Future: definition, operation, mechanisms and use

What are futures: definition and contract structure

Futures are financial instruments, or more precisely, standardized financial contracts whereby parties commit to exchange a certain asset, real or financial, at a predetermined price and with settlement at a future date. It is a type of derivative in which both buyer and seller are bound by a commitment to exchange the underlying asset, known as the underlying asset. This contract is distinguished by being symmetrical: both buyer and seller must fulfill their obligation by the contract’s maturity date. Traders take specific positions: those who buy the futures take a long position (long), committing to buy the asset at maturity, while those who sell it take a short position (short), assuming the obligation to sell.

In the futures market, however, it is common for the contract not to reach expiration, as positions are often closed by offsetting transactions. This means that the trader with an open position makes an opposite transaction to cancel his commitment, thus saving on the cost of physical delivery of the asset.

Settlement of futures: cash settlement and physical delivery

Futures can end in two ways: by cash settlement or by physical delivery of the underlying asset. Cash settlement is common and involves paying the difference between the initial price of the contract and the price at expiration. If, on the other hand, the contract matures without clearing, physical delivery requires the seller to deliver the exact quantity and quality of the asset defined in the terms of the contract. This mode is less commonly used in financial contracts, but more common in commodity futures, where the underlying asset could be an agricultural commodity or a raw material such as oil.

The exchange and the regulation of futures contracts

In the futures system, exchanges regulate contracts by specifying key elements such as the characteristics of the underlying asset, the amount of the contract, the place and period of delivery, the limits of price fluctuations, and the manner of quotation. For example, in Italy, index futures such as FTSE Mib Futures or Mini FTSE Mib are traded at Euronext Derivatives Milan. The Clearing House-in Italy, Euronext Cle aring-plays a crucial role: in addition to ensuring the fairness of transactions and settlements, it imposes margins to reduce the risk of default.

Margins in futures contracts

In order to participate in the futures market, margin payments must be made.

• The initial margin represents a percentage of the nominal value of the contract, set by the Clearing House.
• In addition, a variation margin is established to adjust positions daily to the market price, according to the marking-to-market mechanism.
• Finally, the delivery margin covers the risk of changes in the price of securities during the period from the last day of trading until delivery.

Main types of futures

Futures apply to a variety of underlying assets:

• Currency futures: Contracts in which one currency is traded for another at a fixed price. They are used both to hedge currency risks and for speculation.
• Commodity futures: These refer to commodities such as oil, grain or metals. They not only reflect the expected price of the commodity, but also include storage and insurance costs.
• Equity index futures: Indices such as the FTSE Mib or the S&P 500 are treated as underlying assets, and the future allows traders to earn on the change in the value of the index.

Purposes: hedging, speculation and arbitrage

Futures are used for different purposes.

• Hedgers use these contracts to hedge the risk associated with price fluctuations in the underlying asset, for example, securing a sale price for a commodity.
• Conversely, speculators seek to profit from price changes, taking on the risk of the trade in order to make gains.
• Finally, witharbitrage, traders exploit price differences between different markets, buying and selling the same security at the same time to make a profit.

Role of speculation in futures markets

The role of speculation in futures markets is crucial because it provides the liquidity needed for the market to function properly. Thanks to speculators, hedgers can find counterparties with whom to transfer risk. In addition, some economists believe that speculation helps stabilize prices because it allows risk to be spread among a larger number of participants. However, there are differing views on the ultimate impact of speculation, particularly on the cost of goods to consumers, as it can contribute to higher market prices, especially in times of economic instability.

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