What are Futures?

Futures are a financial derivative known as a forward contract. A futures contract obligates the seller to provide a commodity or other asset to the buyer at an agreed-upon date. They are widely traded for commodities such as sugar, coffee, oil and wheat, as well as for financial instruments such as stock market indexes, government bonds and foreign currencies.

The earliest known futures contract is recorded by Aristotle in the story of Thales, an ancient Greek philosopher. Believing that the upcoming olive harvest would be especially bountiful, Thales entered into agreements with the owners of all the olive oil presses in the region. In exchange for a small deposit months ahead of the harvest, Thales obtained the right to lease the presses at market prices during the harvest. As it turned out, Thales was correct about the harvest, demand for oil presses boomed, and he made a great deal of money.

By the 12th century, futures contracts had become a staple of European trade fairs. At the time, traveling with large quantities of goods was time-consuming and dangerous. Fair vendors instead traveled with display samples and sold futures for larger quantities to be delivered at a later date. By the 17th century, these contracts were common enough that widespread speculation in them drove the Dutch Tulip Mania, in which prices for tulip bulbs became exorbitant. Most money changing hands during the mania was, in fact, for futures on tulips, not for tulips themselves. In Japan, the first recorded rice futures date from 17th century Osaka. These offered the rice seller some protection from bad weather or acts of war. In the United States, the Chicago Board of Trade opened the first futures market in 1868, with contracts for wheat, pork bellies and copper.

By the early 1970s, trading in futures and other derivatives had exploded in volume. The pricing models developed by Fischer Black and Myron Scholes allowed investors and speculators to rapidly price futures and options on them. To supply the demand for new types, major exchanges expanded or opened across the globe, principally in Chicago, New York and London.

Exchanges play a vital role in futures trading. Each contract is characterized by a number of factors, including the nature of the underlying asset, when it must be delivered, the currency of the transaction, at what point the contract stops trading, and the tick size, or minimum legal change in price. By standardizing these factors across a wide range of futures contracts, the exchanges create a large, predictable marketplace.

Futures trading is not without significant risk. Because these contracts generally entail high levels of leverage, they have been at the heart of many market blowups. Nick Leeson and Barings Bank, Enron and Metallgesellshaft are just a few of the infamous names associated with futures-driven financial disasters. The most famous of all may well be Long Term Capital Management (LTCM); despite having both Fischer Black and Myron Scholes on their payroll, both Nobel Laureates, LTCM managed to lose so much money so rapidly that the Federal Reserve Bank of the United States was forced to intervene and arrange a bailout to prevent a meltdown of the entire financial system.

In the United States, these transactions are regulated by the Commodity Futures Trading Commission.