Standardised contract between two parties
Figure 1: participants in futures deal
All futures contracts in all international futures markets are standardised. A future is a legal contract between two parties setting out the details: price, expiry date, etc. At least one party to the contract must be a member of the exchange. As noted, even though a client may buy a future from, or sell a future to, a member of the exchange, the transaction is guaranteed by the exchange, i.e. the exchange acts as the seller for each buyer, and as the buyer for each seller: it interposes itself in each futures deal. This may be illustrated simply as in Figure 1.
Buyer and seller
It should be evident that the futures market is a typical example of a "zero sum game", i.e. for every buyer of a contract there is a seller. Consequently, if the buyer makes a loss, the seller gains by the same amount. The converse is obviously also true. As noted earlier, the buyer and the seller deal with a member of the exchange, unless the buyer and seller are members of the exchange.
Even though the standard definition of a future emphasizes delivery, in practice this is rare, particularly in the financial futures markets. The reason for this is simply that the participants in the futures markets prefer settlement of the profit or loss on expiry date. Even if they wanted delivery, in many cases this is not possible. In the case of a future on an equity index, for example, it is impossible to deliver the index. Nowadays, delivery takes place in only a few financial and commodity futures contracts.
Every futures contract obviously has a specific size, as opposed to a forward contract where size is negotiated between buyer and seller. For example, in the case of the equity / share index futures contracts in South Africa, the size of each contract is ZAR10 x the index value. In the commodities futures markets the contract sizes are usually multiples of standard units, for example, tons, ounces, barrels, bushels, etc.
This is important in the commodities futures markets, particularly in the case of perishable assets. Quality is obviously not an issue in the case of financial futures markets. In these markets contracts are based on underlying specific assets or notional assets the qualities of which do not vary.
A futures contract is a derivative instrument, i.e. it and its value are derived from an underlying asset and it cannot exist in the absence of this asset. The underlying assets of futures contracts can be divided into two broad categories, i.e. specific assets and notional assets, and there are various subcategories under each, such as storable assets, perishable assets, income-producing assets, etc. Specific (also called "physical") assets include the specific bonds and equities, pork bellies, etc, while notional assets include the industrial index, the all share index, the gold index, etc. One may also categorise futures broadly into financial futures and commodity futures, and then split them further into sub-categories as follows:
• Financial futures:
- Interest rates (for example, future on a specific bond, future on a bond index).
- Shares / equities (for example, future on an individual share, future on equity / share index).
- Currencies (for example, future on the USD/GBP exchange rate, future on currency index).
• Commodity futures:
- Agricultural (for example, future on livestock, future on maize).
- Metals and energy (for example, future on gold price, future on crude oil).
Price is the core of a future. Essentially, futures market participants are fixing a price now for settlement in the future. Clearly therefore, the price of the future is related to the price of the underlying instrument. As the price of the underlying instrument varies, so does the price of the future (but not always to the same extent).
The other vital feature of futures contracts is the expiry date, i.e. the date when delivery or cash settlement takes place. Needless to say, the price of the future at the expiry time on the expiry date is equivalent to the spot price. It will therefore be clear that the futures price moves closer to the spot price as time goes by (i.e. it converges on the spot price).
The contract trades (in the sense that it can be reversed = "closed out") because it has a value, and this value is largely influenced by the spot price of the underlying asset, but also by expectations. Price is the only feature of the future that varies. Each contract has a minimum movement size or "tick size", for example LCC1.