introduction to the history and development of futures and futures markets

7/24/2019 Introduction to the History and Development of Futures and Futures Markets

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A futures exchange or futures market is a central financial exchange where people can trade

standardized futures contracts; that is, a contract to buy specific quantities of

acommodityor financial instrumentat a specified price with deliveryset at a specified time

in the future. These types of contracts fall into the category ofderivatives.

uch instrumentsare priced according to the movement of the underlying asset !stock,

physical commodity, index, etc.". The aforementioned category is named #derivatives#

because the value of these instruments are derivedfrom another asset class.

$efinition%edit&

According to The 'ew (algrave $ictionary of )conomics !'ewbery *++", futures markets

#provide partial income risk insurance to producers whose output is risky, but very effective

insurance to commodity stockholdersat remarkably low cost. peculators absorb some of the

risk buthedgingappears to drive most commodity markets. The equilibrium futures price can

be either below or above the !rationally" expected future price !backwardation

or contango"...-ollover hedges can extend insurance from shorthorizon contracts over longer

periods.#%/&

Futures Markets

0n the late /12+s and early /1+s, radical changes in the international currency system and in

the way the 3ederal -eserve managed the 4.. 56')74((87produced unprecedented

volatility in 0'T)-)T-AT)and currency exchange rates. As market forces shook the

foundations of global financial stability, businesses wrestled with heretofore unimagined

challenges. 9etween /1+ and /1:, aterpillar, the (eoriabased maker of heavy equipment,

saw exchangerate shifts give its main orld debt crisis.

tymied financial managers turned to hicago, where the traditional agricultural futures

markets had only recently invented techniques to cope with financial uncertainty. 0n /12*, the

hicago 5ercantile )xchange established the 0nternational 5onetary 5arket to trade theworld?s first futures contracts for currency. The world?s first interestrate futures contract was

introduced shortly afterward, at the hicago 9oard of Trade, in /12:. 0n /1*, futures

contracts on the tandard and (oor?s :++ index began to trade at the hicago 5ercantile

)xchange. These radically new tools helped businesses manage in a volatile and

unpredictable new world order. @ow 3utures 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. The concept of buying and selling for future delivery is not in itself new. 0n

thirteenthand fourteenthcentury )urope, buyers contracted for wool purchases one toseveral years forward. istercian monasteries that produced the wool sold forward more than
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their own production, expecting to buy the remainder on the market !presumably at a lower

price" to satisfy their obligation. 0n seventeenthcentury


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and$)5A'$causes the prices of futures contracts to fluctuate, sometimes moving them up

and down many times in a trading day. 3or example, news of drought or blight that may

reduce the corn harvest, cutting future supplies, causes corn futures contracts to rise in price.

imilarly, news of a rise in interest rates or a presidential illness can cause stockindex futures

prices to fall as investors react to the prospect of difficult or uncertain times ahead. )very

day, the clearinghouse tallies up and matches all contracts bought or sold during the trading

session. (arties holding contracts that have fallen in price during the trading session must pay

the clearinghouse a sort of security deposit called Bmargin.C >hen the contracts are closed

out, it is the clearinghouse that pays the parties whose contracts have gained in value. 3utures

trading is what economists call a zerosum game, meaning that for every winner there is

someone who loses an equal amount.

9ut in a fundamental economic sense, futures trading is positive sum. 9oth sides expect togain, or they would not trade. Another way of saying this is that the loser may be perfectly

happy to lose. That is because many businesses use futures markets as a form of 0'4-A').

A candy maker, for example, might buy sugar and cocoa futures contracts to lock in a price

for some portion of its requirement for these important ingredients. The contracts are as good

as physically buying the commodities and storing them. 0f prices rise, the futures contracts

will also be more valuable. The company can choose to sell the contracts and pocket the cash,

then buy the commodities from its usual suppliers at market prices, or else accept delivery of

the ingredients from the seller of the contract and buy less on the market. )ither way, its costof raw materials is lower than if it had not bought the contracts. The company has cushioned

itself against a price risk and does not have to worry that its production and marketing

strategy will be disrupted by a sudden price increase. 9ut what if prices fall 0n that case the

company loses some money on its futures contracts. 9ut the same price decrease that causes

that loss also caused something goodE the company pays less for its ingredients. -emember,

the purpose of buying the futures contract was to protect against something bad happeningF

a price rise. The bad thing did not happen; prices fell instead. The loss on thefutures contract

is the cost of insurance, and the company is no worse off than a person who purchases fire

insurance and then does not have a fire.

The biggest users of the futures markets rely on them for risk management. That is surely one

reason why defaults are rare. 9ut there is an additional security measure between the

individual trader and the clearinghouse. 9uyers and sellers of futures must do business

through intermediaries who are exchange members. 0nstead of standing between two

individual traders, therefore, the clearinghouse stands between two exchange member firms.

)ach firm monitors its own customers and makes a Bmargin callC when the customer?s losses

make additional margin necessary. 0f the customer cannot pay the margin, the firm closes theaccount, sells off the positions, and may have to take a small loss. >hile firms pay attention
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to the credit of their customers, the clearinghouse pays attention to the credit of the firms. The

clearinghouse needs to make good on a trade only if losses are so great that the exchange

member firm itself fails. This happens occasionally when firms badly mismanage their risks

or when a maDor financial crisis occurs.

9ecause futures contracts offer assurance of future prices and availability of goods, they

provide stability in an unstable business environment. 3utures 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 farmersFat least in 'orth

America and )urope. 9y the early *+++s, although commodities remained the mainstay of

futures markets in Asia, in the developed countries of the >est financial futures contracts had

almost totally eclipsed commodities. The hicago 5ercantile )xchange claimed in *++= that

financial futures accounted for 11 percent of its business, and financial futures also accountedfor the lion?s share of business at the hicago 9oard of Trade and at )uronext.liffe.

!)uronext.liffe is the international derivatives business of )uronext, comprising the

Amsterdam, 9russels, 8ondon, 8isbon, and (aris derivatives markets. 0t was formed

following )uronext?s purchase of the 8ondon 0nternational 3inancial 3utures and 6ptions

)xchange %8033)& in *++/." 0n


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prefer not to gamble on the corn market. 3arming is risky enough, thanks to uneven rainfalls

and unpredictable pests, without adding the risk of changes in market prices.

3armers thus seek to lock in a value on their crop and are willing to pay a price for certainty.

They give 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.

3or 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

Bspeculators.C peculators come to market to take risk, and to make money doing it. ome

speculators, against all odds, have become phenomenally wealthy by trading futures.0nterestingly, even the wealthiest speculators often report having gone broke one or more

times in their career. 9ecause 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. 0f 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. peculators, however, provide a ready and liquid

market for these risksFat a price. peculators who are willing to assume risks for a price

make it possible for others to reduce their risks.65()T0T06'among speculators also makes

hedging less expensive and ensures that the effect of all available information is swiftly

calculated into the market price. >eather reports, actions of central banks, political

developments, and anything else that can affect supply or demand in the future affect futures

prices almost immediately. This is how the futures market performs its function of Bprice

discovery.C

There seems to be no limit to the potential applications of futures market technology. The

'ew 7ork 5ercantile )xchange !'75)H" began to trade heating oil futures in /12. The

exchange later introduced crude oil, gasoline, and natural gas futures. Airlines, shipping

companies, public transportation authorities, homeheatingoil delivery services, and maDor

multinational oil and gas companies have all sought to hedge their price risk using these

futures contracts. 0n /11+ the '75)H traded more than thirtyfive million )')-I7futures

and option contracts.
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5eanwhile, internationalT6J5A-J)Tinvestors have discovered that stockindex futures,

besides being useful for hedging, also are an attractive alternative to actually buying stocks.

9ecause a stockindex future moves in tandem with the prices of the underlying stocks, it

gives the same return as owning stocks. 7et the stockindex future is cheaper to buy and may

be exempt from certain taxes and charges to which stock ownership is subDect. ome large

institutional investors prefer to buy Ierman stockindex futures rather than Ierman stocks

for this very reason.

9ecause stockindex futures are easier to trade than actual stocks, the futures prices often

change before the underlying stock prices do. 0n the 6ctober /12 crash, for example, prices

of stockindex futures in hicago fell before prices on the 'ew 7ork tock )xchange

collapsed, leading some observers to conclude that futures trading had somehow caused the

stock market crash that year. 0n fact, investors who wanted to sell stocks could not sellquickly and efficiently on the 'ew 7ork tock )xchange and therefore sold futures instead.

The futures market performed its function of price discovery more rapidly than the stock

market did.

3utures contracts have even been enlisted in the fight against air pollution and the effort to

curb runaway @)A8T@0'4-A')costs. >hen the )nvironmental (rotection Agency decided

to allow a market for sulfur dioxide emission allowances under the /11+ amendments to the

lean Air Act, the hicago 9oard of Trade developed a futures contract for trading what

might be called air pollution futures. The reason 0f 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.

>ithout a futures market it would be difficult to know whether a price offered or demanded

for emissions allowances is high or low. 9ut hedgers and speculators bidding in an open

futures market will cause quick discovery of the true price, the equilibrium point at whichbuyers and sellers are both equally willing to transact. imilar reasoning has led to some

decidedly unconventional applications of futures technology. The 0owa )lectronic 5arket

introduced political futures in /1, and this market has generally beaten the pollsters at

predicting not only the winner of the >hite @ouse but also the winning margin. This makes

sense because people are much more careful with information when they are betting money

on it than when they are talking to a pollster. )conomist -ichard -oll showed that the orange

Duice futures market is a slightly better predictor of 3lorida temperatures than the 'ational

>eather ervice. And in *++K, the $)3)')$epartment stirred up controversy with plans tolaunch what was quickly dubbed a Bterrorism futuresC market. The idea was to let people
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speculate on events in the 5iddle )ast and win real money if they made the right bet.

ongressional outrage nipped that plan in the bud, but the underlying logic was sound. 0f

futures markets are an efficient mechanism for assimilating information and assessing

probabilities, why not use them for statecraft and military applications

@istory

0n Ancient 5esopotamia, around /2:+ 9, the sixth 9abylonian king,@ammurabi, created

one of the first legal codesE the ode of @ammurabi. @ammurabi?s ode allowed sales of

goods and assets to be delivered for an agreed price, at a future date; required contracts to be

in writing and witnessed; and allowed assignment of contracts. The code facilitated the first

derivatives, in the form of forward and futures contracts. An active derivatives market

existed, with trading carried out at temples.%*&

6ne of the earliest written records of futures trading is in AristotleLsPolitics. @e tells thestory of Thales, a poor philosopher from5iletuswho developed a #financial device, which

involves a principle of universal application#. Thales used his skill in forecasting and

predicted that the olive harvest would be exceptionally good the next autumn. onfident in

his prediction, he made agreements with local olivepressowners to deposit his money with

them to guarantee him exclusive use of their olive presses when the harvest was ready. Thales

successfully negotiated low prices because the harvest was in the future and no one knew

whether the harvest would be plentiful or pathetic and because the olivepress owners were

willing tohedgeagainst the possibility of a poor yield. >hen the harvesttime came, and a

sharp increase in demand for the use of the olive presses outstripped supply !availability ofthe presses", he sold his future use contracts of the olive presses at a rate of his choosing, and

made a large quantity of money.%K&0t should be noted, however, that this is a very loose

example of futures trading and, in fact, more closely resembles anoption contract, given that

Thales was not obliged to use the olive presses if the yield was poor.

The first modern organized futures exchange began in /2/+ at the $oDima -ice

)xchangein 6saka,


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The 4nited tatesfollowed in the early /1th century. hicagohas the largest future exchange

in the world, the hicago 5ercantile )xchange. hicago is located at the base of the Ireat

8akes, close to the farmlands and cattle country of the 5idwest, making it a natural center for

transportation, distribution, and trading of agricultural produce. Iluts and shortages of these

products caused chaotic fluctuations in price, and this led to the development of a marketenabling grain merchants, processors, and agriculture companies to trade in #to arrive# or

#cash forward# contracts to insulate them from the risk of adverse price change and enable

them tohedge. 0n 5arch *++ the hicago 5ercantile )xchange announced its acquisition of

'75)H @oldings, 0nc., theparent companyof the 'ew 7ork 5ercantile )xchange and

ommodity )xchange. 5)Ls acquisition of '75)H was completed in August *++.

3or most exchanges, forward contracts were standard at the time. @owever, most forward

contracts were not honored by both the buyer and the seller. 3or instance, if the buyer of

acornforward contract made an agreement to buy corn, and at the time of delivery the price

of corn differed dramatically from the original contract price, either the buyer or the seller

would back out. Additionally, the forward contracts market was very illiquid and an exchange

was needed that would bring together a market to find potential buyers and sellers of a

commodity instead of making people bear the burden of finding a buyer or seller.

0n /= the hicago 9oard of Trade!96T" was formed. Trading was originally inforward

contracts; the first contract !on corn" was written on 5arch /K, /:/. 0n /M:

standardized futures contractswere introduced.

The hicago (roduce )xchange was established in /2=, renamed thehicago 9utter and

)gg 9oardin /1 and then reorganised into the hicago 5ercantile )xchange!5)" in

/1/1. 3ollowing the end of thepostwar international gold standard, in /12* the 5) formed

a division called the 0nternational 5onetary 5arket!055" to offer futures contracts in

foreign currenciesE 9ritish pound, anadian dollar,Ierman mark,ith the addition of

the'ew 7ork 5ercantile )xchange!'75)H" the trading andhedgingof financial products

using futures dwarfs the traditional commodity markets, and plays a maDor role in the global

financial system,trading over N/.: trillion per day in *++:.%1&

The recent history of these exchanges !Aug *++M" finds the hicago 5ercantile

)xchangetrading more than 2+O of its 3utures contracts on its #Ilobex# trading platform
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and this trend is rising daily. 0t counts for over N=:.: billion of nominal trade !over / million

contracts" every single day in #electronic trading# as opposed to open outcrytrading of

futures, options and derivatives.

0n


10/12

products developed over time, including commodities such as cocoa, orange Duice and sugar.

5assive 4.. cattle production in the led to cattle and pork futures contracts.

The /12+s saw a large expansion in the futures trading markets. The hicago 5ercantile

)xchange !5)" started offering futures trading in foreign currencies. The 'ew 7ork

5ercantile )xchange !'75)H" began offering trading in various financial futures, including4.. Treasury bonds !Tbonds" and eventually futures in stock market indexes. The

ommodities )xchangeprovided futures trading in gold, silver and copper, and later added

platinum and palladium when gold ceased to be pegged to the 4.. dollar. The rapid

expansion of trading in financial futures led to the creation of futures contracts on the $ow


11/12

population centers. The city was a natural hub for trade, but the trading that took place there

was inefficient and unorganized until a group of hicago based business men formed the

9oard of Trade of the ity of hicago in /=. The 9oard was a member owned organization

that offered a centralized location for cash trading of a variety of goods as well as trading of

forward contracts. 5embers served as brokers who facilitated trading in return forcommissions.

As trading of forward contracts increased, the 9oard decided that standardizing those

contracts would streamline the trading and delivery processes. 0nstead of individualized

contracts, which took a great deal of time to negotiate and fulfill, people interested in the

forward trading of corn at the 9oard, for example, were asked to trade contracts that were

identical in terms of quantity, quality, delivery month and terms, all as established by the

exchange. The only thing left for traders to negotiate was price and the number of contracts.

These standardized forwards were essentially the first modern futures contracts. They wereunlike other forwards in that they could only be traded at the exchange that created them, and

only at certain designated times. They were also different from other forwards in that the

bids, offers and negotiated prices of the trades were made public by the exchange. This

practice established futures exchanges as venues for price discovery in 4.. markets.

0n contrast to customized contracts, standardized futures contracts were easy to trade, since

all trades were simply renegotiations of price, and they usually changed hands many times

before expiration. (eople who wanted to make a profit based on a fortuitous price change, or

alternatively, who wished to cut mounting losses as quickly as possible, could offset a futures

contract before expiration by engaging in an opposite tradeE buying a contract which they had

previously sold !or gone short", or selling a contract which they had previously bought !or

gone long".

The usefulness of futures trading became apparent, and a number of other futures exchanges

were established throughout the country in the decades that followed. The hicago 9utter and

)gg 9oard was founded in /1 and evolved into hicago 5ercantile )xchange !5)" in

/1/1. 3utures exchanges also opened in 5ilwaukee, 'ew 7ork, t. 8ouis, Jansas ity,

5inneapolis, an 3rancisco, 5emphis, 'ew 6rleans and elsewhere. hicago, however,

became the most influential and predominant location for futures trading in the 4..

The )ra of 3inancial 3utures

Throughout the first seven decades of the twentieth century, the futures industry remained

essentially as it had been focused on the trading of futures on agricultural products. 9ut a

remarkable change occurred in the industry in /12/, with the introduction of futures based on

financial products.

A 'ew onceptE 3utures on 3oreign urrencies


12/12

4ntil /12/, world currencies had been pegged to an international gold standard, but that year

the gold standard was abolished and currency values were allowed to float. 8eaders of 5)

recognized that a currency whose value was determined by market forces had become a

commodity like any other, and therefore futures could be traded on it. There was !and still is"

an enormous forward market for currency trading, but until then there were no exchangetraded, standardized futures on currencies. As with futures on agricultural commodities,

currency futures offered an opportunity to hedge against risks in price changes, as well as to

profit from changes in values. That year, 5) formed the 0nternational 5onetary 5arket

!055", initially a separate exchange closely linked to 5), and hosted its first futures trades

on foreign currencies.

The notion of trading futures on currencies was highly controversial. 9ut the concept

garnered credibility from the support of economist 5ilton 3riedman, who pronounced that

the 055 would enable the world to operate more smoothly and effectively. 3riedman proved

correct, and now currency futures have become an integral part of international finance

introduction to the history and development of futures and futures markets

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