Futures Contract

The economic work of a futures contract is done by what it refuses to negotiate. Because every contract of a given kind covers the same quantity, the same quality specification, the same delivery period, and the same delivery mechanism, any two contracts of that kind are interchangeable. A party who has bought one can discharge the obligation entirely by selling another — the two cancel, because they are the same object. Interchangeability is what makes a position closeable without ever touching the commodity.

Standardisation also has a cost, and it is the cost that gives rise to basis. A contract that specifies one quality at one delivery point cannot describe a lot of a different quality at a different place. That difference does not disappear; it is simply excluded from the futures price and pushed into the physical market, where it reappears as the gap between a cash price and the reference. A futures price is therefore a precise statement about a narrow thing, not an approximate statement about a broad one.

Quantity

A fixed lot size per contract, set by the exchange. Exposure is varied by holding more or fewer contracts, not by varying the size of one.

Quality specification

A deliverable grade, usually with a schedule of premiums and discounts for stated deviations. Material outside the schedule is not deliverable at all.

Delivery period

A named month or window during which delivery may occur. Contracts for different periods are different, non-interchangeable instruments.

Delivery mechanism

How the obligation is discharged if it runs to term — physical delivery at designated points, or cash settlement against a defined settlement value. Which one applies is a property of the contract.

On execution, the contract between the two trading parties is replaced by two contracts with a central clearing house. This substitution is the mechanism by which a futures market converts a web of bilateral credit exposures into a single, collateralised exposure to one institution. It is why a seller need not investigate a buyer, and why a buyer need not care whether the seller still exists next month.

The clearing house protects itself by requiring collateral at the outset and by revaluing every open position on a regular cycle, collecting from parties whose positions have moved against them and paying those whose positions have moved in their favour. The consequence, which is frequently misunderstood, is that a futures position generates cash movements throughout its life rather than only at the end. A position that is economically sound over its full term can still require cash before that term is reached — the timing of the cash and the timing of the economics are not the same.

The delivery mechanism of a futures contract is essential and is rarely used. It is essential because it is the tether: the possibility of delivery is what compels the futures price to converge on the physical value of the deliverable commodity at the delivery point as the contract approaches its term. Without a credible delivery mechanism, a futures price would be a number about nothing.

It is rarely used because most parties do not want the deliverable commodity at the delivery point — they want exposure to its price, or protection from it, while transacting their actual physical business elsewhere on their own terms. They therefore close the position by an offsetting trade before term, leaving only the price effect. A futures market thus functions largely as a price mechanism that retains a physical delivery mechanism it seldom exercises, and the credibility of the second is what makes the first work.

This has a direct interpretive consequence. A futures price is not a forecast of the commodity’s price at the delivery date, and it is not a prediction. It is the price at which contracts for that delivery period are currently changing hands, given everything the market participants currently believe and everything the contract currently specifies.

A futures price obtained from any source is a statement about one contract, for one delivery period, on one exchange, for one specified quality at one specified delivery mechanism. It is not the price of the commodity. Before it can be applied to any physical question, four things must be known.

• Which contract and which exchange — contracts on the same commodity at different exchanges are different instruments with different specifications and are not interchangeable
• Which delivery period — a nearby month and a deferred month are separate instruments, and the relationship between them is a spread, not a price change
• What quality and delivery mechanism the contract specifies — this determines what the price is actually about, and therefore what it excludes
• What unit and currency — a futures price carries the contract’s own unit and currency, and converting either introduces a second variable