Derivatives Demystified: A Step-by-Step Guide to Forwards, Futures, Swaps and Options, Second Edition

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Commodity and Bond Futures

INTRODUCTION

A futures contract is an agreement made through an organized exchange to buy or to sell a fixed amount of an underlying commodity or financial asset on a future date (or within a range of dates) at an agreed price. Some contracts result in the physical delivery of the underlying. Others are cash-settled which means that the difference between the agreed price and the market price of the underlying on the future date is paid in cash.

Futures are either traded by open outcry in trading pits in the form of an auction, or on electronic screen-based systems. The merged Chicago exchanges CME and CBOT currently (2010) operate both methods in tandem. Other exchanges such as LIFFE in London (now part of NYSE Euronext) and Eurex (the Swiss-German market) are wholly electronic. On an exchange traders representing member organizations transact orders for their own firm and also act on behalf of clients including banks, corporations, money managers and private individuals.

Main Functions of a Futures Exchange

The exchange does not buy or sell contracts on its own account. Its main functions are to facilitate trading, to monitor conduct and ensure that the rules are adhered to, and to publish the prices at which trades are agreed. Overall, the exchange enables price discovery i.e. it helps buyers and sellers to come together to agree a price at which both sides are willing to trade.

When a trade is agreed the details are entered into the exchange’s ...