A futures exchange or futures market is a central financial exchange where people can trade standardized futures contracts ; that is, a contract to buy specific quantities of a commodity or financial instrument at a specified price with delivery set at a specified time in the future.
These types of contracts fall into the category of derivatives. The opposite of the futures market is the spots market , where trades will occur immediately 2 business days after a transaction agreement has been made, rather than at a predetermined time in the future.
Futures instruments are priced according to the movement of the underlying asset stock, physical commodity, index, etc. The aforementioned category is named "derivatives" because the value of these instruments are derived from another asset class.
According to The New Palgrave Dictionary of Economics Newbery , futures markets "provide partial income risk insurance to producers whose output is risky, but very effective insurance to commodity stockholders at remarkably low cost.
Speculators absorb some of the risk but hedging appears to drive most commodity markets. The equilibrium futures price can be either below or above the rationally expected future price backwardation or contango Rollover hedges can extend insurance from short-horizon contracts over longer periods. The code facilitated the first derivatives, in the form of forward and futures contracts. An active derivatives market existed, with trading carried out at temples. One of the earliest written records of futures trading is in Aristotle 's Politics.
He tells the story of Thales , a poor philosopher from Miletus who developed a "financial device, which involves a principle of universal application".
Thales used his skill in forecasting and predicted that the olive harvest would be exceptionally good the next autumn. Confident in his prediction, he made agreements with local olive-press owners to deposit his money with them to guarantee him exclusive use of their olive presses when the harvest was ready. Thales successfully negotiated low prices because the harvest was in the future and no one knew whether the harvest would be plentiful or pathetic and because the olive-press owners were willing to hedge against the possibility of a poor yield.
When the harvest-time came, and a sharp increase in demand for the use of the olive presses outstripped supply availability of the presses , he sold his future use contracts of the olive presses at a rate of his choosing, and made a large quantity of money.
The first modern organized futures exchange began in at the Dojima Rice Exchange in Osaka , Japan. Before the exchange was created, business was conducted by traders in London coffee houses using a makeshift ring drawn in chalk on the floor.
Lead and zinc were soon added but only gained official trading status in The exchange was closed during World War II and did not re-open until The exchange ceased trading plastics in The United States followed in the early 19th century. Chicago has the largest future exchange in the world, the Chicago Mercantile Exchange.
Chicago is located at the base of the Great Lakes , close to the farmlands and cattle country of the Midwest , making it a natural center for transportation, distribution, and trading of agricultural produce. Gluts and shortages of these products caused chaotic fluctuations in price, and this led to the development of a market enabling grain merchants, processors, and agriculture companies to trade in "to arrive" or "cash forward" contracts to insulate them from the risk of adverse price change and enable them to hedge.
For most exchanges, forward contracts were standard at the time. However, most forward contracts were not honored by both the buyer and the seller. For instance, if the buyer of a corn forward contract made an agreement to buy corn, and at the time of delivery the price of corn differed dramatically from the original contract price, either the buyer or the seller would back out.
Additionally, the forward contracts market was very illiquid and an exchange was needed that would bring together a market to find potential buyers and sellers of a commodity instead of making people bear the burden of finding a buyer or seller. Trading was originally in forward contracts ; the first contract on corn was written on March 13, In standardized futures contracts were introduced.
Following the end of the postwar international gold standard , in the CME formed a division called the International Monetary Market IMM to offer futures contracts in foreign currencies: In a regional market was founded in Minneapolis, Minnesota , and in introduced futures for the first time. Trading continuously since then, today the Minneapolis Grain Exchange MGEX is the only exchange for hard red spring wheat futures and options.
Futures trading used to be very active in India in the early to late 19th Century in the Marwari businessmen community. There are records available of standardized Opium futures contracts done in 's in Calcutta. The first organised futures market was established only in by the Bombay Cotton Trade Association to trade in cotton contracts.
In modern times, most of the futures trading happens in the National Multi commodity Exchange NMCE which commenced futures trading in 24 commodities on 26 November on a national scale.
The s saw the development of the financial futures contracts, which allowed trading in the future value of interest rates. Today, the futures markets have far outgrown their agricultural origins. In April the entire ICE portfolio of energy futures became fully electronic. In the New York Stock Exchange teamed up with the Amsterdam-Brussels-Lisbon-Paris Exchanges "Euronext" electronic exchange to form the first transcontinental futures and options exchange.
These two developments as well as the sharp growth of internet futures trading platforms developed by a number of trading companies clearly points to a race to total internet trading of futures and options in the coming years. Exchange-traded contracts are standardized by the exchanges where they trade. The contract details what asset is to be bought or sold, and how, when, where and in what quantity it is to be delivered.
The terms also specify the currency in which the contract will trade, minimum tick value, and the last trading day and expiry or delivery month. Standardized commodity futures contracts may also contain provisions for adjusting the contracted price based on deviations from the "standard" commodity, for example, a contract might specify delivery of heavier USDA Number 1 oats at par value but permit delivery of Number 2 oats for a certain seller's penalty per bushel.
Before the market opens on the first day of trading a new futures contract, there is a specification but no actual contracts exist. Futures contracts are not issued like other securities, but are "created" whenever Open interest increases; that is, when one party first buys goes long a contract from another party who goes short.
Contracts are also "destroyed" in the opposite manner whenever Open interest decreases because traders resell to reduce their long positions or rebuy to reduce their short positions. Speculators on futures price fluctuations who do not intend to make or take ultimate delivery must take care to "zero their positions" prior to the contract's expiry.
After expiry, each contract will be settled , either by physical delivery typically for commodity underlyings or by a cash settlement typically for financial underlyings. The contracts ultimately are not between the original buyer and the original seller, but between the holders at expiry and the exchange.
Because a contract may pass through many hands after it is created by its initial purchase and sale, or even be liquidated, settling parties do not know with whom they have ultimately traded. Compare this with other securities, in which there is a primary market when an issuer issues the security, and a secondary market where the security is later traded independently of the issuer.
Legally, the security represents an obligation of the issuer rather than the buyer and seller; even if the issuer buys back some securities, they still exist.
Only if they are legally cancelled can they disappear. The contracts traded on futures exchanges are always standardized. In principle, the parameters to define a contract are endless see for instance in futures contract. To make sure liquidity is high, there is only a limited number of standardized contracts. Most large derivatives exchanges operate their own clearing houses, allowing them to take revenues from post-trade processing as well as trading itself.
By netting off the different positions traded, a smaller amount of capital is required as security to cover the trades. There is sometimes a division of responsibility between provision of trading facility, and that of clearing and settlement of those trades. Derivative exchanges like the CBOE and LIFFE take responsibility for providing the trading environments, settlement of the resulting trades are usually handled by clearing houses that serve as central counterparties to trades done in the respective exchanges.
Derivative contracts are leveraged positions whose value is volatile. They are usually more volatile than their underlying asset. This can lead to credit risk , in particular counterparty risk: In a safe trading environment, the parties to a trade need to be assured that the counterparties will honor the trade, no matter how the market has moved.
This requirement can lead to complex arrangements like credit assessments and the setting of trading limits for each counterparty, thus removing many of the advantages of a centralised trading facility. To prevent this, a clearing house interposes itself as a counterparty to every trade, in order to extend a guarantee that the trade will be settled as originally intended.
This action is called novation. As a result, trading firms take no risk on the actual counterparty to the trade, but instead the risk falls on the clearing corporation performing a service called central counterparty clearing.
The clearing corporation is able to take on this risk by adopting an efficient margining process. A margin is collateral that the holder of a financial instrument has to deposit to cover some or all of the credit risk of their counterparty , in this case the central counterparty clearing houses.
Clearing houses charge two types of margins: The Initial Margin is the sum of money or collateral to be deposited by a firm to the clearing corporation to cover possible future loss in the positions the set of positions held is also called the portfolio held by a firm.
Several popular methods are used to compute initial margins. The Mark-to-Market Margin MTM margin on the other hand is the margin collected to offset losses if any that have already been incurred on the positions held by a firm.
This is computed as the difference between the cost of the position held and the current market value of that position. If the resulting amount is a loss, the amount is collected from the firm; else, the amount may be returned to the firm the case with most clearing houses or kept in reserve depending on local practice.
In either case, the positions are ' marked-to-market ' by setting their new cost to the market value used in computing this difference.
The positions held by the clients of the exchange are marked-to-market daily and the MTM difference computation for the next day would use the new cost figure in its calculation. Clients hold a margin account with the exchange, and every day the swings in the value of their positions is added to or deducted from their margin account.
If the margin account gets too low, they have to replenish it. In this way it is highly unlikely that the client will not be able to fulfill his obligations arising from the contracts. As the clearing house is the counterparty to all their trades, they only have to have one margin account.
This is in contrast with OTC derivatives, where issues such as margin accounts have to be negotiated with all counterparties. Each exchange is normally regulated by a national governmental or semi-governmental regulatory agency:.
There are several sources of futures data on the internet which can be used by professional traders, analysts and individual investors. The largest collection of futures data online can be found on Quandl and can be downloaded in any format.
From Wikipedia, the free encyclopedia. For markets that trade directly in predictions of future events, see Prediction market. Derivatives Credit derivative Futures exchange Hybrid security. Foreign exchange Currency Exchange rate. For more details on this topic, see Futures contract. Bond market Commodity markets Currency market List of futures exchanges List of traded commodities Paper trading Prediction market Stock market Trader finance.
Futures markets, hedging and speculation. The New Palgrave Dictionary of Economics 2 ed.More...