The Benefits of Futures Contracts

Earlier this month, Chinese cryptocurrency exchange OKCoin announced it was launching Bitcoin Futures trading. It is one of many financial derivatives making its way to cryptocurrency markets. Futures Contracts are also one of the oldest financial derivatives, and can be used to the purpose of both risk management as well as speculation. Due to this, Futures are a valuable addition to the Bitcoin ecosystem.

Definition

Futures Contracts or simply Futures are nothing more than an agreement between two parties to buy or sell a certain commodity (or financial instrument) at a pre-determined price in the future. Effectively, the involved parties are locking in a future price.

Origin

Farmers have been using Futures for centuries as a tool for price risk management, with modern Futures trading starting to take shape as of the early 1700s. This happened at the Dojima Rice Market in Osaka, Japan. At this time, Japan was in a period of military rule by the Shoguns. To secure the Samurai’s support, the Shogunate paid them fixed amounts of rice each year. Low rice prices in the late 1720s put a strain on the samurai’s finances, and the Shogun responded by easing restrictions on Futures trading after they had been prohibited for many years, providing the Samurai with a stable conversion to currency.

In 1848, the Chicago Board of Trade (CBOT) opened as a central place where farmers and dealers could meet to deal in “spot” grain. In a spot (or cash) market, commodities or financial instruments are traded for immediate delivery. In the case of the CBOT this meant the exchange of cash for immediate delivery of wheat. Futures Contracts evolved from this, as farmers started making agreements with dealers to deliver a number of bushels of wheat by the end of a certain period. The two parties would agree to a price beforehand, and exchanged a written contract and even a “guarantee” (a small amount of money). Standardized Futures Contracts were introduced in 1865.

How do Futures work Exactly?

Like the Samurai in the 1700s, a farmer producing wheat could try to secure his income by entering into a Futures contract, and lock-in a selling price for next season’s crop. Assume the farmer offers 5,000 bushels of grain to be delivered to the buyer in June. If a price of $4 per bushel is agreed, the farmer has secured an income of $20,000. This way, the farmer is protected against a drop in prices. As the farmer is the delivering party, this is a short position. The buyer has a long position, and could be a bread maker trying secure his profits by fixing his costs. The bread maker would be protected from an increase in the price of grain.

If the actual price of grain per bushel rises to $5 by the end of the contract, it would mean a loss of $5,000 to the farmer. Without the Futures Contract, the farmer could have sold 5,000 bushels for $25,000. Due to the contract, the farmer is obliged to deliver 5,000 bushels at an agreed price of $4 per bushel. Likewise, the bread maker would only pay $20,000 instead of $25,000 and therefore earn $5,000 on the contract.

In Futures, however, positions are settled on a daily basis instead of at the end of the contract. This means that if the contract of $4 per bushel would be agreed today, and prices would move to $5 tomorrow, then the gains and losses would be immediately credited or deducted. The farmer’s account would be credited $5,000 and the bread makers accounted would be debited $5,000, the result of a $1 move for 5,000 bushels. Given the daily adjustment, most transactions in the Futures market are settled in cash.

Hedging and Speculation

If the price at maturity of the contract still is at $5, the farmer will have minus $5,000 in his account as a result of the Futures Contract. Nevertheless, the farmer still has 5,000 bushels that can be sold at $5 per bushel in the spot market. The farmer will receive $25,000 and use $5,000 to pay off his debt, leaving the fixed income of $20,000. Also, the bread maker still needs to buy grain which can be done at $25,000 in the spot market. Using the $5,000 profit in his trading account, the bread maker effectively only pays $20,000. This offsetting is referred to as hedging.

On the other hand, it should be obvious that two speculators could also enter into a Futures contract. The speculator in the farmer’s (long) position would then simply gain $5,000 from an increase in prices, while a speculator in the (short) position of the bread maker would lose $5,000. To ensure that cash can be debited, both parties are required to maintain a certain amount of money in their account. This is typically a percentage of the full value of the Futures Contract, and referred to as margin requirements.

Bitcoin

For Bitcoin Futures, the situation is no different. A merchant can use Futures to lock-in a future Bitcoin price, this results in a guaranteed income. Likewise, a certain party might take a loan in Bitcoin and use Futures to lock-in the amount to be repaid. This way, it becomes possible to manage (hedge) the price volatility in Bitcoin. Others can simply speculate on an increase or decrease in price.

Zero-Sum Game

Whatever the case, it should be noted that in a Futures Contract one person’s gain is equal to another person’s loss. The examples provided show that net change in wealth is zero (excluding transaction costs). Futures are therefore an example of a zero-sum game.

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