FUTURE (Encyclopedia)

Financial futures are contracts in which the two parties agree on purchasing a pre-determined quantity of an asset at a pre-defined price. They are standardised (expiration, underlying asset, settlement method) and are traded on stock exchanges. They are traded by means of the Clearing House and therefore the counterparty risk is eliminated. From an economic point of view, derivatives can be used to hedge, speculate and arbitrage. Futures are widely used to hedge core business risks: an example is a foreign exchange contract where the buyer, a European exporter, can hedge the euro-dollar exchange rate by buying futures on the euro-dollar exchange rate. Futures are considered to be an efficient financial instrument to hedge. Speculation usually refers to a purchase that does not correspond to any underlying asset in the portfolio. Arbitrage means that operators look for mis-priced contracts, between spot and derivatives markets, and try to exploit the differential in prices at their favour.
The standard formula to price a financial future, in the absence of arbitrage and with constant interest rates, is:
F: future price; S: spot price of the underlying asset; e: exponential function; r: risk-free interest rate (constant from the underwriting of the contract to its expiration); t: expiration of the contract (length).
Functions of futures are the same of derivatives.
In Italy, they are traded on the MIF and IDEM.

1. Origin.

The first futures contracts were traded in ancient Mesopotamia, on agricultural commodities (corn, wheat). The trading took place at the temple, and the priests played the clearinghouse function. More recently, derivatives and futures spread in Northern Europe (16th and 17th century), and after the first half of 17th century in the USA.
Financial futures appeared in 1972 on the Chicago Mercantile Exchange (CME), in the form of foreign exchange futures, together with the settlement of the International monetary market-IMM. The first future on interest rate appeared in 1975 at the Chicago Board of Trade (CBOT). In Europe, futures have been traded on the London Stock Exchange since 1982, and today this market is the second biggest after the CBOT. The most developed and deepest stock exchange for derivatives is the one in Chicago: it is named Chicago Board of Trade (CBOT) and it trades commodities (wheat, corn, soy, orange juice, and many others). With regard to financial assets, the Chicago Board Option Exchange (CBOE) and the New York Stock Exchange are the biggest markets. The high level of standardisation makes futures contracts liquid, tradable and marketable.

2. Types of futures.

Futures are traded on stock exchanges worldwide, and are written on commodities, financial securities, probabilities and events.

2.a) Commodity futures.

They can be traded on every commodity, industrial or not. For agricultural goods and precious metals, this market is very important. For energy goods (e.g. oil), it should be a relevant indicator of future spot prices; however, during 2007-09, this forecasting ability dramatically diminished.

The share of futures traded OTC is very high.

2.b) Financial futures.

They are written on any type of financial security, like currencies, interest rates, stock indices, shares, bonds, Treasury Bonds and Bills.

2.c) Event Futures.

They bet on the probability of an event like the default of a creditor (Credit Default), or on the weather (rain or not) which directly influences the agricultural activity.

3. Trading.

It takes place by means of a broker that operates through the clearing house (CH). Buyers and sellers never meet, but the CH guarantees all transactions. At the writing of the contracts, the parties pay an initial margin, between 2% and 10% of the nominal value of the contract. At end of every trading day, a maintenance margin should be paid to eliminate the counterparty risk.
Hull J. (2008) Options, futures and other derivatives, Prentice Hall.
Oldani C. (2008) Governing Global Derivatives, Ashgate, London.
Editor: Chiara OLDANI

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