin is 2 to 10 percent of the full value of the futures contract. When the position moves against the trader leading to a drop below the maintenance amount, then the trader will receive a margin call to top up the margin account, or be forcibly liquidated out of his position.
This allows the exchange to limit the amount of counter-party risk involved.
Note that the price of the contract is not stated. Instead, it is determined by market forces.
A futures contract is similar to a forward contract in that they both agree to trade an underlying at a specified future date. However, future contracts
- are traded through an exchange,
- are standardized,
- require a margin, and
- have negligible counter-party risk.
Your futures contract is invalidated You buy it back for $0 because they are bankrupt The bankruptcy court will decide a suitable settlement Nothing. Your contract is with the exchange The SEC will guarantee the contract
You sell a May Gold Futures contract from a Lehman Brothers trader. What happens when Lehman collapses?
Image credit: The logo is the trademark of Lehman Brothers.
Payoff Diagrams
The value of a futures position at maturity is the difference between the delivery price \( K \) and the underlying price \( S_T \) at the time of maturity:
- For a long position, the payoff is \( S_T - K \), and it will benefit from a higher underlying price.
- For a short position, the payoff is \( K - S_T \), and it will benefit from a lower underlying price.
Pricing Futures Contracts
For further details, see Pricing Forward and Futures.
The value of the physical delivery can be priced as
\[ F = S_0 e ^ { rt }. \]
Increases. It is more expensive to borrow money Stays constant. Interest rate has no effect Decreases. More people want to place their money in the bank Increases. More people can borrow money to buy stocks Decreases. It is more expensive to borrow money
How does the price of a future change as interest rate increases?
Image credit: Google Finance
Cite as: Futures contract. Brilliant.org. Retrieved from https://brilliant.org/wiki/futures-contract/
Join Brilliant The best way to learn math and computer science. Sign up
Sign up to read all wikis and quizzes in math, science, and engineering topics.
Log in with Google
Log in with FacebookLog in with email
Join using Google
Join using FacebookJoin using email
Reset password New user? Sign up
Existing user? Log in
