Futures are financial instruments that I deal with daily in my professional life, yet to most of my friends, they feel obscure and especially the word "derivative" makes them get  goosebumps. I hope that after reading this article, futures will become familiar and straightforward to you.

Futures are forwards that are traded on the exchange

To be honest, I could just write above sentence and conclude the article. If you could remember one thing from what I've written, it should be the title of this section:

Futures are forwards that are traded on the exchange.

A forward contract is an agreement between two parties, where one side buys good G from the other for price P, at a future date T. The detail, that goods are delivered and paid for in the future, is what differentiates a forward from a regular purchase. The moment of exchanging goods is called the settlement of the contract.

Usually, if you want to buy something, you just go to the shop and pay money in exchange for the goods instantly – on the spot. If instead, you would enter an agreement with the vendor, which obliged both of you to perform that transaction at some future date at the predetermined price – that would be a forward transaction. What makes forwards interesting is that the price is already determined at the moment of entering the contract.

Because the contract is entered into directly by two counterparties, it is called an over-the-counter product (OTC for short), in contract to exchange-traded products. Furthermore, that requires trust – what if the other party changes their mind between the contract signing date and a settlement date? In the finance world, that kind of risk is called the credit risk – when we're not sure that the counterparty will hold their end of the bargain up.

Given this requirement, usually, only large financial institutions and trustworthy entities enter forward transactions with each other. Forwards are generally not available for small investors directly. This risk is especially prominent, as the other party will most likely default (not pay their obligations) on the forward when the transaction turns out to be settled at a loss to them.

Pricing forward contracts

Let's make one concrete example of a forward trade. We want to enter a contract with a large bank on 1st of January 2017 to buy 1 ounce of gold on 1st of January 2018.

Additionally, a price of gold today (1st of January 2017) is 1200.00 USD per ounce and the safest one-year bond yields 2%.

With that information, what would be the fair price you would buy gold for on 1st of January 2018? A fair price is one for which you could both buy and sell a good, and you wouldn't be at a disadvantage doing either of these things.

Having 1200.00 USD today, you could buy an ounce of gold and hold it for a year. Alternatively, you could invest it in a bond, turning it into 1224.0 USD at the end of the period. Since both of these alternatives cost the same in terms of today's dollars, they're equivalent at the time of signing a contract. The fair price of an ounce of gold of gold on 1st of January 2018 is 1224.0 USD.

We can write down a formula for pricing forward contracts:

\[ F_T = S_t e^{r(T - t)} \]

where

\[ \begin{align*} T &- \textrm{settlement date} \\ t &- \textrm{contract signing date} \\ T-t &- \textrm{time to maturity} \\ F_T &- \textrm{Forward price} \\ S_t &- \textrm{Spot price} \\ r &- \textrm{interest rate} \end{align*} \]

An important thing to be aware of is that this price is only fair when the contract is entered. During the following year, the price of gold to be bought on the spot-\(S_t\) will fluctuate
and may end up significantly higher or lower than the \(F_T\) we've determined. Even though when the contract was signed, the price was fair, when it will be settled, one party most likely will have a significant advantage.

In other words, it may happen that after a year (on 1st of January 2018) one ounce of gold will cost 1400.0 dollars due to the high demand and uncertainty in the stock market. At the same time, we'll be paying only 1224.0 dollars for it (as agreed beforehand), which means the transaction would be profitable for us. That's also why the trust that our counterparty will hold their end of the deal up is so important when entering the contract.

Futures are traded on the exchange

As I've mentioned in the previous sections, forwards are entered into directly by two counterparties and bear credit risk.

Futures contracts are very similar in most ways – the participant is obliged to buy a particular good at a predetermined price on a future date. The difference is that futures are standardized and exchange-traded.

To make one liquid global marketplace for goods in future delivery, unit size, settlement dates and contract terms are fixed and the same for every participant – available for all investors via public exchanges. Exchanges are stable, regulated, transparent and liquid venues that intermediate trade between counterparties. In general terms, futures are available for the largest and most liquid markets in the world, although one can find a few ones that are relatively obscure and barely traded.

When executing a trade on the exchange, you don't know who you're entering the contract with. You send an order, and once it's executed, you have a position open. The other party does the same, and the buys and the sells are matched anonymously by the algorithms on the exchange. Since futures are just contracts, there is no difference between "buying" and "selling" -- these are just two sides of the same contract.

One may ask if we don't know who we are transacting with, how do settle the trade? Who do we pay or who will pay us? This is the moment, where the clearing house comes into play. They are entities closely connected to the exchanges, which provide clearing services for all trades performed.

According to the wikipedia[3], "clearing denotes all activities from the time commitment is made for a transaction until it is settled.". That's a pretty generic statement, giving very little insight into what does it involve.

So let's take a look into a more specific resource – CME Group (world's largest option and futures exchange) informational website glossary entry on clearing:

The procedure through which a clearing house becomes the buyer to each seller of a futures contract and the seller to each buyer, and assumes the responsibility of ensuring that each buyer and seller performs on each contract.

That illustrates a bit more about the process. When we execute the trade, we are matched with another trader. But from our perspective, our counterparty becomes the clearing house. The other side also transacts with the clearing hourse and only they now that these two orders were matched to each other.

We need to make one digression here and mention another concept linked closely to trading futures – margin. Before we can execute any trade in the futures market one needs to post collateral to the exchange (or through a broker) that will be used for covering any obligations.Before any trade is executed, a credit check is performed to assert that a posted margin is larger than an initial margin requirement for that position. Usually, exchanges allow to some extent for netting out the margin requirements so e.g. for spread positions margin requirements are smaller than for individual legs.

At the end of each trading session, a settlement price for each futures contract is determined, usually as a weighed average of price over a period shortly before the market is closed. The futures trades are settled daily, which means that after a settlement price has been determined, your account will be credited or debited the difference between the price you've entered the contract and the settlement price.

Where does this money come from? A margin of one of the counterparties taking part in the trade. Clearing houses monitor every margin account level carefully versus the maintenance margin requirement -- the minimum required to maintain the position, which should always be enough to cover any loss that may result from holding this position over the next day. If that requirement is not met a margin call is issued which is a call from the broker to the investor to post additional margin. If this request is not met, then certain positions will be liquidated for that account holder at the current market prices.

With above procedures, exchanges and clearing houses manage to almost completely remove the credit risk from futures markets. At the end of each trading session, one account is credited, and another is debited a certain amount depending on the current market prices – a clearing house is an entity managing the process. In the end trading futures is the zero sum game, what one side is earning another side is losing. To make sure that everyone has enough funds to settle their trades, each investor needs to keep margin posted at the exchange.

What about good delivery then? Firstly, a vast majority of futures are not delivered, most often traders close out their position before expiry. Still, a small fraction of the futures will get delivered. Some, like equity index futures or certain interest-rate products are cash-settled, which means delivery happens in the priced mark-to-market cash equivalent of the underying. But some futures indeed have physical delivery, which means that holding the contract until expiry will actually result in delivery of the underlying. There are numerous checks happening at the exchange and brokerage that should protect against such event happening, but there is at least one record online of a failed futures delivery [7].

Futures are derivatives

Futures are financial derivative contracts – they derive their value from an underlying asset. Like we've seen before it's just a contract between two counterparties on the future delivery of a good.

Derivatives fulfill an important role in the financial world, allowing investors to hedge their risks. Whether you're an airline, exposed to fluctuations in fuel prices, a corn farmer facing uncertainty at which price you'll be selling your goods or a US manufacturer buying parts from Europe in Euros – most human endeavors are exposed to multiple different sources of risk. Futures markets allow such entities to lock in the future price of goods to a known value beforehand, bringing predictability in future cash flows.

On the other side of the market, we have the speculators – hedge funds and day traders who take that risk and manage it, hoping to turn in a profit.

What kind of futures are there?

We've already talked quite a lot about futures, but without any concrete data.

To bring bring in some real-world examples, I've downloaded a quite extensive data set from Quandl[5] including five major US and European exchanges – CME group, Intercontinental Exchange(ICE), Eurex Exchange, Chicago Board Options Exchange (subsidiary of CME group) and London International Financial Futures  Exchange(LIFFE, subsidiary of ICE). Together, they cover most of the European and North American volume, but it's vital to remember we're not accounting for the activity happening in Asia, South America, Russia, Australia and other places.

Below you can find a breakdown of  volume and number of assets among these exchanges:

From this data set, I've summed total traded volume of all contracts traded for each asset for the year 2016. We can see a fat-tailed distribution of volume, where 100 most heavily traded underlyings account for 99.3% of activity. Top 10 account for 56.1%, top 20 account for 73.4%, and top 50 for 93.3%.

Let's see how this data looks on the graph (volume, for each futures type):

We can see on the graph that the most heavily traded types of contracts, but it's not clear what CME/ED means. For that, I've prepared the same data in the form of a table, which gives a more detailed look into what each futures actually is.

Exchange Code Volume
Eurodollar Futures CME ED 623'360'644
E-mini S&P 500 Futures CME ES 484'356'164
EURO STOXX 50 Index Futures EUREX FESX 374'448'391
10 Year Treasury Note Futures CME TY 354'309'424
Brent Crude Oil Futures ICE B 193'572'941
Euro-Bund Futures EUREX FGBL 186'621'883
5 Year Treasury Note Futures CME FV 166'237'866
Euro-Bobl Futures EUREX FGBM 130'668'939
Low Sulphur Gasoil Futures ICE G 122'278'270
Crude Oil Futures CME CL 114'159'170
EURIBOR Futures LIFFE I 103'175'690
Short Sterling Futures LIFFE L 102'914'799
Soybeans Futures CME S 92'648'132
Wheat Futures CME W 89'726'100
WTI Crude Futures ICE T 87'252'726
Natural Gas Futures CME NG 80'979'159
2-Year Treasury Note Futures CME TU 78'784'782
Euro-Schatz Futures EUREX FGBS 73'604'489
Treasury Bond Futures CME US 70'274'465
Corn Futures CME C 64'930'203
FTSE 100 Index Futures LIFFE Z 62'361'538
S&P 500 Volatility Index VIX Futures CBOE VX 60'124'279
Gold Futures CME GC 55'201'414
Euro Futures CME EC 49'904'967
Long Gilt Futures LIFFE R 45'693'167
E-mini Dow ($5) Futures CME YM 42'428'583
RBOB Gasoline Futures CME RB 39'158'655
mini MSCI Emerging Markets Index Futures ICE MME 37'559'484
Heating Oil Futures CME HO 35'883'454
E-mini NASDAQ 100 Futures CME NQ 35'102'564
EURO STOXX Banks Futures EUREX FESC 34'784'728
CAC40 Index Futures LIFFE FCE 33'388'481
Sugar No. 11 Futures ICE SB 30'358'748
British Pound Futures CME BP 29'214'521
Euro-OAT Futures EUREX FOAT 29'041'392
Federal Funds Futures CME FF 28'744'178
Long-Term Euro-BTP Futures EUREX FBTP 28'339'932
Russell 2000 Index Futures ICE TF 28'082'021
Mexican Peso Futures CME MP 27'960'374
Japanese Yen Futures CME JY 27'539'228
Ultra T-Bond Futures CME UL 27'351'459
DAX Futures EUREX FDAX 27'261'861
Soybean Oil Futures CME BO 26'170'836
Soybean Meal Futures CME SM 24'544'082
Cocoa Futures (Europe) LIFFE C 22'404'036
Copper Futures CME HG 21'264'498
Canadian Dollar Futures CME CD 18'669'492
Ultra 10-Year U.S. Treasury Note Futures CME TN 16'179'235
Nikkei/Yen Futures CME N1Y 14'777'311
Silver Futures CME SI 14'450'711
SMI Futures EUREX FSMI 12'745'019
Brent Crude Oil Financial (Brent look-alike) Futures CME BZ 12'565'789
Live Cattle Futures CME LC 12'391'693
Swiss Franc Futures CME SF 11'979'028
Euro-Buxl Futures EUREX FGBX 11'840'848
STOXX Europe 600 Index Futures EUREX FXXP 11'707'122
ECX EUA Futures (Carbon emission allowance) ICE C 11'696'874
EUROSWISS Futures LIFFE S 11'412'116
VSTOXX Futures EUREX FVS 10'084'867
AEX Index Futures LIFFE FTI 9'834'242
Heating Oil Futures ICE O 9'546'192
Coffee Futures ICE KC 9'288'386
mini MSCI EAFE Index Futures ICE MFS 9'256'126
Cocoa Futures (US) ICE CC 9'184'497
Milling Wheat Futures LIFFE EBM 8'975'719
Brent NX/WTI Crude Spr ICE TIB 8'594'794
KC Hard Red Winter (HRW) Wheat Futures CME KW 7'916'924
Australian Dollar Futures CME AD 7'559'031
Dollar Index Futures ICE DX 7'393'376
Cotton No. 2 Futures ICE CT 7'193'884
White Sugar Future ICE W 7'155'924
Short-Term Euro-BTP Futures EUREX FBTS 6'766'913
Lean Hogs Futures CME LN 6'185'359
New Zealand Dollar Futures CME NE 5'917'640
Canola Futures ICE RS 5'694'269
EURO STOXX 50 Index Dividend Futures EUREX FEXD 5'651'611
PJM Western Hub Real-Time Off-Peak Calendar-Month 5 MW Futures CME N9 5'373'924
(RBOB) Gasoline Futures ICE N 5'243'717
Robusta Coffee Futures LIFFE RC 4'058'659
UK Natural Gas Futures ICE M 3'895'650
Platinum Futures CME PL 3'832'722
Nikkei/USD CME NK 3'458'658
E-mini Crude Oil Futures CME QM 3'077'874
E-micro Euro/American Dollar Futures CME M6E 2'644'770
PJM Northern Illinois Hub Real-Time Off-Peak Calendar-Month 5 MW Futures CME B6 2'556'120
Rapeseed Futures LIFFE ECO 2'544'661
Feeder Cattle Futures CME FC 2'507'076
S&P MidCap Futures CME MD 2'459'370
S&P500 Futures CME SP 1'880'020
MSCI Europe Index Futures EUREX FMEU 1'727'702
Henry Hub Swap Futures CME NN 1'703'891
European Low Sulphur Gasoil (100mt) Bullet Futures CME GLI 1'456'598
PJM AEP Dayton Hub Real-Time Off-Peak Calendar-Month 5 MW Futures CME V3 1'393'037
Henry Hub Penultimate NP Futures CME NP 1'325'230
Mont Belvieu LDH Propane (OPIS) Futures CME B0 1'226'275
E-micro Australian Dollar/American Dollar Futures CME M6A 1'215'204
MISO Indiana Hub (formerly Cinergy Hub) Real-Time Off-Peak Calendar-Month 5 MW Futures CME H4 1'137'840
PJM Western Hub Day-Ahead Off-Peak Calendar-Month 5 MW Futures CME E4 1'129'110
Natural Gas (Henry Hub) Last-day Financial Futures CME HH 1'096'276
Coal (API2) CIF ARA (ARGUS-McCloskey) Futures CME MTF 1'089'966

We can see that the most popular futures market in the United States and Europe is the Eurodollar - contracts for interbank 3-month dollar deposits outside of the US – over 600 million lots traded. They're closely followed by stock index futures S&P 500 and EUROSTOXX 50 which are major stock indexes from the US and Europe respectively. On that list we can also see a lot of commodities, represented for example by Crude Oil, Wheat or Soybeans, currencies – among others EUR/USD , GBP/USD and MXN/USD.

The least represented is the volatility asset class with VIX and VSTOXX index futures available for trading. Below you can see a breakdown of both – volume and number of assets among asset classes:

Closing remarks

I hope I have scratched the surface of introductory knowledge to futures. You should know by now what futures are, where they are traded and what kind of different markets are the most popular.

If you have any questions not answered in this article, please ask them in the comments!

References