[An updated version of this article can be found at Futures and Options Markets in the 2nd edition.]
In the late seventies and early eighties, radical changes in the international currency system and in the way the Federal Reserve managed the nation's money supply produced unprecedented volatility in interest rates and in currency exchange rates. As market forces shook the foundations of global financial stability, businesses wrestled with heretofore unimagined challenges. Between 1980 and 1985 Caterpillar, the Peoria-based maker of heavy equipment, saw exchange-rate shifts give its main Japanese competitor a 40 percent price advantage. Meanwhile, even the soundest business borrowers faced soaring, double-digit interest rates. Investors clamored for dollars as commodity prices collapsed, taking whole nations down into insolvency and ushering in the Third World debt crisis.
Stymied financial managers turned to Chicago, where the traditional agricultural futures markets had only recently invented techniques to cope with financial uncertainty. In 1972 the Chicago Mercantile Exchange established the International Monetary Market to trade the world's first futures contracts for currency. The world's first interest-rate futures contract was introduced shortly afterward, at the Chicago Board of Trade, in 1975. In 1982, futures contracts on the Standard and Poor's 500 index began to trade at the Chicago Mercantile Exchange. These radically new tools helped businesses manage in a volatile and unpredictable new world order.
How? Futures are standardized contracts that commit parties to buy or sell goods of a specific quality at a specific price, for delivery at a specific point in the future. They are not contracts directly between buyers and sellers of goods. The farmer who sells a futures contract and commits to deliver corn in six months does not make his commitment to a specific corn buyer, but rather to the clearinghouse of the futures exchange. The clearinghouse stands between buyers and sellers and, in effect, guarantees that both buyers and sellers will receive what they have contracted for.
Thanks to the clearinghouse, the farmer does not have to be concerned about the financial stability of the buyer of the futures contract, nor does the buyer need to be concerned about the progress of any particular farmer's crop. The clearinghouse monitors the credit of buyers and sellers. New information about changes in supply and demand causes the prices of futures contracts to fluctuate, sometimes moving them up and down many times in a trading day. For example, news of drought or blight that may reduce the corn harvest, cutting future supplies, causes corn futures contracts to rise in price. Similarly, news of a rise in interest rates or a presidential illness can cause stock-index futures prices to fall as investors react to the prospect of difficult or uncertain times ahead. Every day, the clearinghouse tallies up and matches all contracts bought or sold during the trading session. Parties holding contracts that have fallen in price during the trading session must pay the clearinghouse, a sort of security deposit called "margin." When the contracts are closed out, it is the clearinghouse that pays the parties whose contracts have gained in value. Futures trading is what economists call a zero-sum game, meaning that for every winner there is someone who loses an equal amount.
Because futures contracts offer assurance of future prices and availability of goods, they provide stability in an unstable business environment. Futures have long been associated with agricultural commodities, especially grain and pork bellies, but they are now more likely to be used by bankers, airlines, and computer makers than by farmers. By the end of the eighties, financial futures accounted for three-quarters of all futures volume, almost totally supplanting the agricultural commodities contracts that had been the futures industry's raison d'etre for over a hundred years.
Obviously, the idea of hedging against an unstable financial environment has great appeal. Companies like Caterpillar now protect themselves against currency shifts by buying and selling futures contracts or similar instruments. Investors use interest-rate, bond-futures, and stock-index contracts to protect against a decline in the value of their investments, just as farmers have long used futures to protect against a drop in the price of corn or beans.
Although the underlying risks have changed, the futures market operates much as it always has, with traders standing in a ring or a pit shouting buy and sell orders at each other, competing for each fraction of a cent. Futures exchanges are private, member-owned organizations. Members buy "seats" on the exchange and, depending on the kind of seat they buy, enjoy various trading rights. Since traders deal in contracts rather than actual commodities, they may not be expert in the oil or corn or stocks that underlie their contracts. Traders consider themselves experts on market movements rather than authorities on minerals and crops. This is why financial futures were relatively easy to introduce to markets originally designed for agricultural commodity futures. Full membership in the Chicago Mercantile Exchange, to pick just one example, now entitles a trader to deal in everything from pork bellies to European Currency Units.
In the nineteenth century Chicago's trading pits offered an organized venue in which farmers and other suppliers of agricultural commodities, such as warehouse owners and brokers, could remove the risk of price fluctuations from their business plans. Farmers who planted corn in the spring had no way of knowing what the price of their crop would be when they harvested in the fall. But a farmer who planted in the spring and sold a futures contract committed to deliver his grain in the fall for a definite price. Not only did he receive cash in the spring in return for his commitment, but he also received the contract price for his crop even if the market price subsequently fell because of an unexpected glut of corn. In exchange the farmer gave up the chance to get a higher price in the event of a drought or blight, receiving the same fixed price for which he had contracted. In the latter case, if the farmer had not sold the future, he would have netted more. However, most farmers preferred not to gamble on the corn market. Farming was risky enough, thanks to uneven rainfalls and unpredictable pests, without adding the risk of changes in market prices.
Farmers thus sought to lock in a value on their crop and were willing to pay a price for certainty. They gave up the chance of very high prices in return for protection against abysmally low prices. This practice of removing risk from business plans is called hedging. As a rule of thumb, about half of the participants in the futures markets are hedgers who come to market to remove or reduce their risk.
For the market to function, however, it cannot consist only of hedgers seeking to lay off risk. There must be someone who comes to market in order to take on risk. These are the "speculators." Speculators come to market to take risk, and to make money doing it. Some speculators, against all odds, have become phenomenally wealthy by trading futures. Interestingly, even the wealthiest speculators often report having gone broke one or more times in their career. Because speculation offers the promise of astounding riches with little apparent effort, or the threat of devastating losses despite even the best efforts, it is often compared to casino gambling.
The difference between speculation in futures and casino gambling is that futures market speculation provides an important social good, namely liquidity. If it were not for the presence of speculators in the market, farmers, bankers, and business executives would have no easy and economical way to eliminate the risk of volatile prices, interest rates, and exchange rates from their business plans. Speculators, however, provide a ready and liquid market for these risks—at a price. Speculators who are willing to assume risks for a price make it possible for others to reduce their risks. Competition among speculators also makes hedging less expensive and ensures that the effect of all available information is swiftly calculated into the market price. Weather reports, actions of central banks, political developments, and anything else that can affect supply or demand in the future affects futures prices almost immediately. This is how the futures market performs its function of "price discovery."
There seems to be no limit to the potential applications of futures market technology. The New York Mercantile Exchange (NYMEX) began to trade heating oil futures in 1978. The exchange later introduced crude oil, gasoline, and natural gas futures. Airlines, shipping companies, public transportation authorities, home-heating-oil delivery services, and major multinational oil and gas companies have all sought to hedge their price risk using these futures contracts. In 1990 the NYMEX traded over 35 million energy futures and option contracts.
Meanwhile, international stock market investors have discovered that stock-index futures, besides being useful for hedging, also are an attractive alternative to actually buying stocks. Because a stock-index future moves in tandem with the prices of the underlying stocks, it gives the same return as owning stocks. Yet the stock-index future is cheaper to buy and may be exempt from certain taxes and charges to which stock ownership is subject. Some large institutional investors prefer to buy German stock-index futures rather than German stocks for this very reason.
Because stock-index futures are easier to trade than actual stocks, the futures prices often change before the underlying stock prices do. In the October 1987 crash, for example, prices of stock-index futures in Chicago fell before prices on the New York Stock Exchange collapsed, leading some observers to conclude that futures trading had somehow caused the stock market crash that year. In fact, investors who wanted to sell stocks could not sell quickly and efficiently on the New York Stock Exchange and therefore sold futures instead. The futures market performed its function of price discovery more rapidly than the stock market (see Program Trading).
Futures contracts have even been enlisted in the fight against air pollution and the effort to curb runaway health insurance costs. When the Environmental Protection Agency decided to allow a market for sulfur dioxide emission allowances under the 1990 amendments to the Clean Air Act, the Chicago Board of Trade developed a futures contract for trading what might be called air pollution futures. The reason? If futures markets provide price discovery and liquidity to the market in emission allowances, companies can decide on the basis of straightforward economics whether it makes sense to reduce their own emissions of sulfur dioxide and sell their emission allowance to others, or instead to sustain their current emission levels and purchase emission allowances from others.
Without a futures market it would be difficult to know whether a price offered or demanded for emissions allowances is high or low. But hedgers and speculators bidding in an open futures market will cause quick discovery of the true price, the equilibrium point at which buyers and sellers are both equally willing to transact. Similar reasoning led to the development of health insurance futures and options contracts, also at the Chicago Board of Trade. This contract may provide businesses, insurers, and other participants in the health care market with an effective mechanism to hedge themselves against the uncertain rise and fall of health insurance prices.
Options are one of the most important outgrowths of the futures market. Whereas a futures contract commits one party to deliver, and another to pay for, a particular good at a particular future date, an option contract gives the holder the right, but not the obligation, to buy or sell. Options are attractive to hedgers because they protect against loss in value but do not require the hedger to sacrifice potential gains. Most exchanges that trade futures also trade options on futures.
There are other types of options as well. In 1973 the Chicago Board of Trade established the Chicago Board Options Exchange to trade options on stocks. The Philadelphia Stock Exchange has a thriving business on currency options.
There is also a large, so-called over-the-counter (OTC) market in options. Participants in the OTC market include banks, investment banks, insurance companies, large corporations, and other parties. OTC options differ from exchange-traded options. Whereas exchange-traded options are standardized contracts, OTC options are usually tailored to a particular risk. If a corporation wants to hedge a stream of foreign currency revenue for five years, but exchange-traded options are available only out to six months, the corporation can use the OTC market. An insurance company or bank can design and price a five-year option on the currency in question, giving the company the right to buy or sell at a particular price during the five-year period.
Although users of the OTC options market do not access the futures exchange directly, the prices discovered on the futures exchanges are important data for determining the prices of OTC options. The liquidity and price discovery elements of futures help to keep the OTC market from getting far out of line with the futures market. When futures markets do not exist or cannot be used, hedgers pay steeply for the protection they seek.
Gregory J. Millman is a journalist who writes about financial markets for Barron's, Corporate Finance, Institutional Investor, Journal of Applied Corporate Finance, and other financial journals. In 1992 he was awarded a fellowship by the Alicia Patterson Foundation to research and write about financial futures and options markets.
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