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What is a Futures Contract

A futures contract is essentially a forward contract that is traded on an organised financial exchange such as the Chicago Mercantile Exchange (CME).’ Organized futures markets as we know them arose in the mid-1800s in Chicago. Futures markets began with grains, such as corn, oats, and wheat, as the underlying asset. Financial futures are futures contracts based on a financial instrument or financial index. Today, financial futures based on currencies, debt instruments, and financial indexes trade actively. Foreign currency futures are futures contracts calling for the delivery of a specific amount of a foreign currency at a specified future date in return for a given payment of U.S. dollars.

Interest rate futures take a debt instrument, such as a Treasury bill (T-bill) or Treasury bond (T-bond), as their underlying financial instrument. With these kinds of contracts, the trader must deliver a certain kind of debt instrument to fulfil the contract. Also, some interest rate futures are settled with cash. A popular cash-settled interest rate futures contract is the CME’s Eurodollar futures contract, which has a value at expiration based on the difference between 100 and the then-prevailing three-month London Interbank Offer Rate (LIBOR). Eurodollar futures are currently listed with quarterly expiration dates and up to 10 years to maturity. The 10-year deferred contract, for example, has an underlying of the three-month U.S. dollar LIBOR expected to prevail 10 years hence.

Financial futures also trade based on financial indexes. For these kinds of financial futures, there is no delivery, but traders complete their obligations by making cash payments based on changes in the value of the index. Stock index futures are futures contracts that are based on the value of an underlying stock index, such as the S&P 500 index. For these futures, movements in the index determine the gains and losses. Rather than attempt to deliver a basket of the 500 stocks in the index, traders settle their accounts by making cash payments that are consistent with movements in the index. Table 1.1 lists the world’s major futures exchanges and the types of financial futures that they trade. Financial futures were introduced only in the early 1970s. The first financial futures contracts were for foreign exchange, with interest rate futures beginning to trade in the mid-1970s, followed by stock index futures in the early 1980s.

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