History
of Futures. The history of futures trading is, in a sense, two histories, both
focused on how people have tried to improve the effectiveness of the commercial
marketplace. The early story is a tale of how people in an agrarian society used
forward contracts (agreements to buy now, but pay and deliver later) as a means
of getting farm commodities efficiently from producers to consumers, at established
prices and delivery terms, and how those forward contracts evolved into futures
contracts. The present day story explains how the futures industry reinvented
itself in the latter part of the twentieth century, essentially by redefining
the meaning of "commodity," so that it could accommodate the needs of complex
financial markets in a society whose economy was no longer based primarily on
agriculture. The Early Story Commodity markets have existed for centuries around
the world because producers and buyers of foodstuffs and other items have always
needed a common place to trade. Cash transactions were most common, but sometimes
"forward" agreements were also made - deals to deliver and pay for something in
the future at a price agreed upon in the present. There are records, for example,
of "forward" agreements related to the rice markets in seventeenth century Japan;
most scholars agree that forward arrangements actually date back much farther
in time. The immediate predecessors of futures contracts were "to arrive" contracts.
These were simple agreements to purchase designated goods when they arrived by
ship, and they were used for centuries when shipping was the primary mode of international
trade. The first organized grain futures trading in the U.S. began in places such
as New York City and Buffalo, but the development of "modern" futures, which are
a unique type of forward agreement, began in Chicago in the 1840s. With the construction
of the railroads, Chicago began to emerge as a center for transportation between
midwestern producers and east coast population centers. The city was a natural
hub for trade, but the trading that took place there was inefficient and unorganized
until a group of Chicago-based business men formed the Board of Trade of the City
of Chicago in 1848. The Board was a member-owned organization that offered a centralized
location for cash trading of a variety of goods as well as trading of forward
contracts. Members served as brokers who facilitated trading in return for commissions.
As trading of forward contracts increased, the Board decided that standardizing
those contracts would streamline the trading and delivery processes. Instead of
individualized contracts, which took a great deal of time to negotiate and fulfill,
people interested in the forward trading of corn at the Board, for example, were
asked to trade contracts that were identical in terms of quantity, quality, delivery
month and terms, all as established by the exchange. The only thing left for traders
to negotiate was price and the number of contracts. These standardized forwards
were essentially the first modern futures contracts. They were unlike other forwards
in that they could only be traded at the exchange that created them, and only
at certain designated times. They were also different from other forwards in that
the bids, offers and negotiated prices of the trades were made public by the exchange.
This practice established futures exchanges as venues for "price discovery" in
U.S. markets. In contrast to customized contracts, standardized futures contracts
were easy to trade, since all trades were simply re-negotiations of price, and
they usually changed hands many times before expiration. People who wanted to
make a profit based on a fortuitous price change, or alternatively, who wished
to cut mounting losses as quickly as possible, could "offset" a futures contract
before expiration by engaging in an opposite trade: buying a contract which they
had previously sold (or "gone short"), or selling a contract which they had previously
bought (or "gone long"). The usefulness of futures trading became apparent, and
a number of other futures exchanges were established throughout the country in
the decades that followed. The Chicago Butter and Egg Board was founded in 1898
and evolved into Chicago Mercantile Exchange (CME) in 1919. Futures exchanges
also opened in Milwaukee, New York, St. Louis, Kansas City, Minneapolis, San Francisco,
Memphis, New Orleans and elsewhere. Chicago, however, became the most influential
and predominant location for futures trading in the U.S. The Era of Financial
Futures Throughout the first seven decades of the twentieth century, the futures
industry remained essentially as it had been - focused on the trading of futures
on agricultural products. But a remarkable change occurred in the industry in
1971, with the introduction of futures based on financial products. A New Concept:
Futures on Foreign Currencies Until 1971, world currencies had been pegged to
an international gold standard, but that year the gold standard was abolished
and currency values were allowed to "float." Leaders of CME recognized that a
currency whose value was determined by market forces had become a commodity like
any other, and therefore futures could be traded on it. There was (and still is)
an enormous forward market for currency trading, but until then there were no
exchange-traded, standardized futures on currencies. As with futures on agricultural
commodities, currency futures offered an opportunity to hedge against risks in
price changes, as well as to profit from changes in values. That year, CME formed
the International Monetary Market (IMM), initially a separate exchange closely
linked to CME, and hosted its first futures trades on foreign currencies. The
notion of trading futures on currencies was highly controversial. But the concept
garnered credibility from the support of economist Milton Friedman, who pronounced
that the IMM would "enable the world to operate more smoothly and effectively."
Friedman proved correct, and now currency futures have become an integral part
of international finance. Interest Rate Futures For many people it is one thing
to understand the agricultural futures markets and even currency futures, but
quite another to begin to imagine futures on interest rates. Like agricultural
products and currencies, however, interest rates - the price of money - vary according
to market pressures, and in this sense, they can also be viewed as a type of commodity.
Since many businesses are subject to risk as rates change, the futures industry
reasoned that interest rate futures could offer opportunities for hedging against
rising or falling rates or capitalizing on rate changes, as did futures on other
commodities. CME launched its first interest rate product in 1976 - a 90-day U.S.
Treasury bill futures contract - and over the next six years it became CME's most
actively traded product. CME then proposed trading futures on interest rates paid
for U.S. dollars on deposit overseas - dubbed "Eurodollars" - and again broke
new industry ground by making Eurodollar futures the first futures contract which
did not feature an actual or physical delivery but rather used cash settlement.
Cash settlement eliminated the difficulty of physically delivering interest obligations,
such as Treasury bills or notes, and thereby expanded the range of products upon
which futures could feasibly be traded. Stock Index Futures Like currencies, interest
rates, and crop prices, stock index values also vary according to numerous market
pressures. Changes in index values can positively or negatively affect businesses
that depend on them, such as mutual fund companies and pension funds. Stock indexes,
then, also fit into the expanded definition of "commodity." In the early 1980s,
stock index values had become the barometers of overall health of the stock markets,
and stock index futures drew an immediate audience because they enabled people
to trade the values of "the market" without having to own any individual shares.
CME launched its first stock index futures contract, the S&P 500® contract, in
1982. Stock index traders quickly learned that they could use the futures markets
to hedge against falling prices and take advantage of rising prices. When a market
move took place, traders could use index futures to either protect their investments
or increase their position in the market without having to actually buy or sell
stocks. Stock index futures are also appealing in that they are typically less
costly and easier to buy and sell than buying and selling shares of hundreds or
even thousands of stocks. Quite clearly, trading futures on stock index levels
was a far cry from trading on live cattle or corn. The futures industry, however,
led by the innovative thinking at CME, had learned how to expand its markets and
to meet the risk management needs of our complex, post-agrarian society. What
are futures Futures are contractual agreements made between two parties through
a regulated futures exchange. The parties agree to buy or sell an asset - livestock,
a foreign currency, or some other item - at a certain time in the future at a
mutually agreed upon price. Each futures contract specifies the quantity and quality
of the item, expiration month, the time of delivery and virtually all the details
of the transaction except price, which the two parties negotiate based on current
market conditions. Some futures contracts call for the actual, physical delivery
of the underlying commodity or financial instrument at contract termination. Others
simply call for a cash settlement at contract termination. Generally, however,
market participants do not hold their futures contracts until termination but
rather offset futures contracts they have bought ("gone long") by a subsequent
sale; or, offset futures contracts they have sold ("gone short") by a subsequent
purchase. Futures contracts are also called derivatives, because their value is
derived from the market value of the underlying commodity or financial instrument
on which the contracts are based. Futures traded on exchanges regulated by governmental
agencies may be distinguished from derivatives traded over-the-counter. In broadest
terms, futures are about anticipated future prices of basic commodities and financial
instruments, based on current information. Futures are concerned with such questions
as what will the price of cattle be next December? What will interest rates be
in six months? How much will a euro be worth in May? Because commodity prices
are constantly changing, virtually all businesses face ongoing price risk. Meat
processors face risk from fluctuating cattle prices, lenders from changing interest
rates, and international businesses from varying currency rates. All these businesses
can use futures to help manage their exposure to price risk. Futures contracts
- price agreements - are bought and sold in what is basically a marketplace of
opportunity for two symbiotic groups: hedgers, who seek to offset price risk,
and speculators, who try to make a profit from favorable price fluctuations. Hedgers
are typically businesses and financial institutions who buy and sell futures contracts
seeking to "lock in" future prices for commodities that are essential to their
business operations. Speculators are a diverse group that includes day traders,
financial institutions such as banks and hedge funds, and arbitragers. These groups
are brought together at a futures exchange, which provides a venue where their
orders may interact on a trading floor or a computer network, and where price
agreements can be negotiated. Traders' decisions generally aren't random, but
are based on a synthesis of a great deal of data and a variety of different strategies.
Some people make trading decisions based on fundamental analysis of the forces
of supply and demand in a commodity market ("fundamental analysis"); others trade
based on an analysis of market trends and price chart patterns ("technical analysis").
Because futures prices represent the aggregate of all available information that
may affect the market, they are viewed as reflecting a process of "price discovery."
Prices change constantly in response to numerous factors, ranging from weather
and wars to political decisions and popular trends. The futures markets assimilate
that information and provide a means of determining the price above which buyers
will not buy and below which sellers will not sell - the "equilibrium" price -
where the supply to be sold and the demand to buy are in balance. The price of
futures and the underlying cash markets on which futures are based tend to come
together or "converge" by contract expiration. The price of a futures contract
at expiration and the cash ("spot") price of the underlying asset must be the
same, because both refer to the same asset are basically equivalent, because both
prices refer to the same asset. What is a futures exchange? A futures exchange,
legally known in the U.S. as a "designated contract market," is, at its core,
an auction market - highly regulated, technical and complex - but an auction market
nonetheless. A futures exchange is the only place where futures and options on
futures (which offer the right, but not the obligation, to buy or sell an underlying
futures contract at a particular price) can be traded. Trading may take place
either on the exchange's trading floor or via an electronic trading platform.
An exchange itself does not trade futures. Instead, it: * Provides and maintains
the facilities where buyers and sellers meet, ranging from traditional "trading
pits" to global electronic trading networks * Researches, develops and offers
futures contracts to be traded * Oversees the trading of its products and enforces
trading-related rules and regulations * Monitors and enforces financial and ethical
standards * Provides daily and historical data on the contracts traded under its
auspices Futures exchanges in the U.S. are subject to a great deal of regulation.
They are monitored by the Commodity Futures Trading Commission (CFTC) and the
National Futures Association (NFA). In addition, most futures exchanges practice
intense self-regulation, monitoring their employees and the trading practices
that occur in their facilities. These agencies look after the public interest,
ensure fair practice and monitor the process of price discovery that occurs in
futures trading. Other governmental bodies, including the Securities and Exchange
Commission, the Federal Reserve Board, and the U.S. Treasury Board also monitor
some futures exchange functions. Violations of exchange rules can result in substantial
fines, as well as suspension or revocation of trading privileges. Futures Exchanges
in the U.S. and Abroad There are currently 13 futures exchanges registered in
the U.S. but not all are hosting active trading. CME is the largest futures exchange
in the U.S. by volume, and the first U.S. futures exchange to become a for-profit
corporation, after revising its original private membership structure and a becoming
publicly traded company in 2002. Most U.S. exchanges remain not-for-profit, private
membership organizations, but a number of them are actively weighing the advantages
of changing to stock corporations. There are more than 50 futures exchanges worldwide,
and they are structured in a number of different ways. Some futures exchanges
are owned by groups of banks or by a stock exchange holding company. Other exchanges,
or their holding companies, are publicly listed on a stock exchange, similar to
CME. How Futures Exchanges Earn Income Since futures exchanges do not themselves
engage in trading, people sometimes wonder how they earn money. Futures exchanges
earn income primarily by: * Receiving a fee for every trade made through the exchange.
* Selling price data - current, streaming price data in real time as well as historical
price data on trades made through the exchange. At CME, data subscription services
include CME E-quotes™ and CME E-history. * Charging for clearing services, if
the futures exchanges own their own clearing house, as is the case with CME. Some
exchanges outsource the clearing function. The Chicago Board of Trade, for example,
has its contracts cleared through the CME Clearing House. Types of Futures Traders
Hedgers Hedgers are looking for some measure of price certainty. Commodity hedgers
- people who trade agricultural products, energy products or metals, for example
- typically are involved in commercial interests that either produce, process
or utilize the commodity they are trading. Hedgers of financial futures are typically
in businesses that depend upon interest rates, foreign exchange rates, or stock
index levels, such as banking or pension fund management. Cattle ranchers, for
example, may fear that cattle prices will decline before they bring their animals
to market. To protect themselves, they decide to sell futures on live cattle that
will expire at approximately the same time they expect to deliver their cattle
to the market, and at the price they are hoping to get in the cash market. If
cattle prices do go down, the ranchers can still make money on their futures positions,
that will hopefully offset the reduced price they receive for their cattle. Cash
Market Futures Market June 1 Cattle is $0.87/lb. Rancher sells one CME October
Live Cattle futures contract at $0.89/lb*. October 1 Cattle prices have dropped
to $0.77/lb. Rancher sells cattle at market price of $0.77/lb. Rancher buys back
the October contract at $0.79/lb. Outcome Rancher receives $0.10/lb. less than
desired price. Rancher sells futures contract at gain of $0.10/lb. Calculations
Price rancher wanted: $0.87/lb. x 40,000 lbs. = $34,800 Rancher sold futures at
$0.89/lb. Rancher bought back futures at $0.79/lb. Actual price received: $0.77/lb.
x 40,000 = $30,800 Actual price received is $4,000 less than the rancher wanted.
Futures profit = $0.10 x 40,000 = $4,000 Net Result Rancher's loss in cash market
is offset by gain in futures market. Hedging strategy succeeded. *Note: The futures
price is slightly higher than the cash price to accommodate costs of shipping
and delivery of cattle. Speculators Speculators trade futures with the objective
of making a profit by being on the right side of a price move. Since the prices
of commodities and financial instruments tend to change frequently, at least in
certain markets, trading opportunities can be numerous. Speculators can be categorized
into several broad groups: scalpers, day traders, position traders, arbitragers,
and people seeking exposure to certain markets. Scalpers typically trade for a
small profit on any single trade and therefore often trade continuously, seeking
to make as many small gains as possible. In so doing, they create liquidity -
the presence of enough people in the market so that market participants, notably
hedgers, can buy and sell quickly and in large volume without substantially impacting
prices. Scalpers' frequent trades increase the trading possibilities available
to others, and help provide the liquidity that is essential to the existence of
futures markets. Other speculators include day traders, who typically make one
or two trades per day, and position traders, who tend to hold contracts for days,
weeks or months, depending on market factors. And finally, arbitragers are speculators
who watch the relative value of multiple markets closely and step in to trade
whenever momentary price discrepancies appear. By keeping prices in line for the
same product trading on different exchanges, arbitragers lend stability to the
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