What Are Financial Futures?

Financial futures are contracts based on underlying financial instruments. These can be interest-rate sensitive instruments such as U.S. Treasury bonds, equity instruments such as the Standard & Poor's 500R Index, or currencies such as the Japanese yen.

Like all futures contracts, a financial futures contract specifies a specific quantity of the underlying financial instrument at a market-determined price. They can be settled via cash or physical delivery, depending on the instrument. Supply and demand factors determine pricing, and while common fundamentals often influence many markets globally, there are also factors that are unique to each particular market.

Financial futures were developed amid a rapidly growing trend toward globalization in the world's investment and economic landscape starting in the early 1970s. They were designed to meet new needs and risks that businesses, governments, and individuals faced amid changing capital flows. Even though they have a shorter history than agricultural futures, they now dominate the exchange-traded product offerings. Today, the majority of futures traded globally are financial-based contracts, and futures exchanges are continually on the lookout for new successes in this category.

Types of Financial Futures

Financial futures fall into three broad categories - those tied to interest rate instruments, stocks or stock indexes, and global currencies. Some of the most popular are outlined briefly here.

Interest Rate Products

In simple terms, interest rates reflect the price of money. And like all goods and services, interest rates are determined mainly by supply and demand. A greater demand for money is likely to drive up the price of money, reflected in the interest rate. Demand depends on factors such as the nation's economic health, the level of government borrowing to support budgets, and societal perception of inflation. Also, a nation's central bank can manipulate interest rates - rates are adjusted upward in an attempt to slow the economy, while rates are adjusted downward to act as a stimulus.

Interest rate futures products encompass a range of short-term instruments, such as the Federal funds rate, an overnight inter-bank lending rate, to long-term, such as the 30-year Treasury bond. The relationship between short- and long-term interest rates along a broad time continuum is called the yield curve. Typically, the yield curve has an upward slope, with a longer period of lending risk resulting in higher rates for long-term instruments.

Some of the most popular U.S. interest rate futures products and their features are detailed below.

Eurodollar Futures

Eurodollars are U.S. dollars on deposit in commercial banks outside the country, mainly in Europe. Eurodollars are commonly used to settle international transactions and are not guaranteed by any government, but rather, by the obligation of the bank holding them. Eurodollar futures track the interest rate on 90-day Eurodollar deposits, and frequently top the list of the world's most popular futures contracts traded.

The Chicago Mercantile Exchange's Eurodollar futures contract reflects the London Interbank Offered Rate (LIBOR) for a three-month, $1 million offshore deposit. The exchange lists a total of 40 quarterly futures contracts, spanning 10 years, plus the four nearest serial (nonquarterly) months. This contract is frequently used as a barometer for monetary policy implications, with a cash yield that has a close tie to the Federal funds rate. Therefore, economic statistics that may alter monetary policy have a big influence on Eurodollar futures prices.

Treasury Futures

Because of the strength and stability of the U.S. government, which has never defaulted on debt, U.S. Treasury instruments are often described as "safe-haven" investments. Indeed, when strong buying occurs in the Treasury futures market because of some type of global or economic shock, it's often called a "flight to quality" among the part of global investors.

U.S. Treasury bonds are long-term debt issues of the U.S. government with maturities of more than 10 years. U.S. Treasury notes are medium-term obligations of the U.S. government with maturities that range from one to 10 years. Futures are traded on the 30-year bond and the two-, five- and 10-year Treasury notes. U.S. economic strength, inflation and monetary policy are the major influences on the pricing of Treasury futures. Demand for money in a strong and/or inflationary economy typically causes cash Treasury yields (i.e. the interest rate paid) to rise and the price of the futures to fall, while conversely, a weak economy typically causes yields to fall while futures prices rise.

Treasury bills are U.S. government debt issues with maturities of up to one year. T-bills are the most widely issued government debt security and are auctioned weekly and monthly. The T-bill interest rate is considered the risk-free rate of variable return to investors. Because of their short durations, T-bills are considered money-market instruments. Treasury bills do not pay periodic interest. Instead, they are sold at a discount from their face value, and upon maturity, the investor receives the face value. The difference between the face value and the price at which it was sold is treated as interest.

Foreign Government Debt Futures

Similar to the U.S. government, most foreign governments also issue short- and long-term debt and many have corresponding futures contracts listed at exchanges around the globe. Europe's leading futures exchanges, Eurex and Euronext.liffe, offer many popular euro-based contracts including euro-bund futures, which are long-term debt instruments, and three-month euribor futures, which are short-term instruments.

Prior to the start of the European Monetary Union in 1999, German government bonds were the recognized benchmark for the European government bond market due to their liquidity, credit rating, a record of stable German monetary policy and Germany's market size and depth. Germany had been considered the "safe haven" of Eurozone issuers, but the recent integration of Europe's markets with the EMU has created new debt instruments and market dynamics.

In the U.S., the Chicago Board of Trade lists futures on three German debt instruments-the Bund, Bobl and Schatz. These contracts trade exclusively on the CBOT's electronic platform. The remaining term to maturity on the Bund is 8 ½- 10 ½ years, the Bobl has a remaining term to maturity of 4 ½ to 5 ½ years, while the Schatz has a remaining term of maturity of 1 ¾ to 2 ¼ years.

Swap Futures

Swaps are generally defined as agreements between two parties to exchange periodic interest payments. They have become an interest rate benchmark and are an innovative means for those seeking ways to transfer financial risk. Swap futures are traded at the Chicago Mercantile Exchange and Chicago Board of Trade and are designed to provide investors involved in U.S. dollar-denominated swaps with new trading and hedging opportunities. Investors can trade two-year, five-year and 10-year swap futures contracts.

Currency Futures

Also known as foreign exchange, forex or simply FX, financial institutions, investment managers, corporations and private investors trade currency futures to manage the risks and capture potential opportunities associated with currency rate fluctuations.

Trading a nation's currency doesn't occur in a vacuum; you don't actually trade one currency but a pair based on its relationship to another currency. A number of factors go into determining the "strength" or "weakness" of a currency vs. another, but it usually comes down to comparing one nation's economy to another's. Generally, expanding economies have stronger currencies while recessionary economies have weaker currencies.

Factors influencing a currency's value include gross domestic product (GDP) as well as the trade balance between countries. The current account balance and money flows from one country to another reflect a currency's supply and demand, so traders are always watching each country's trade balance to see changes in surpluses/deficits. Other factors influencing currency valuations include fiscal and monetary policies, including interest rates on government-issued securities, and political leadership.

The Chicago Mercantile Exchange is the leader for currency futures trading in the United States, and offers a variety of contracts with pricing based on a nation's respective currency value vs. the U.S. dollar. Traders can also access cross-rate futures contracts, which allow a value comparison of a currency against another currency besides the U.S. dollar. For example, you can trade futures on the Australian dollar vs. the Canadian dollar, or British pound vs. the Japanese yen.

To learn more about FX pricing and the differences between trading cash FX and futures FX, or to translate futures FX prices into cash FX prices, visit CME's web-based application: CME E-quivalentsR: A free tool for smarter FX trading at www.cme.com/e-quivalents.

Equity-Based Futures

Some of the most popular futures contracts are related to the equity markets. Most major economies with a vibrant stock market also have a futures contract on a stock index that represents that particular economy. For example, in the United States, futures contracts are available on the Dow Jones Industrial Average as well as the broader Standard & Poor's 500 Index and the technology-oriented Nasdaq-100 Index. Other countries have similar contracts, such as the FTSE-100 in the United Kingdom, the Hang Seng in Hong Kong and the CAC 40 in France. The Dow Jones Euro STOXX 50 covers selected stocks in the euro economy.

Fundamental factors influencing stock markets encompass factors affecting companies' earnings potential, such as news about the global and domestic economy, inflation, currency values, politics and interest rates.

Stock Indexes

Stock index futures contracts were introduced in the U.S. in 1982, nine years after listed equity options began trading at the Chicago Board Options Exchange, the securities offshoot of the Chicago Board of Trade. Interestingly, the CBOT had come up with the idea of futures on stocks as a way to diversify its product line, although futures on individual stocks were many more years in coming.

The Kansas City Board of Trade launched the first stock index futures contract on the Value Line in February 1982, and the Chicago Mercantile Exchange followed with its S&P 500 Index contract a few months later. The S&P contract quickly became the market leader and continues to dominate U.S. stock index futures trading today. A number of stock index futures and options contracts are now available to traders, covering all areas of the market. The most popular major index futures contracts are listed below.

Standard & Poor's 500R Index

The S&P 500 Index is a market value-weighted index of 500 large-capitalization stocks traded on the New York Stock Exchange, American Stock Exchange and Nasdaq National Market System. Because the S&P is capitalization-weighted, those stocks with the most shares outstanding at the highest prices will have the most influence on the index movement. The S&P 500 index, introduced in 1957, is known as the investment industry's standard for measuring portfolio performance and is licensed by McGraw-Hill Companies Ltd.

The Chicago Mercantile Exchange introduced S&P 500 futures in 1982, and they originally traded at $500 times the cash index. As the market began to surge during the 1990s, the initial margin became too costly for many traders. In response, the CME decided to cut the contract's value to $250 times the index. The CME went even further to attract individual investors.

In 1997, the CME launched an even smaller version of its popular S&P 500 futures contract, which was felt to be more attractively sized for individual traders. The E-mini S&P 500 futures are priced at one-fifth the size of the big contract at $50 times the index, with a lower initial margin. But the real innovation of the new "mini" futures was the fact that they traded on an electronic platform, and not in open-outcry pits. CME officials decided trading would take place entirely on a trade-matching computer, giving traders direct access to the market and not an order-handler. Electronic trading would no longer be used only for after-hours trading or as a supplement to the primary pit contract. It became the mainstream market for the E-mini contracts. And, as long as trading was all computer-based, the CME decided to keep the market open nearly 24 hours a day. In just a year after its launch, the E-mini S&P futures were the third most active stock index contract in the country, and today, boast the strongest volume of any U.S. stock index product. Because of its strong liquidity, what started out as mainly a product for small speculators, day-traders and other retail investors is now also an institutional favorite.

Nasdaq-100R Index

The Nasdaq-100 Index is a modified market-capitalization index and includes the top 100 non-financial stocks (both domestic and foreign) listed on the Nasdaq Stock Market. Stocks such as Microsoft, Intel, eBay, Dell, Cisco, etc. dominate the index, so it's frequently associated with the high-flying technology sector of the stock market.

Futures on the Nasdaq-100 began trading in 1996 with a value of $100 times the index. Like the S&P 500 Index, the value of the Nasdaq-100 rose dramatically during the 1990s, and the CME launched a mini-sized electronic contract. E-mini Nasdaq-100 futures are priced at $20 times the index.

Both E-mini S&P 500 and E-mini Nasdaq-100 futures were smashing successes. Volume quickly grew in both to overtake their larger futures benchmarks and paved the way for many other mini-sized futures products at the CME and other exchanges.

Dow Jones Industrial Average

The Dow Jones Industrial Average is an index of 30 large capitalization "blue chip" stocks traded on the New York Stock Exchange, accounting for about 20 percent of the market value of all U.S. equities. The index, first published in 1896, is the most widely quoted market indicator in newspapers, radio, television and electronic media throughout the world. Futures on the DJIA began trading at the Chicago Board of Trade in 1997 after heated competition between the Chicago exchanges for the rights to trade futures and options on products owned by Dow Jones & Co., which had remained reluctant to allow its name to be used in trading.

The large DJIA futures contract has a value of $10 times the average. The CBOT began trading electronic, mini-sized DJIA futures valued at $5 times the average in 2002, and similar to the E-mini S&P contract, the mini-sized DJIA has become the more popular of the two with larger overall volume.

Single-Stock Futures

Single-stock futures, also known as security futures, began trading in 2002 after many years of regulatory debate. The so-called Johnson-Shad Accord in the early 1980s had set the ground rules for stock index futures, but futures on individual stocks and narrow-based stock indexes were not allowed to trade. They remained banned until Congress opened the door with passage of the Commodity Futures Modernization Act of 2000.

The legislation gave the green light to single-stock futures, and two new exchanges made their debut in November 2002. OneChicago, LLC was formed via a joint venture of the Chicago Mercantile Exchange, Chicago Board of Trade and Chicago Board Options Exchange , while NQLX, LLC was formed via a joint venture of Nasdaq and Euronext.liffe until the former dropped out. Currently, only OneChicago offers trading in the products; NQLX decided to suspend their trading effective in December 2004 due to lack of interest.

In the United States, single-stock futures trade solely on an electronic platform, and each futures contract represents 100 shares of the underlying stock. Despite years of anticipation surrounding their development, single-stock futures have been viewed as slow to catch on in the marketplace. However, they do offer many potential advantages futures in general hold over cash stocks, such as greater leverage, an easier ability to take a short position, and positive tax benefits.

Volatility Futures

The CBOE Futures Exchange, LLC launched trading in VIX futures in March 2004. VIX futures are based on the CBOE Volatility Index, which was first introduced in 1993 and became known as a benchmark of stock market sentiment among investors. Derived from real-time S&P 500 Index option prices, the CBOE states the VIX is designed to reflect investors' consensus view of expected stock market volatility over the next 30 days.

In May 2004, the CBOE CFE launched a realized variance futures contract. The CBOE S&P 500 three-month variance futures is an exchange-traded futures contract based on the realized variance of the Standard & Poor's 500 stock Index over a three-month period.

 

 

Who Participates in Financial Futures Markets?

There are two basic types of participants in the financial futures markets - hedgers and speculators. The hedgers are those seeking to minimize and manage price risk, while speculators are those willing to take on risk in the hope of making a profit. Hedgers include institutions such as banks and insurance companies, large multinational corporations, pension plans, and mutual funds. Despite their name, "hedge funds" actually often act as speculators in the marketplace. They utilize an array of complicated and varied strategies that not only seek to hedge against other cash investments held by their investors, but also to enhance returns through speculative positions.

As an example of a hedger in the financial futures markets, put yourself in the position of a mutual fund manager running an S&P 500 Index fund that contains individual stocks that comprise the S&P 500 Index. You are worried that a shaky U.S. economy and incidents of global terrorism could negatively impact the index and your returns, yet you can't disrupt your stock holdings. However, you could take a short position in S&P 500 Index futures, and if the stock prices fall, you could then buy back the futures at a lower price. That would allow you to offset losses to the stock holdings in your fund. Of course, if your worries were unfounded and the stock prices rose, you'd lose money on the futures transaction. But, the idea is to use futures as a hedge to minimize your potential risk.

While speculators can include large institutions and funds, many are individual traders who provide valuable liquidity to the marketplace. An individual trader who commits his or her own capital to act as speculator on a particular exchange is known as a local. Typically, these individuals provide market liquidity by constantly buying and selling throughout the trading session and are viewed as important participants in the market by shouldering risk. While the term local has been used to designate those trading in the open-outcry markets, this era of electronic trading is making the phrase a little obsolete. However, their function as liquidity providers is equally important in electronic markets. The Commodity Futures Trading Commission defines this new breed of electronic traders "E-locals," but they are often more simply known as independent traders.

A speculative trader typically takes a position in the futures markets with the hope of making a profit without any underlying cash stock market position. In the example above, the speculator may take the other side of the portfolio manager's trade, thinking it's unlikely a terrorist incident will soon strike and that stock prices will hold up.

 

History of Financial Futures

The history of established futures markets dates back to the 1800s, but up until the early 1970s, all futures markets were basically designated as "commodity" markets because the products traded were mainly agricultural. However, futures on financial products were quickly and enthusiastically embraced. They now dominate trading activity, accounting for about 75 percent of all derivatives trading volume in the world.

The Chicago Mercantile Exchange claims credit for the creation of financial futures with the launch of seven foreign currency contracts in 1972. According to the CME, they were introduced in response to the breakdown of the Bretton Woods Agreement, which had governed international currency exchange-rate policy since the end of World War II.

It was during the FX market turmoil leading up to the initial revision of the U.S. dollar "gold peg" that Leo Melamed, Chairman Emeritus of CME, with the endorsement of Nobel Laureate economist Milton Friedman, championed the idea of foreign exchange futures contracts. On May 16, 1972, the CME's International Monetary Market opened for business, listing seven foreign currency futures contracts: British pound, Canadian dollar, Deutsche mark, French franc, Japanese yen, Mexican peso and Swiss franc.

Also during the 1970s, the challenges of inflation and volatile interest rate fluctuations spawned the development of futures contracts tied to interest rates.

In 1975, the Chicago Board of Trade launched its first financial futures contract on Government National Mortgage Association mortgage-backed certificates, or GNMAs. In 1977, the CBOT introduced trading in U.S. Treasury bond futures and a suite of other Treasury futures products followed.

In 1981, the CME launched Eurodollar futures, which had an innovative feature that paved the way for even more growth in financial contracts to come. Eurodollar futures were the first futures contracts that did not require delivery of an underlying instrument, but were settled in cash. The cash-settlement innovation safeguarded their usefulness to hedgers and opened the door for new types of contracts in which a delivery option would be impossible or prohibitively expensive. The cash-delivery feature also helped fuel the creation of stock index futures. First came the Kansas City Board of Trade's launch of the Value Line Index in 1982, then the same year the CME launched the Standard & Poor's 500 Index contract and the New York Financial Exchange (now part of the New York Board of Trade) launched the NYSE Index contract.

In the 1990s, more financial futures products came to the marketplace, and the advent of electronic trading caused a further explosion in their popularity. Mini-sized, all-electronic versions of stock index futures contracts charged onto the scene in the late 1990s and were quickly embraced. Today, volume in the E-mini S&P 500 Index futures contract at the Chicago Mercantile Exchange often tops a million contracts per day, surpassing the larger and older benchmark S&P 500 futures contract that spawned it. Exchanges continue to launch new financial futures products to meet ever-changing investor needs.

Among the newest innovations in financial futures are single-stock futures, launched in 2002, VIX futures, launched in 2004, and event futures, which are based on specific economic releases or events. The CME launched one such event futures product, CPI futures, in 2004. They are based on the market's expectation for future inflation based on the popular consumer price index indicator.

What Contracts Can I Trade?

A wide variety of financial futures markets are available to trade around the world, and new contracts are continually being introduced while others retired.

A list of U.S. exchanges that offer trading in financial futures and their corresponding contract listings is shown here, although not exhaustive.

Some of these futures markets have limited liquidity and therefore can be more challenging to trade. Therefore, it is recommended you contact your broker and learn more before deciding to trade these markets. Click on each exchange's link below for more details on contract specifications.

• CBOT - Chicago Board of Trade
• CBOE - CBOE Futures Exchange
• CME - Chicago Mercantile Exchange
• Eurex US
• Kansas City Board of Trade
• NYBOT - New York Board of Trade
• OneChicago LLC

Major Contracts Available With Links to U.S. Exchanges