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Add Some Standardization to Contracts with Futures

By Michael Taillard

Futures contracts are highly standardized in a number of ways: futures contracts must be for a homogenous commodity of a standardized type and quality; each futures contract must be for a standardized quantity; futures contracts must be in a single currency determined by the location of trade; and futures contracts must have a standardized delivery date

Basically, futures contracts of a single type must all be completely identical. This continuity allows futures contracts to be freely bought, sold, and traded. The buyer of a futures contract is obligated to the terms of the contract until it’s resold, but the buyer doesn’t have to actually read the contract to know what’s on it because all futures contracts of that type are the same.

As a result, unlike forward contracts, futures contracts are highly liquid; that is, they’re sold in very high volume and very high frequency on markets (much like stocks).

Risk management and futures contracts

Although futures are less customizable than forwards, they’re still extremely common (or perhaps even more common than forwards) as a form of risk management. After all, for those corporations that either produce or purchase goods for which futures contracts are available for market trade, futures are extremely easy to both buy and sell.

The initial contract sale by the producers, called the primary market, is quite easy to make, and then that contract will likely change hands many, many times before the delivery date. It’ll be traded on the secondary market between investors and then, eventually, to the people who really want the underlying goods.

That being said, the actual function of futures in risk management is essentially identical to that of forwards, but the liquid nature of futures allows for more robust risk management strategies that allow the investor to buy or sell multiple times before the delivery date.

Revenue generation and futures contracts

Futures are far more viable as a method of revenue generation than forwards, but buying and selling futures strictly to generate revenue can be very dangerous to attempt. Like stocks, people purchase futures contracts with the expectation that the price will change dramatically either up or down and then resell the contract to the seller or the buyer or perhaps even to other investors.

The point is to sell these contracts before the delivery date for more than you bought them for or for less value than the delivery should you decide that you actually want the goods underlying the contract (which, in many cases, is cash, making that valuation particularly simple to calculate).

When you buy and sell futures solely to generate revenue, not only do you risk losing value through these trade exchanges as with stocks, but in the case of commodities, the underlying goods to be delivered may also be worth less than you paid for them. As with options, these risks cause deviations between the book value of a corporation’s assets and the real value of asset obligations through futures contracts.

Valuation of futures contracts

Because the mechanics of a futures contract are the same as those of a forward contract, the valuation methods also tend to be the same. The basics of valuation that I discuss in the previous section on forwards still apply, and a number of variations have been applied either to customize the calculations for the individual needs of the parties involved or to improve on the accuracy for investing purposes.

As noted, though, the increased liquidity in futures allows for additional strategies involving futures that more closely resemble stock investing strategies instead of simply hedging the risk of the exchange of the assets underlying the futures contract.