Many people think that futures markets are just about speculating or “gambling.” Futures markets can be used for speculating, but they are designed as vehicles for hedging and risk management so that people can avoid “gambling” if that is not their choice. For example, a wheat farmer who plants a crop is, in effect, betting that the price of wheat won’t drop so low that the farmer would have been better off not planting at all. This bet is inherent to the farming business, but the farmer may prefer not to make it. The farmer can hedge this bet by selling a wheat futures contract. Futures markets can be used for both hedging and speculating.

Because a forward contract is similar to a futures contract from an economic standpoint, it is helpful to begin by defining a forward contract. A forward contract is an agreement between two parties (say, a wheat farmer and a breakfast cereal manufacturer) in which the seller (the farmer) agrees to deliver to the buyer (the cereal manufacturer) a specified quantity and quality of an asset or commodity (the wheat) at a specified future date at an agreed upon price. A forward contract can be distinguished from a spot contract, that is, a contract for immediate delivery of the commodity.

A forward contract is typically a privately negotiated bilateral contract that is not conducted on an organized marketplace or exchange. The contract terms are not standardized but are determined by what the parties agree on. The price generally is determined when the contract is entered into, although there are some forward contracts where the parties may agree to transact at a price to be determined later in a manner that is specified on the day the contract is entered into.

Forward contracts are primarily merchandising vehicles, whereby both parties expect to make or take delivery of the commodity on the agreed upon date. It is difficult to get out of a forward contract unless you can get your counterparty to agree to extinguish the contract. To enter into a forward contract, it is also necessary to find someone who wants to buy exactly what you want to sell when and where you want to sell it. As such, forward contracts are commonly used as merchandising vehicles in a variety of commodity and currency markets; however, forward contracts lack certain features that make futures contracts especially useful for hedging.

Futures contracts are very similar to forward contracts, but futures contracts typically have certain features that make them more useful for hedging and less useful for merchandising than forward contracts. These include the ability to extinguish positions through offset, rather than actual delivery of the commodity, and standardization of contract terms.

Futures contracts typically are traded on organized exchanges in a wide variety of physical commodities (including grains, metals, and petroleum products) and financial instruments (such as stocks, bonds, and currencies). Before around 1970, most futures trading was in agricultural commodities, such as corn and wheat. Today, successful futures markets exist in a variety of non-agricultural commodities, including metals such as gold, silver, and copper and fossil fuels such as crude oil and natural gas.

The most widely traded futures contracts are in financial instruments, such as interest rates, foreign currencies, and stock indexes. Single-stock futures, banned in the United States for many years, began trading in November 2002.

Traditionally, futures contracts were traded in an open outcry environment where traders and brokers in brightly colored jackets shout bids and offers in a trading pit or ring. While open outcry is still the primary method of trading agricultural and other physical commodity futures in the U.S., trading in many financial futures has been migrating to electronic trading platforms (where market participants post their bids and offers on a computerized trading system). Almost all futures trading outside the U.S. is conducted on electronic platforms.

Standardized terms. Futures contracts have standardized terms that are determined by the exchange, rather than by market participants. Standardized terms include the amount of the commodity to be delivered (the contract size), delivery months, the last trading day, the delivery location or locations, and acceptable qualities or grades of the commodity.

For example, the Chicago Board of Trade (CBOT) wheat futures contract provides for delivery of 5,000 bushels of any of several varieties of wheat during March, May, July, September, or December in Chicago or any of several other specified delivery locations. The exchange specifies that different varieties and grades can be delivered at various fixed differentials (premiums or discounts) to the contract price.

This standardization enhances liquidity, by making it possible for large numbers of market participants to trade the same instrument. This liquidity makes the contract more useful for hedging, but, on the other hand, the standardization reduces the usefulness of a futures contract as a merchandising vehicle.

A Nebraska farmer who wants to deliver wheat to his or her elevator near Omaha, might find the CBOT wheat futures contract useful for hedging, but would not want to make delivery on the futures contract, since the closest CBOT wheat futures delivery point is in St. Louis. Instead, he or she will buy back or offset the contract before the last trading day and sell the wheat on the spot market locally, as they would have if they had not used the futures market. Most futures contracts (by volume) are liquidated via offset and do not result in delivery. The purpose of the physical delivery provision is to ensure convergence between the futures price and the cash market price.

Clearing. Futures trades that are made on an exchange are cleared through a clearing organization (clearing house), which acts as the buyer to all sellers and the seller to all buyers. When you buy or sell a futures contract, you are technically buying from, or selling to, the clearing organization rather than the party with whom you executed the transaction on the trading floor or through an electronic trading platform. Since you ultimately buy and sell from the same party, if you buy a futures contract and subsequently sell it (probably to a different party than you bought it from but technically back to the clearing house), you have offset your position and the contract is extinguished. Compare this to the forward market: If you buy a forward contract and then sell an identical forward contract to a different person, you now have obligations under two contracts—one long and one short.

Margin. Futures traders are not required to put up the entire value of a contract. Rather, they are required to post a margin that is typically between 2 percent and 10 percent of the total value of the contract. Margins in the futures markets are not down payments like stock margins, but are performance bonds designed to ensure that traders can meet their financial obligations.

When a futures trader enters into a futures position, he or she is required to post initial margin of an amount specified by the exchange or clearing organization. Thereafter, the position is "marked to the market" daily. If the futures position loses value when the market moves against it—if, for example, you are buying and the market goes down—the amount of money in the margin account will decline accordingly. If the amount of money in the margin account falls below the specified maintenance margin (which is set at a level less than or equal to the initial margin), the futures trader will be required to post additional variation margin to bring the account up the initial margin level. On the other hand, if the futures position is profitable, the profits will be added to the margin account. Futures commission merchants (FCMs) often require their customers to maintain funds in their margin accounts that exceed the levels specified by an exchange.

These examples are simplified for ease of understanding and they do not consider “basis.”

Hedging Example One: a Chicago Board of Trade wheat futures contract. The CBOT contract provides for delivery of 5,000 bushels of wheat in Chicago and various other locations during the contract month. The available contract months are July, September, December, March, and May.

Suppose a farmer near Omaha, Nebraska plants wheat with an expected yield of 50,000 bushels during the spring at a time when the CBOT contract for delivery during December (the first new crop contract month for spring wheat) is trading at $3.50 per bushel. While the price of wheat in the Omaha area may differ from the futures price (which reflects wheat prices in one of the delivery locations: Chicago, St. Louis, Toledo, Ohio, or Burns Harbor, Indiana), it is reasonable to assume that the prices are closely related.

The farmer knows that if he or she can sell the wheat at $3.50 per bushel, there will be a reasonable profit. By planting the wheat, the farmer is in effect betting that the price of wheat will not decline between now and harvest time. Such bets are intrinsic to the business of farming, since farmers have no control over the prices they receive for their crops.

A farmer can hedge this bet by establishing a short futures position at the current quoted price of $3.50 per bushel. Since each futures contract provides for delivery of 5,000 bushels and the expected harvest is 50,000 bushels, the farmer would sell ten futures contracts.

In this example, the initial margin for a hedger and the maintenance margin on the wheat contract are both $650 per contract. The farmer must deposit at least $6,500 with the clearing organization through a futures commission merchant (FCM) to cover the margin for the ten contracts sold. Each day the position is marked to market. This means that if the market moves in the farmer's favor—the futures price declines on a particular day—the farmer’s margin account is credited with the accrued profit for that day. On each day that the futures price rises, the margin account is debited with the accrued loss. On any day when the margin account falls below $6,500, the farmer is required to post variation margin to bring the account back up to at least $6,500.

At harvest time, the weather has been ideal and the farmer does harvest 50,000 bushels of wheat. In general, there has been a bumper crop and the futures contract has declined to $3.00 per bushel. The farmer now has 50,000 bushels of wheat in his silo and is short 50,000 bushels of wheat on the futures market. The farmer now needs to unwind this hedged position—there are two ways to accomplish this.

One way is to make delivery pursuant to the terms of the futures contract at one of the specified delivery locations during the delivery period. This would require paying to transport the wheat to one of the locations specified in the futures contract, which would be cost prohibitive from Nebraska.

The vast majority of futures contracts are liquidated via offset rather than delivery, in part because the delivery mechanism is inconvenient for most market participants.

In our example, the farmer is better off taking an equal and opposite position in the futures market by buying ten contracts at the current price of $3.00 per bushel. The ten contracts the farmer bought offset the ten contracts previously sold. The farmer no longer has a futures position.

Assuming that there have been no deposits or withdrawals, the farmer’s margin account has increased by $25,000 (50 cents per bushel times 50,000 bushels). The futures trade has given the farmer a profit of 50 cents per bushel. The farmer can complete the unwinding of the hedged position by selling the 50,000 bushels of wheat at the local elevator for the current spot price of $3.00 per bushel. Considering the 50 cent profit on the futures trade, the farmer has effectively received $3.50 per bushel for the wheat. The hedge in this instance was successful.

It is of course possible that after the farmer hedges his position on the futures market the price of wheat will rise rather than fall. If the price of wheat rises to $4.00 per bushel, the farmer will lose 50 cents per bushel on the futures trade, but will be able to sell the wheat on the spot market for $4.00 per bushel. His effective price is $3.50 per bushel. This does not mean that the hedge was not successful. The farmer considers himself to be in the business of growing crops, rather than betting on the price of wheat. Sometimes the price of wheat goes up and sometimes it goes down, but hedging provides the farmer with the peace of mind of knowing what his profit will be, regardless of price changes.

Hedging Example Two: The producers and food manufacturers who purchase grain can use futures contracts to hedge the risk that grain prices will go up—known as a long hedge. For example, a breakfast cereal manufacturer who uses wheat and expects to purchase 50,000 bushels in December (which is several months away) can purchase ten December Chicago Board of Trade futures contracts for $3.50 per bushel. The manufacturer will post margin with the clearing organization just like the farmer in Hedging Example One.

By purchasing the futures contracts, the manufacturer effectively locks in a price of around $3.50 per bushel, whether the price of wheat goes up or down between now and December. When December rolls around, the manufacturer will probably buy wheat on the spot market and sell and offset the futures contracts rather than taking delivery.

Other Uses of Hedging. Hedging can be extended to other types of futures contracts. An oil producer can sell crude oil futures contracts to hedge against the possibility that oil prices will decline. An electricity-generating firm that uses natural gas for fuel can buy natural gas futures contracts to hedge against the possibility that natural gas prices will rise. A pension fund with a portfolio of stocks can use stock index futures to manage the risks associated with stock price fluctuations. Importers and exporters can use currency futures contracts to hedge the risk of adverse changes in exchange rates.

Short-term interest rate futures contracts (such as Eurodollar futures or Federal funds futures contracts) and long-term interest rate futures contracts (such as Treasury note and bond futures contracts) can be used to hedge a variety of risks associated with rises and falls in interest rates. A bank with variable-rate assets (for example, variable-rate credit card accounts) can use short-term interest rate futures to hedge the risk that the yield on these assets will decline due to a decline in interest rates. By buying short-term interest-rate futures, the bank can effectively convert these variable-rate assets to fixed-rate assets. An insurance company with a portfolio of Treasury notes can sell Treasury note futures contracts to hedge against the risk of long-term interest rates rising (which would cause the value of the Treasury note portfolio to decline).

Basis. The hedging examples we used are simplified because we ignored basis—the difference between the futures price and a specified cash market spot price.

For example, in August, the December Chicago Board of Trade wheat contract is trading at $3.50 per bushel and the spot price in Chicago is $3.45 per bushel. In this case, the basis is 5 cents futures over cash.

The basis can be affected by a number of factors, including interest rates and the cost of storing the commodity. If you buy a futures contract rather than the commodity itself, you do not pay the total value of the contract, but instead post a margin deposit that is typically a small fraction of the total value of the contract.

In part, the basis is determined by the fact that you can collect interest on the difference between your margin deposit and the total value of the contract. The basis also is determined in part by the fact that by not holding the actual commodity, you save on storage costs. Futures prices for physical commodities are thus typically higher than spot prices, a situation known as contango.

Differences in quality and grade as well as expectations about future supply (for example the expected crop yield) also can affect the basis. If expected future supplies greatly exceed current supplies (for example, last year’s crop was poor and this year’s crop is expected to be excellent), futures prices may be lower than spot prices, a situation known as backwardation.

Basis Risk. Returning to Hedging Example One, the Omaha farmer who was hedging his wheat crop with the Chicago Board of Trade wheat futures contract that provides for delivery in Chicago, Burns Harbor, St Louis, or Toledo at various differentials specified by the CBOT. Any short position holder who does want to deliver will want to do so at whichever location is cheapest given the differentials and actual transportation costs. At delivery time the futures price will converge with the spot price in one of those locations. Since the farmer plans to sell his wheat in Omaha, he is more concerned with the spot price in Omaha than spot prices in any of the other locations. While the spot price of wheat in the Omaha area is closely related to the CBOT wheat futures price, the correlation is not perfect and the basis between the Omaha spot price and the futures price can change. For example, Omaha wheat prices may go down 55 cents from $3.50 per bushel to $2.95, while the futures price declines only 45 cents from $3.50 to $3.05. If the basis changes adversely in this way, a futures market hedge will not cover all of the farmer’s cash market loss. This possibility is known as basis risk.

Futures contracts are often relied on for price discovery as well as for hedging. In many physical commodities (especially agricultural commodities), cash market participants base spot and forward prices on the futures prices that are “discovered” in the competitive, open auction market of a futures exchange.

This price discovery role is considered an important economic purpose of futures markets. In financial futures contracts such as stocks, interest rates, and foreign currency, the price discovery role of futures occurs in tandem with the cash markets, which also contribute significantly to price discovery.

A speculator is one who does not produce or use a commodity, but risks his or her own capital trading futures in that commodity in hopes of making a profit on price changes. While speculation is not considered one of the economic purposes of futures markets, speculators do help make futures markets function better by providing liquidity, or the ability to buy and sell futures contracts quickly without materially affecting the price. Long and short hedgers may not be sufficient to create a liquid futures market by themselves. The participation of speculators willing to take the other side of hedgers' trades adds liquidity and makes it easier for hedgers to hedge.

Types of speculators include: