What are Futures?​

Overview

This is a brief module to familiarize you with forward contracts and futures. ​
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We will delve into the definition of a forward contract and futures contract. In doing so, we will understand the difference between the two and why investors make use of these derivatives.

Defining Futures

What exactly is a forward contract, and what is a future? Both forwards and futures are contracts between two parties, where one party wishes to buy and the other to sell, a pre-determined amount of a particular security, based upon an agreed transaction rate, for delivery at some future date in time.​

Though both types of contracts are exactly similar in that they each provide a guaranteed rate at which to transact in the future, what sets futures and forwards apart is that they are traded via different markets. This by implication often also results in different types of market participants trading in each.​

Though, most importantly, when it comes to their functionality there are hardly any differences between forwards and futures, as both are equally effective in fixing a transaction rate for the future.​

Futures, in particular, —also called futures contracts— are a class of derivatives that allow traders to lock in a price of the basic asset or commodity. ​

They are identified by their expiration month. For instance, a December gold futures contract terminates in December. The term futures has a tendency of representing the general market. Nevertheless, there are countless types of futures contracts offered for trading including:​
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Commodity futures for instance in wheat, corn, crude oil and natural gas​
Stock index futures such as the FTSE/JSE Top 40 Index​
Currency futures ​
Precious metal futures for gold and silver​
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It's essential to take note of the difference between options and futures. Options contracts provide the holder the right to buy or sell the underlying asset at termination, whereas the futures contract holder is required to comply with the terms of the contract.

A forward trades via a market known as Over The Counter or OTC. This is a market in its bare form. In other words, the participants deal directly with each other and every deal is negotiated on its own merits and unique characteristics. This allows for contracts to be for any particular required amount, done at a specific rate and to a very specific delivery date.​
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A future on the other hand is a standardised contract which trades and clears via a central exchange, thus referred to as Exchange Traded instruments. ​
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As a result of the contracts existing on exchange, all contracts are standardised, and uniform in terms of expiration date, quantity per contract, and future expiration dates. This is done in order to improve the ability for the exchange itself to manage the exposures related to each contract more efficiently. ​
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One important take away is that one of the biggest concerns in trading in the OTC market is the existence of counterparty credit risk (also known as default risk). By using exchange traded contracts one can effectively remove default risk altogether.

Example of a Futures Contract

You bought shares in company XYZ at R120 per share and it is currently trading at R150 per share. You think that the price is going to fall in the coming months due to a downturn in the market. You want to protect the profits you have made from these shares and so you go into a futures contract at a pre-determined price of R160 per share that is actionable upon the expiry of the contract.​

As you predicted, the price falls down to R110 per share at the time of expiry of the contract and you then sell your shares at the pre-determined price of R160 per share, therefore protecting yourself from the drop in share price. 

Futures Listed on the JSE

The JSE offers both Single Stock Futures (SSF) as well as Contracts For Difference (CFDs). Both these styles of futures contracts allow an investor the ability to be exposed to the price movements of an actual underlying share’s price movements. ​

By entering into an SSF or a CFD (i.e. buying or selling the contract), the investor has locked in a rate at which the future transaction will occur, and in doing so now have full exposure to the directional movement of the underlying share price, in relation to the futures contract rate. ​

Given that the calculation of the price of an equity futures contract includes some assumption of possible future dividends, yet to be received during the life of the futures contract, there is a residual risk that exists should the actual dividend differ to what was expected. To counter this risk, the JSE also offers Dividend Futures. ​

A Dividend Futures contract aims to settle the net difference between the actual and expected dividend which was used (implied) in calculating the price of the underlying SSF contract. Note that Dividend Futures are traded in addition to the SSF and is not mandatory, in other words, only those who wish to hedge against the dividend risk will trade Dividend Futures. ​

Single Stock Futures and CFDs are offered on almost all of the Top 40 companies listed on the exchange. ​

In addition to having these contracts available on actual company shares, the JSE also listed a few index futures which enable one to transact over a broader spectrum of shares instead of one single company’s shares.