Investment Theory and Risk Management, + Website

Institutional Detail and Futures Mechanics

Futures markets exist because of fundamental uncertainty about how future events will unfold and the concomitant risk that events may turn against us. Uncertainty breeds two types of futures market participants—hedgers, who lock in prices in an effort to eliminate future price volatility and speculators, who bet on their beliefs about future directional movements in prices.

A cattle rancher, for example, may have 120,000 pounds gross weight in a herd that he intends to bring to market in three months. The rancher wants to hedge the uncertainty that cattle prices may fall in the interim. He could enter a contract with a counterparty to sell his cattle forward for a price agreed upon today, thereby locking in a price. Alternatively, he could sell futures contracts. As we'll see, forwards are simpler versions of futures, not in how they are priced but in how they are managed. If we assume that the live cattle futures contract on the Chicago Mercantile Exchange (CME) is for delivery of 40,000 pounds, the rancher could sell (short) three contracts to deliver his cattle in three months at a price determined today. His short futures position locks in the price of cattle, thereby eliminating the risk of a price decline. The other side of this trade could be taken by a beef processor (or a speculator) who buys the futures contract (goes long), agreeing to take delivery of the cattle at the futures price and thereby eliminating the risk that cattle ...