Other Futures

So far we’ve considered only the traditional futures markets, which have their origin in the 19th century. But as I mentioned at the beginning futures contracts are now available on many different underlying things, so we need to go through the variety that is available.

Bond Futures

A bond is a loan which pays interest, and on maturity you get your money back. On the face of it, it doesn’t sound like the value of it should vary much. But it does, and that is because interest rates change. If interest rates go up, then someone buying bonds would expect more for their money, so you have to sell an existing bond with a fixed rate for less than the face value. If interest rates on new loans are falling, an existing bond with a set rate will become more valuable, and sell for more than the face value. The longer it is until maturity of the bond, the more the value of the bond will change.

A bond future is a commitment to deliver a notional bond on a future date — it’s normally settled in cash, although there are specifications for delivery if required. For instance, a 10 year Treasury Note future would require delivery of $100,000 face value bonds with 6 1/2 to 10 years until maturity. Whatever these bonds are selling for at the futures expiration date would be the contract commitment. Note that there aren’t any price limits the bond futures, so the price can fluctuate a lot.

Interest-Rate Futures

Although bond values are affected by interest rates, interest rate futures are a more direct play on changes in the rate. Banks and financial houses use them to hedge against changes which are detrimental to other financial interests. It’s based on a notional deposit, and the value of the futures contract varies each day according to the expected interest rate for the contract period.

For example, the Eurodollar future (nothing to do with the Euro) which is traded on the CME is based on a $1 million on three months deposit. Eurodollars are dollar denominated deposits held in banks outside the US, mainly in London. The interest rate used is the US dollar LIBOR rate, set by British bankers.

The price for the future contract is quoted as 100 minus the interest-rate, so a quote of 96.5 means the expected annual rate is 3.5%. If the expected rate fell to 3.4%, the contract would be worth 96.6, which in money terms will be a profit of $250. Note that it does not matter what the rate actually falls to, as it is the expectation of the rate that is reflected in the ongoing futures contract price.

Index Futures

Whenever equities are mentioned in connection with futures contracts, the assumption is usually made that you’re talking about Index futures. They’ve been around for about 30 years, which explains why they are so predominant. An index future is based on the movement of a standard stock index, such as the S&P 500. There is no delivery as it is impractical to deliver (in this case) shares of 500 different companies — all index futures are cash settled.

The S&P 500 futures contracts are worth 250 times the value of the S&P, so each point of the index counts for $250. This makes them quite expensive to trade, with the initial margin in the region of $20,000. And you can select from a range of settlement months, just as with other futures contracts.

It’s interesting to see that the futures price goes up and down, just as the share index price does, but they don’t always move together. This is because the futures contract reflects the traders’ view of the values, rather than the actual values. In other words, if everyone thinks that prices are going down the futures contract price will probably reflect that and be less than the actual Index. This is simple market action — speculators will be selling the contract before the share prices fall, and this makes the futures contract price fall. But the futures price keeps broadly in line with the market Index.

Single Stock Futures

Most people are familiar with options on stocks, but don’t know so much about futures on stocks. As noted above, equity futures normally refer to market indices, not individual stocks. That may be because single stock futures are so new — they were introduced in London in 2001, and later still in the US. A single stock futures contract usually covers 100 shares and is cash settled.

Why would you use single stock futures instead of trading the shares? The main answer to that is obvious, you can enjoy much greater leverage or gearing with futures contracts, so you can participate in the gains of a larger number of shares for the same amount of money. Picking your stocks would be the same exercise as if you were investing directly, except that you must remember that futures contracts are marked to market each day, and can result in a margin call to you. You have less scope to ride out the downside of market fluctuations than you have when you trade the shares.

FX Futures

Foreign currency futures are frequently used by businesses to hedge against swings in currency exchange rates. Speculators frequently take the other side of contract, effectively betting on which way the exchange rates are going to go.

The currency contracts are for a set amount, and delivery is possible but usually the contracts are cash settled.

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