Why derivatives?

Futures

A futures contract is a binding agreement between two parties, a seller who agrees to deliver and a buyer who agrees to take delivery of the Underlying Asset at a specified future date, with agreed-upon payment terms.

Generally speaking, most futures participants are speculators rather than hedgers resulting in approx 2/3 of open interest being cash-settled and closed out prior to delivery. Futures contracts are standardized with respect to the delivery month; the asset quantity, quality, delivery location, and payment terms. The Standardization of futures contracts is important because it allows traders to focus on a single variable, the price.

In contrast to the cash forward contract market, in which changes in specifications from one contract to another might cause price differentials from one transaction to the next. Standardization makes it possible for traders anywhere in the world to trade in Futures markets and know exactly what they are trading. Thus, one of the reasons futures markets are a good source of asset price information is because price changes are singularly attributable to changes in the asset price levels rather than any change in contract terms. Unlike the forward cash contract market, futures exchanges provide:

• Rules of conduct that traders must follow or risk expulsion
• An organized market place with established and publicized trading hours
• Standardized trading through rigid contract specifications, which ensure that the attributes of the asset being traded are identical in every contract
• A focal point for the collection and dissemination of information about the supply and demand of the asset, which helps ensure all traders have equal access to information
• A mechanism for settling disputes among traders without resorting to the costly and often slow court procedures
• Guaranteed settlement of contractual and financial obligations via the exchange clearing mechanism

Purpose

Futures markets serve two primary purposes:

• Price discovery: Futures markets provide a central marketplace where buyers and sellers from all over the world can interact to determine prices.
• Transfer of risk: Futures give buyers and sellers of commodities the opportunity to establish prices for future delivery. This price risk transfer process is called hedging.

History of Forward Agreements and the emergence of Standardized Futures

In England, commodity forward agreements started trading in 1571 (the Royal Exchange) while the London Metals and Market Exchange was established in 1877. Similar trends emerged around the world with Dojima Rice Exchange being established in 1697 Japan for the exclusive purpose of trading Rice Futures. In the United States, Futures trading originated with the formation of the Chicago Board of Trade (CBOT) around the middle of the 19th century. Grain middlemen and producers in Illinois were experiencing trouble financing their grain inventories. The volatility of prices and the risk of falling grain prices after the harvest made lenders reluctant to extend credit to purchase grain for subsequent sale. To reduce their exposure to this risk, the grain middlemen began selling “To arrive” contracts with a specified future date, a specified quantity of grain would be delivered at a pre-arranged location at a pre-arranged price, specified in the initial contract. The fact that the price was fixed in advance of delivery meant that the risk was reduced, facilitating easier credit access for the middleman to finance grain purchases from farmers. These “To Arrive” contracts (Forward Agreements as they would be known today) were the precursors to today's standardized futures agreement. Although utilization of “To Arrive” contracts was advantageous in reducing risk, market participants soon found these inadequate for a number of reasons:

• Lack of Contract Fungibility — each contract being unique could not be easily replaced with another
• Lack of transparent secondary markets — Once bought or sold it was difficult to track the product value or offload risk
• Lack of Default protection — In the event of a party failing to deliver, the recovery procedure was lengthy and costly.

In an effort to resolve these flaws Futures Exchanges were formed. Offering uniformity of contracts with transparent secondary markets and the protection of a central clearing party in the event of Counterparty default.

The first such exchange was the CBOT (formed in 1848). This was quickly followed by similar such exchanges e.g. KCBT (1876) to deal in red wheat and Chicago Product Exchange (1874) to deal in butter.

In all cases, the exchanges were formed because commercial dealers in various commodities needed a way to reduce some of their price risk, which hampered the day-to-day management of their business.

Sellers e.g. producers wanted to protect themselves from falling prices while the buyers e.g. manufacturers wanted to protect themselves from rising prices.

Thus, this relationship is mutually beneficial allowing for risk management, growth, and price patterns modeling for any business that relies on such tools.

As futures exchanges have grown in size and reputation new contracts were added, some successful others less so.

Trading the entire curve.

Today

Since the Global Financial Crises (GFC), there has been a coordinated push by the regulators to get a large number of the Over-The-Counter (OTC) traded derivatives onto Exchange and screens in an effort to improve price transparency, risk management while decreasing systematic default risk.

This has meant windfall profits for a number of larger venues resulting in complacency which in turn manifests itself through a lack of product innovation due to perceived reputational risk. Ironically undoing the very reason for the existence of these venues i.e. creating avenues for risk mitigation.