{"id":251,"date":"2019-04-09T08:30:45","date_gmt":"2019-04-09T08:30:45","guid":{"rendered":"http:\/\/algotrading101.com\/wiki\/?p=251"},"modified":"2019-04-30T07:35:55","modified_gmt":"2019-04-30T07:35:55","slug":"futures-finance","status":"publish","type":"post","link":"https:\/\/algotrading101.com\/wiki\/futures-finance\/","title":{"rendered":"Futures (Finance)"},"content":{"rendered":"\n

Definition<\/strong><\/p>\n\n\n\n

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A future contract is a legal agreement for a buyer to buy a certain amount of goods (or a seller to sell a certain amount of goods) at a predetermined future date and price.<\/p>\n\n\n\n

Description<\/strong><\/p>\n\n\n\n

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Futures contracts are traded at a centralized financial exchange.<\/p>\n\n\n\n

Each future contract is based on an underlying asset. This underlying asset is the good that is exchanged at a future date<\/p>\n\n\n\n

Example<\/strong><\/p>\n\n\n\n

Today (9th April 2019), trader X buys 1 contract (1000 barrels) of crude oil futures at $60 with an expiry on 30th June 2019 from trader Y. In other words, trader Y sold 1 contract of crude oil futures at $60 to trader X.<\/p>\n\n\n\n

On 30th June 2019, trader X is required to buy 1000 barrels of crude oil from trader Y at $60. Trader Y is required to sell 1000 barrels of crude oil to trader X.<\/p>\n\n\n\n

If the actual crude oil (more specifically, WTI oil) is priced at $65 on 30th June, trader X profits as he can buy the oil at $60 and immediately sell it at $65. Conversely, trader Y will lose as he has to buy the oil at $65 from the market to sell it at $60 to trader X.<\/p>\n\n\n\n

Purpose of Futures<\/strong><\/p>\n\n\n\n

There are 2 main purposes to trading futures – 1) Speculation and 2) Hedging.<\/p>\n\n\n\n

Speculation<\/u><\/p>\n\n\n\n

Traders make bets on the future price changes of certain assets. They trade futures instead of the underlying asset as it is more conveniently and cheaper.<\/p>\n\n\n\n

Hedging<\/u><\/p>\n\n\n\n

Companies hold commodities for their business operations. An airline uses jet fuel for its planes. Thus, to protect against raising prices, they buy jet fuel futures.<\/p>\n\n\n\n

Financial institutions hold various assets and have exposures to certain market risks. They buy and sell futures to protect themselves against unwanted risks. <\/p>\n\n\n\n

Settlement<\/strong><\/p>\n\n\n\n

Settlement is the process in which the underlying good of the futures contract is exchanged. There are 2 kinds of settlement – 1) physically delivery and 2) cash-settled.<\/p>\n\n\n\n

Physically delivery<\/u><\/p>\n\n\n\n

The seller of the futures contract must deliver the specified goods to the buyer.<\/p>\n\n\n\n

Cash-Settled<\/u><\/p>\n\n\n\n

The trader who made a lost on the trade will pay the other party the amount he lost.<\/p>\n\n\n\n

In the above crude oil example, trader Y has to pay trader X $5000 (($65-$60)*1000 barrels) when the futures contract expires on 30th June 2019.<\/p>\n\n\n\n

Pricing<\/strong><\/p>\n\n\n\n

There are 2 popular pricing theories – 1) Arbitrage and 2) Expectations<\/p>\n\n\n\n

Arbitrage<\/u><\/p>\n\n\n\n

Arbitrage is a fancy word that describes a scenario where 2 similar assets should be similarly priced, accounting for any limitation.<\/p>\n\n\n\n

This pricing theory states that a futures contract should be priced similarly to its underlying product, accounting for any holding or opportunity costs.<\/p>\n\n\n\n

Expectations<\/u><\/p>\n\n\n\n

This theory states that a futures contract should be priced higher if the market expects the price of the underlying to be higher in the future, and vice versa.<\/p>\n\n\n\n

Examples of Popular Futures Contracts<\/strong><\/p>\n\n\n\n

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