Futures Contracts and Futures Trading

What is a futures contract? What is futures trading?

A futures contract is an agreement to purchase or sell a commodity for delivery in the future: (1) at a price that is determined at initiation of the contract; (2) that obligates each party to the contract to fulfill the contract at the specified price; (3) that is used to assume or shift price risk; and (4) that may be satisfied by delivery or offset.

The futures price is commonly held to mean the price of a commodity for future delivery that is traded on a futures exchange; or simply the price of any futures contract. (Source: CFTC)

A futures contract is an agreement to buy or sell a specific quantity of a commodity or financial instrument at a specified price on a particular date in the future. Commodities include bulk goods, such as grains, metals, and foods, and financial instruments include U.S. and foreign currencies.

With limited exceptions, the trading of futures must be executed on the floor of a commodity exchange. Similar to broker-dealers that are members of the National Association of Securities Dealers, Inc. or some other self-regulatory organization, all firms and individuals who trade futures with the public or give advice about futures trading must be registered with the National Futures Association (NFA). (Source: SEC)

In finance, a futures contract is a standardized contract, traded on a futures exchange, to buy or sell a certain underlying instrument at a certain date in the future, at a specified price. The future date is called the delivery date or final settlement date. The pre-set price is called the futures price. The price of the underlying asset on the delivery date is called the settlement price. The settlement price, normally, converges towards the futures price on the delivery date.

A futures contract gives the holder the obligation to buy or sell, which differs from an options contract, which gives the holder the right, but not the obligation. In other words, the owner of an options contract may exercise the contract. If it is an American-style option, it can be exercised on or before the expiration date; a European option can only be exercised at expiration. Thus, a Futures contract is more like a European option. Both parties of a "futures contract" must fulfill the contract on the settlement date. The seller delivers the commodity to the buyer, or, if it is a cash-settled future, then cash is transferred from the futures trader who sustained a loss to the one who made a profit. To exit the commitment prior to the settlement date, the holder of a futures position has to offset his position by either selling a long position or buying back a short position, effectively closing out the futures position and its contract obligations.

Futures contracts, or simply futures, are exchange traded derivatives. The exchange's clearinghouse acts as counterparty on all contracts, sets margin requirements, etc.

Futures traders are traditionally placed in one of two groups: hedgers, who have an interest in the underlying commodity and are seeking to hedge out the risk of price changes; and speculators, who seek to make a profit by predicting market moves and buying a commodity "on paper" for which they have no practical use.

Hedgers typically include producers and consumers of a commodity.

For example, in traditional commodities markets farmers often sell futures contracts for the crops and livestock they produce to guarantee a certain price, making it easier for them to plan. Similarly, livestock producers often purchase futures to cover their feed costs, so that they can plan on a fixed cost for feed. In modern (financial) markets, "producers" of interest rate swaps or equity derivative products will use financial futures or equity index futures to reduce or remove the risk on the swap.

The social utility of futures markets is considered to be mainly in the transfer of risk, and increase liquidity between traders with different risk and time preferences, from a hedger to a speculator for example. (Source: Wikipedia)

Eurodollars

What are eurodollars?

US dollar deposits placed with banks outside the US. Holders may include individuals, companies, banks, and central banks. (Source: CFTC)

Eurodollars are deposits denominated in United States dollars at banks outside the United States, and thus are not under the jurisdiction of the Federal Reserve. Consequently, such deposits are subject to much less regulation than similar deposits within the United States, allowing for higher margins.

Historically, such deposits were held mostly by European banks and financial institutions, and thus became known as "eurodollars". Such deposits are now available in many countries worldwide, but they continue to be referred to as "eurodollars" regardless of the location.

Futures Contract

At the same time, eurodollar refers to the financial futures contract based upon these deposits. Traded at the Chicago Mercantile Exchange (CME) in Chicago, the contract has a notional or 'face value' of $1,000,000, though the leverage used in futures allows one to trade a contract for just hundreds of dollars. Trade in Eurodollar futures is extensive, thus offering uniquely deep liquidity. A purchase or sale is, in effect, a bet on U.S. short-term interest rates. Prices are quite responsive to Fed policy, inflation, and other economic indicators.

The price of a Eurodollar futures contract is equal to 100 minus the yield (interest rate) for the given future date. Thus, a price of 95 would imply a 5% yield on the Eurodollar deposit. If you believe that interest rates will fall, you would then buy a Eurodollar contract (and vice versa; if you believe rates will rise, you would sell a Eurodollar contract). Each "tick" (.01) on the price of a Eurodollar contract is worth $25 and is equal to one basis point (i.e., a move from 95.010 to 95.020, but the Eurodollar trades in half ticks (.005, $12.50 per contract) and quarter ticks (.0025, $6.25 per contract).

The CME eurodollar contract is used to hedge interest rate swaps. There is an arbitrage relationship between the interest rate swap market and the Eurodollar contract. Eurodollar futures can be traded by implementing a spread strategy among multiple contracts to take advantage of movements in the forward curve for future pricing of interest rates.

The front month contracts are among the most liquid futures markets in the world. The contract suite has quarterly expirations out to 10 years. Each year has a reference color, with the first year from today being referred to as 'front' months.

Finance

In finance, the prefix "euro" as in "eurodollars" or "euroyen" refer to currency deposited outside the country of their origin.

Eurodollars are time deposits denominated in United States dollars at banks headquartered outside the United States, or in foreign branches of banks headquartered within the United States. There is nothing "European" about Eurodollar deposits; a US dollar-denominated deposit in Tokyo or Caracas would likewise be deemed Eurodollar deposits. Such deposits are normally in excess of $1,000,000, and typically (although not exclusively) involve deposits placed by one financial institution with another financial institution. As such, the Eurodollar rate is reflective of a large bank's cost of funds. Trading is extensive and quite active, particularly in maturities ranging from one day to six months; there is some very light trading that may run out as far as five years.

Although paid on deposits booked elsewhere in the world, the Eurodollar rate is driven primarily by the American economy (because it represents an interest rate paid on US dollar-denominated deposits). By and large, when the Fed tightens (or is expected to tighten within the lifetime of the deposit) the Eurodollar rate goes up, and when the Fed eases (or is expected to ease) the Eurodollar rate goes down.

In addition, the interest rate on Eurodollar deposits can and does vary throughout the day in response to supply and demand. This can be problematic for market participants who seek to use Eurodollar rates as benchmarks. The LIBOR rate and other similar rates were therefore developed for that purpose, representing a snapshot of the Eurodollar market in a specific locality and point in time (11:00 a.m. in London in the case of LIBOR).

Eurodollar rates should not be confused with the currency called the euro, which is the common currency of some members of the European Union. Prior to the introduction of this currency, traders in Eurodollars would colloquially refer to them as "Euros", but this practice has diminished since 2002.

The market for Eurodollar futures has grown to be highly liquid with the introduction of online trading. (Source: Wikipedia)