How are futures contracts setup at an exchange?

Question

I'm having a hard time wrapping my head around how the actual contracts are structured at an exchange. Here are my questions:

• If an exchange facilitates the trading of futures contracts and nobody intends to take delivery of the product, nor do they own it so they can deliver it, then how are the contracts issued?
• Is there a fixed number of contracts that are created and traded, or is there an "unlimited" number of contracts?
• If none of the traders intend to take delivery nor do they want to deliver, then where do the sellers get the contracts to sell? How does that process work?

It's easy to figure out how it works with trading stocks or currencies: the stocks are issued by the company and granted to the owners, then they sell the stocks. Currencies are much the same: you have accumulated some cash and you want to trade it. But in both of those cases the trader either owns something or buys it from somebody else. How do traders of futures contracts obtain them?

P.S. I'm not sure if this is the correct place to get clarification on this subject, but if there is a better stackexchange sub-domain for it, then I'll go there.

Answer 1

If an exchange facilitates the trading of futures contracts and nobody intends to take delivery of the product, nor do they own it so they can deliver it, then how are the contracts issued?

Say I want to buy a future contract that allows me to buy coffee at a given price in December 2013. Technically, this contract allows me to buy 37,500 pounds of coffee at the specified price in December 2013. I have two options. If the contract already exists in the market (this contract does), I can simply purchase the contract in the market. If it doesn't exist, however, the process works like this:

I approach a futures commission merchant, who sends the buy order to a broker on the trading floor/pit or to the exchange order system. Assuming someone else has put in a sell order for the same commodity, expiration, etc. the orders are matched at the agreed upon price, and the futures contract is created.

Also, the FCM reports the trade to the exchange's clearing house, which guarantees the trade and removes counter-party risk. In other words, if the price of coffee changes dramatically, and one of the parties in the trade cannot meet its buy or sell obligation, there isn't a default. The clearing house settles the trade.

Is there a fixed number of contracts that are created and traded, or is there an "unlimited" number of contracts?

No, there is no fixed number. The Wikipedia article on futures exchanges sums this up:

Futures contracts are not issued like other securities, but are "created" whenever Open interest increases; that is, when one party first buys (goes long) a contract from another party (who goes short). Contracts are also "destroyed" in the opposite manner whenever Open interest decreases because traders resell to reduce their long positions or rebuy to reduce their short positions.

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If none of the traders intend to take delivery nor do they want to deliver, then where do the sellers get the contracts to sell? How does that process work?

The futures market doesn't consist of only traders. The terminology that you usually hear are speculators and hedgers. Speculators are the traders you're thinking of, while hedgers are farmers, oil producers, or companies that rely on commodities. All of these groups enter the futures market in order to lock in a future price at which to buy or sell the products they need, in order to protect themselves from future price swings.

For example, if I'm an oil producer like ExxonMobil, the price of oil significantly affects my future revenue. The price of Brent crude oil is currently around $108/barrel. If this price increases to $120/barrel in a year, they may earn much more revenue. However, if the price drops to $80/barrel, however, their revenue stream is negatively affected. Therefore, I go to the futures market and sell a futures contract that expires in one year and allows me to sell oil for $108/barrel.

If the price of oil jumps to $120/barrel in one year, I would have been better off without a futures contract. However, if the price drops to $80/barrel, I saved myself a considerable loss. This is how the futures market lowers risk and helps to smooth commodity prices in the long run.

Who takes the other side of the trade? Consider an airline company that knows it will need oil¹ for its planes in a year. The airline company will earn more revenue if the price of oil drops to $80/barrel (the exact opposite of ExxonMobil), but lose revenue if the price jumps to $120/barrel. The airline may decide to enter the futures market and agree to buy oil at $108/barrel in one year, thus completing the trade. The futures contract is created and traded in the market.^{2 3}

Expiration

When the contract expires, the buyer/seller either takes delivery of the commodity or the contract is settled for cash between parties. As maturity nears, the price of the contract usually converges to the spot price. Consider our example oil contract, which was created at $108/barrel. If in one year, the spot price of oil has increased to $120/barrel, the contract's price will converge to $120/barrel. Exxon received $108 for its sale of the contract, and now owes $120 in cash or $120 in oil. The cost of its hedge was $12. The airline company bought the contract for $108, and now receives $120. It profited $12 from its hedge, so Exxon would pay the airline company $12. Exxon could sell oil for $120/barrel, but because of the cost of its hedge, it's only receiving $108/barrel, exactly the price it locked in by selling the contract in the first place.

Consider what happens if the price of oil had decreased to $80/barrel. Exxon received $108 for its sale of the contract, and now owes only $80, for a profit of $28. The airline company, however, paid $108, but only received $80 in return, for a loss of $28, so the airline company would pay Exxon $28. Similar to above, Exxon can only fetch $80/barrel for its oil in the spot market, but because it earned $28/barrel by selling a futures contract, it's really receiving $108/barrel for the barrels in the contract.

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¹ In reality, planes don't run on oil; they run on jet fuel. Since there isn't a futures contract for jet fuel, the airline could study the past relationship between prices of jet fuel and oil in order to estimate the future price of jet fuel, given a future price of oil. Since the company can lock in the price of oil through a futures contract, they'll lock in a price of oil that, based on their estimated model of jet fuel/oil prices, will give them enough funds to purchase the appropriate amount of jet fuel.

² It's also important to understand that not all hedgers will operate this way. It's certainly possible for a company to hedge too much, and therefore not benefit at all if the price swings in their favor. This has happened to airline companies in the past; even when oil prices have fallen, they haven't benefited because their hedges were expensive enough to outweigh the potential gain. However, had the price increased dramatically, their hedge would have been highly effective.

³ Also, in this simple example, two companies may choose to bypass the futures market all together and create an over-the-counter (OTC) contract instead. For example, ExxonMobil could agree to sell oil to a specific company at $108/barrel in one year, without entering the futures market at all. This option may be cheaper than entering the futures market, but futures markets also have the benefit of clearing houses to mitigate counterparty risk. If Exxon agrees to sell oil to a company, which then goes bankrupt, Exxon is protected if the hedging was done through the futures market. In the OTC market, this protection isn't always there. OTC contracts can be useful, however, if (for example), the company wants to make or take delivery of a commodity at a different location than that specified in the standardized contracts available on an exchange.

Answer 2

John Bensin's answer above gives a clear and thorough explanation. However, a useful and simple tool to aid understanding is to consider a futures contract as a bet . . .

Suppose that you and I enter into a bet on whether it will be sunny or not tomorrow. I think that it will; you think it won't. We each wager an agreed upon sum. By the end of tomorrow, one of us will owe the other money. Note that neither of us are required to own or 'deliver' the weather in order to settle this bet!

We can take this example further. Suppose that I bet you, at an agreed rate of $1 per hour, that it will be sunny tomorrow. For each hour in which it is sunny you will owe me a dollar, and for each hour in which it is not sunny I will owe you a dollar. By the end of tomorrow, depending on how much the sun has shone, one of us will owe the other money. The amount of sunshine will fluctuate throughout the day in much the same way as the price of a commodity or any other asset that underlies a futures contract does. But even after this bet, it is not the sunshine that one of us must deliver tomorrow, but a previously agreed sum based on the amount of sunshine.

Answer 3

There are (at least) two different futures contracts. One futures contract is for 1) physical delivery, and the other type is for 2) financial delivery (i.e. only money is handed over, not the actual goods).

1) All the producers will only sell physical delivery futures that together sum up to 100% of the physical goods. Say that all gold producers can produce 50 ton of gold per month, then the producers will only issue physical delivery futures that together sums up to 50 ton per month. They will not sell 200 ton of physical delivery futures, because they don't have the ability to deliver that much gold. If they sell more than they can deliver, they will have big problems with the exchange because they are not fulfilling their obligations.

However, a speculator, say a hedge fund might sell another 10 ton of gold with physical delivery in 6 months. So in 6 months, there are 50+10 = 60 ton gold for physical delivery futures. This is more than 50 ton. But then the hedge fund must make sure it gets another 10 tons of gold in due time, so when delivery date occurs, everyone can fulfill their obligations. Either the hedge fund can try to buy 10 tons from a producer to cover his position - in this case there will only be 50 ton of gold delivered that month. Or, the hedge fund can buy 10 ton from, say Fort Knox which has a gold reserve - in this case there will be 50 ton + 10 ton = 60 ton delivered that month. In either case, at delivery date, all will fulfill their obligations. Before delivery date, there might be excess gold futures with physical delivery but as delivery date gets near, these excess futures will be eliminated or covered up.

These futures with physical delivery can be sold and resold very fast, so more than 50 ton can be traded in short time.

2) We also have futures with financial delivery. These futures does not deliver gold, when delivery date occurs, you get money instead of gold. These futures are typically used by speculators such as hedge funds. And these futures can be much more than 50 ton, maybe even 500 ton each month. And they are sold and resold very fast as well. But they are never settled in gold, so it does not matter how large this volume is.

If someone wants to buy a future at a certain price, he puts his order into the exchange, and then waits. Someone else will eventually take the opposite position and at that very moment, open interest increases. The open interest can decrease if the futures are delivered, or eliminated in other ways.

There are different futures, one for each time period. Say that you have futures with delivery every day, then there will be 365 futures on the market. All have different price that fluctuates every millisecond. If the price gets low enough, someone will buy. So a buyer will see 365 different futures prices fluctuating wildly. All these prices are probably connected in some way.

I hope this helps?