What Is a Futures Contract?

A futures contract is a standardized agreement to buy or sell an underlying asset at a future date. Unlike most forwards, futures trade on organized exchanges and are typically cleared through a central clearinghouse. Contract size, expiry months, settlement procedures and other terms are standardized.

Futures exist on equity indices, government bonds, interest rates, currencies, commodities and other markets. They are widely used because they provide liquid and capital-efficient exposure.

Futures Versus Forwards

Both futures and forwards create a linear exposure to an underlying price. The major difference is market structure. A forward is usually bilateral and customized; a future is standardized, exchange-traded and centrally cleared. Futures are also marked to market daily, while a forward typically realizes most of its gain or loss at maturity or termination.

Initial and Maintenance Margin

A futures trader does not normally pay the full notional value of the contract. Instead, the trader posts margin. Initial margin is the amount required to open the position. Maintenance margin is the minimum balance that must be maintained. If losses reduce the account below required levels, additional funds may be required.

Margin is not a down payment on the underlying asset. It is collateral designed to support the daily settlement process and reduce credit risk.

Leverage

Because margin is only a fraction of notional exposure, futures create leverage. A useful exposure measure is:

\[
\text{Leverage} = \frac{\text{Notional Exposure}}{\text{Capital Committed}}
\]

If a contract provides $100,000 of market exposure while $10,000 is committed as margin, the exposure-to-capital ratio is 10 times. A 1% move in the underlying therefore has a much larger effect relative to the margin capital than it would on a fully funded cash position.

Marking to Market

At the end of each trading day, gains and losses are calculated using the settlement price and transferred through the margin account. This process is called marking to market. Daily settlement prevents unrealized losses from accumulating indefinitely and is a central feature of futures risk management.

Cash and Physical Settlement

Some futures settle through physical delivery of the underlying asset. Others are cash settled. Equity-index futures, for example, are generally settled using a cash amount linked to the final index value because delivering every constituent stock would be impractical.

Basis and Convergence

The basis is the difference between the spot price and the futures price. As expiry approaches, futures and spot prices should converge under normal market conditions. Before expiry, financing costs, income, storage and other carry components can cause futures prices to differ from spot prices.

Using Futures for Hedging

An equity portfolio manager can sell stock-index futures to reduce market beta temporarily without selling individual holdings. A bond manager can use interest-rate futures to alter duration. A commodity producer can sell futures to reduce uncertainty about the future selling price of production.

Key Takeaways

Futures combine standardized contracts, central clearing, margin and daily settlement. These features make them liquid and efficient, but leverage means that relatively small market moves can produce significant gains or losses relative to posted capital.

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