EDUCATORS ’ PERSPECTIVE
What is a Futures Contract ?
The CME Group defines a futures contract as : “ A standardized contract for the purchase and sale of financial instruments or physical commodities on a futures exchange for future delivery .” These contracts are used to hedge against price risk and to speculate .
Hedgers usually own the asset in question or need to own it . For instance , suppose a flour mill knows it will need to purchase wheat four months from now . The mill knows the amount of wheat it will need and when it will need it , but the price of wheat in four months is not known with certainty . Buying futures contracts for wheat can substantially reduce this price uncertainty and give the mill a better idea of what its production costs will be in four months .
Suppose the mill purchases a Chicago SRW Wheat futures contract , which obligates it to buy 5,000 bushels of wheat at $ 6.80 per bushel four months from now . If the price of wheat in four months is $ 7.30 per bushel , the mill saves 50 cents per bushel . However , if the price of wheat four months from now is $ 6.65 per bushel , the mill loses 15 cents per bushel because it is contractually obligated to buy wheat at $ 6.80 per bushel .
The other side of the trade may be taken by a wheat farmer who wants to sell wheat in four months and wishes to lock in a price . It may also be taken by a speculator who does not own the underlying asset ( wheat in this case ) or use it as a product input but is willing to bet on the direction of wheat prices in four months . Our flour mill operator is most likely concerned about rising wheat prices , but the speculator may have reason to believe that wheat prices will fall in four months .
The flour mill is hedging or reducing the price risk it bears by buying a futures contract . The speculator , on the other hand , is willing to bear that risk by selling a futures contract at a delivery price of $ 6.80 in four months . This obligates the speculator to sell wheat in four months at $ 6.80 , regardless of the actual price of wheat four months hence . If the price in four months increases to $ 7.30 , the speculator loses the 50 cents a bushel that the flour mill gains . If the price in four months decreases to $ 6.65 , the speculator gains the 15 cents per bushel that the flour mill loses . ( See the payoff diagram .)
Futures trading thus results in what is known as a zero-sum game . There is no wealth creation with a futures contract since the gains on one side of the contract are offset by losses on the other side of the contract .
The futures exchange clearinghouse stands between the buyer and the seller of a futures contract . Its primary purpose is to ensure that neither side defaults on the contract . This is accomplished through a variety of safeguards , including the clearinghouse making one side of the contract whole if the other side defaults .
For more information , see the CME Group publication , A Trader ’ s Guide to Futures ( https :// www . cmegroup . com / education / files / a-traders-guide-to-futures . pdf ).
Payoff Diagram for a Wheat Futures Contract
Markham , Jerry W . The History of Commodity Futures Trading and Its Regulation . Praeger : New York . 1987 .
Melamed , Leo and Bob Tamarkin . Leo Melamed : Escape to the Futures . John Wiley & Sons : New York . 1996 .
Morse , Laurie and David Greising . Brokers , Bagmen , and Moles : Fraud and Corruption in the Chicago Futures Markets . Wiley : New York . 1991 .
Newman , Kara . The Secret Financial Life of Food : From Commodities Markets to Supermarkets . Columbia University Press : New York . 2012 .
Onions : Hearings before the Subcommittee on Domestic Marketing of the Committee on Agriculture , House of Representatives , Eighty-fifth Congress , first session on H . R . 376 , H . R . 1933 , H . R . 1935 , H . R . 3418 , H . R . 5236 , and H . R . 5732 , May 1 , 2 , and , 3 , 1957 . United States Government Printing Office : Washington , DC . 1957 .
Past , Present , and Futures : Chicago Mercantile Exchange . Write Stuff Enterprises : Fort Lauderdale , Florida . 2008 .
Tamarkin , Bob . The Merc : The Emergence of a Global Financial Powerhouse . HarperBusiness : New York . 1993 .
Tamarkin , Bob . The New Gatsbys : Fortunes and Misfortunes of Commodity Traders . Morrow : New York . 1985 .
Warden , Philip . “ Chicago Onion Dealer Named for Price Fix : Federal Complaint Accuses Two .” Chicago Daily Tribune , 7 . 1956 .
Notes
1 . This definition can be found at https :// www . cftc . gov / LearnAndProtect / Education Center / CFTCGlossary / glossary _ co . html
2 . Egg futures continued to trade until September 1982 . Lambert writes , “ The egg business had changed . Small farms had been swallowed by big ones . Growers built confined operations with chicken buildings the size of football fields to supply the supermarket chains that had replaced corner grocers . The price of eggs was stable and predictable , and the space on the trading floor could be put to better use . So one day the egg futures trade disappeared . The era of the egg men was officially over .”
3 . Storability is crucial for agricultural commodities futures . Perishable produce , such as lettuce or snow peas , which must be consumed soon after they are harvested , are only sold on the spot market .
4 . These were futures contracts which obligated Kosuga and Seigel to buy onions at specified prices in November when the contracts expired .
5 . Cox ’ s work as special prosecutor during the Watergate scandal in the early 1970s helped propel Ford into the presidency after Nixon was forced to resign .
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