A forward contract with a bank is tailor-made and carries the bank’s credit risk. A futures contract is the same promise in standard form, traded on an exchange that stands behind every deal and demands cash deposits to guarantee them. That standard form lets anyone close a position in a minute, and it lets a company hedge a currency, an interest rate or a share index.
But the standard size and dates never match the exposure exactly, and the futures price never equals the spot price, which leaves a gap called basis.
This topic covers what futures are, financial and commodity futures, exchanges and settlement dates, the exchange as counterparty and margin, long and short positions and closing out, ticks and tick values, basis and basis risk, and how to create a hedge and why it is imperfect. The previous topic covered forward rates and currency swaps. The next covers currency futures and short-term interest rate futures.
Neither the May 2014 nor the November 2014 Pathfinder sets a stand-alone question on futures.
In 30 seconds
A future is a standardised forward contract for a standard quantity, traded on an exchange with a few settlement dates a year (March, June, September, December). The exchange (through a clearing house) is counterparty to every trade, which removes credit risk, and it requires an initial margin plus variation margin when a position loses. Long = bought; short = sold. Most positions are closed out before settlement by doing the opposite trade.
A tick is the smallest price move; gain = ticks × tick value × contracts. Basis = spot − futures (the gap), falling to zero at settlement; for exams assume it falls in a straight line. Basis risk is the actual basis differing from the expected one. Hedge by taking a futures position opposite to the exposure, with settlement after the transaction.
Number of contracts = exposure ÷ contract size, rounded; the hedge is imperfect because of rounding and basis.
Key terms in plain English
| Term | What it means |
|---|---|
| Future | A standardised contract to buy or sell a standard quantity at a set future date and a price agreed now |
| Initial margin | The cash deposit paid to the exchange when a position is opened |
| Variation margin | Extra cash paid when a position makes a loss |
| Long / short position | Having bought / having sold futures |
| Tick | The minimum price movement of a contract |
| Basis | The difference between the spot price and the futures price |
| Basis risk | The risk that the actual basis at close-out differs from expectation |
Syllabus check
This topic is in syllabus area E (treasury and advanced risk management). It covers:
- explaining how futures are used to hedge risk;
- explaining how currency and interest rate futures hedge exposures.
CAMA 2020 and futures trading
The Companies and Allied Matters Act 2020 (CAMA 2020) is the company law of Nigeria.
| Section | What it says | Link to this topic |
|---|---|---|
| s. 305 | A director must act in good faith in the best interests of the company | Hedging should protect the company, not speculate with its resources |
| s. 308 | A director must use the care, diligence and skill of a reasonably prudent director | Directors should set limits and oversight for any futures positions |
| s. 377(1) and s. 378 | Directors prepare statements that follow IFRS and give a true and fair view | Decisions later affect reported assets, profit and cash |
| s. 385 | The directors’ report covers performance and risk | Major plans and risks are reported to shareholders |
The nature of futures
A future is a forward contract for a standard quantity of an item for settlement at a specified date, at a price agreed now. Features: (a) every contract for an item is identical except for the settlement date; (b) it is traded on an exchange, not negotiated over the counter.
Commodity futures cover wheat, oil, copper, gold, coffee and so on; financial futures cover currency, short-term interest rates, bonds and stock indexes. Exchanges include the CBOT and CME in Chicago, Eurex and LIFFE. Contracts settle on four dates a year (March, June, September, December), so a position is a “June” or “December” future; the exam assumes month-end. Prices are published throughout the trading day.
The exchange and margin
The exchange (strictly, its clearing house) becomes the buyer to every seller and the seller to every buyer, so each party relies on the exchange, not on the other, and credit risk is nearly eliminated. The exchange protects itself with margin: an initial margin deposit from both parties, and variation margin calls whenever the market moves against a party.
A coffee buyer at $2,000 a tonne must pay initial margin and then variation margin if the price falls.
Long and short positions, and closing out
Buying futures without having sold any gives a long position; selling without having bought gives a short position. The total of longs always equals the total of shorts. At settlement, short-term interest futures are cash-settled and bond futures by delivery. Most positions are closed out beforehand: a long position by selling the same number of the same contract, a short position by buying.
The gain or loss is the difference between the opening and closing prices.
Choosing the contract: a company needing to sell 20 euro futures in November, with September and December contracts only, should use December, the next settlement date after the transaction, and close the position in November. A contract settling before the transaction would leave the exposure open.
Ticks and tick values
A tick is the minimum price movement. Examples: US dollar–euro futures are for €125,000, priced in $ per €, tick $0.0001, so a tick is worth 125,000 × 0.0001 = $12.50. Short-term interest futures are priced at 100 minus the rate, tick 0.0001 (0.01% a year); a Eurodollar future represents a three-month $1,000,000 deposit, so a tick is 1,000,000 × 0.0001 × 3÷12 = $25. Stock index futures move in index points; for the FTSE 100 a tick is worth £10.
Gain or loss = contracts × ticks moved × tick value. ICAN’s example: buy 20 June Eurodollar at 96.50, sell at 96.72 (22 ticks): 20 × 22 × $25 = $11,000.
Basis and basis risk
The futures price differs from spot by the basis, which shrinks to zero at settlement (otherwise traders could buy in one market and sell in the other for a riskless profit). Positions are usually closed early, so some basis remains. Exam assumption: basis falls in a straight line. ICAN’s example: in April a company sells September sterling futures at 1.9800 with spot at 1.9600, so basis = 200 points.
Five months to September: it falls 40 points a month. Closing in July (three months), basis falls 120, so the expected basis is 80. Basis risk: the actual basis may differ; if the futures price is 1.9790 and spot 1.9740, basis is 50, 30 less than expected.
Creating a hedge
Hedging with futures means taking a futures position opposite to the exposure so a loss on the exposure is offset by a gain on the futures (and a gain by a loss). Rules: a long position gains if the futures price rises; a short position gains if it falls. Futures hedge only short-term exposures because contracts expire within about 12 months. Three steps for currency futures:
- Identify the underlying transaction (buying or selling which currency, and when).
- Identify the currency risk (will the company pay more, or receive less, if the currency rises or falls?). State it in the currency the futures are denominated in.
- Find the futures position that gives a profit when the underlying transaction makes a loss.
Examples: a coffee producer holding beans fears a fall in price, so sells futures; a buyer of beans fears a rise, so buys futures. A US company expecting €2,000,000 in four months fears a fall in the euro, so it sells June futures: 2,000,000 ÷ 125,000 = 16 contracts. The gain on the short futures offsets the lower value of the euros.
Imperfect hedges
Contracts are standard, so an exposure rarely matches a whole number. A French company expecting US$1,200,000 buys September futures at 1.2350 ($ per €): 1,200,000 ÷ 1.2350 = €971,660, or 7.8 contracts (€971,660 ÷ 125,000). It must buy 7 or 8; 8 is nearer. The hedge is also imperfect because of basis, since the futures price moves by more than spot as the basis closes.
The rules in more depth
Why the exchange removes credit risk
It is counterparty to both sides and collects margin daily.
Why positions are closed early
The company wants the profit or loss in cash at the date of the underlying transaction, not delivery.
Why the settlement month must be after the exposure
An earlier settlement would end the hedge before the exposure ends.
Why basis causes imperfect hedges
The futures price moves towards spot, so the gain or loss on the future is not exactly the opposite of the loss or gain on the exposure.
Effect on analysis
State the position (long or short), the contract month and the number of contracts, then compute gain or loss and the effective rate.
Worked examples
Example 1: tick value gain. A company sells 10 short sterling futures (tick £12.50) and the price falls by 30 ticks.
- Gain = 10 × 30 × £12.50.
- Gain = £3,750.
- A short position gains when the price falls.
Example 2: number of contracts. A company expects to receive $3,000,000. The euro futures price is 1.2500; a contract is €125,000.
- Euro equivalent.
3,000,000 ÷ 1.2500 = €2,400,000. - Contracts = 2,400,000 ÷ 125,000 = 19.2.
- Buy 19 contracts.
Example 3: expected basis. Spot is 1.2000 and the futures price is 1.2060 with six months to settlement. The position will be closed in two months.
- Basis now = 60 points; it falls by 10 points a month.
- After two months it falls by 20.
- Expected basis = 40 points.
Example 4: long or short. A US company must pay €750,000 in November. It fears the euro will rise.
- A rise in the euro costs it more.
- It needs a futures position that gains when the euro rises: buy December euro futures.
- Number = 750,000 ÷ 125,000 = 6 contracts.
How to score full marks
- State the exposure and which way the price moves against you.
- Choose long or short with a reason.
- Pick the settlement month after the transaction.
- Calculate contracts and round sensibly.
- Use the tick value for gains and losses.
- Comment on basis risk and imperfect hedging.
Common mistakes in the exam
- Taking the wrong position (buy when you should sell).
- Choosing a settlement month before the transaction.
- Dividing by the wrong contract size.
- Forgetting that tick value differs by contract.
- Ignoring basis in the effective rate.
- Expecting basis to be constant.
Quick revision
- Futures: standard, exchange-traded, margin, four dates a year.
- Long gains if price rises; short gains if price falls.
- Close out with the opposite trade.
- Gain = contracts × ticks × tick value.
- Basis falls to zero at settlement; basis risk.
- Hedge opposite to the exposure, month after the transaction.
- CAMA 2020: ss. 305, 308, 377(1), 378, 385.
Practice questions
These are original questions written in the style of the Institute of Chartered Accountants of Nigeria (ICAN) exam. Try each one before you open the answer. Full model answers follow the written questions.
Recall check: multiple choice
Recent ICAN papers are written, although older papers such as May 2014 included multiple-choice questions. These questions are for quick recall. The written questions that follow are closer to the exam.
Question 1. A futures contract differs from a forward contract because it is:
- Standardised and exchange-traded
- Tailor-made
- Over the counter
- Never settled
Show the answer
A. The exchange guarantees it.
Question 2. The initial margin is:
- A cash deposit paid to the exchange
- A fee to the broker
- A tax
- The profit
Show the answer
A. Variation margin follows losses.
Question 3. A short position gains when the futures price:
- Falls
- Rises
- Is unchanged
- Doubles
Show the answer
A. The position was sold first.
Question 4. A euro future is for €125,000 and the tick is 0.0001. A tick is worth:
- $12.50
- $125
- $1.25
- $25
Show the answer
A. 125,000 × 0.0001.
Question 5. A Eurodollar future tick is worth:
- $25
- $12.50
- $100
- $2.50
Show the answer
A. 1,000,000 × 0.0001 × 3÷12.
Question 6. Basis falls to zero:
- At settlement
- At the start
- Never
- After a year
Show the answer
A. Otherwise there would be arbitrage.
Question 7. Basis 200 points, five months to settlement, closing after three months. Expected basis:
- 80 points
- 120 points
- 200 points
- 40 points
Show the answer
A. 200 − 3 × 40.
Question 8. To hedge a receipt of €2,000,000 with €125,000 contracts, sell:
- 16 contracts
- 8 contracts
- 20 contracts
- 250 contracts
Show the answer
A. 2,000,000 ÷ 125,000.
Question 9. A hedge with futures is imperfect mainly because of:
- Contract size and basis
- The exchange
- Tax
- The broker
Show the answer
A. Standard sizes and the gap to spot.
Question 10. Which section of CAMA 2020 sets the director’s duty of care and skill?
- Section 308
- Section 400
- Section 405
- Section 409
Show the answer
A. Directors should test the assumptions behind a decision.
Written questions
Question 11 (10 marks). (a) State four features of futures contracts. (4 marks) (b) Explain how margin protects the exchange. (3 marks) (c) Explain why most futures positions are closed before settlement. (3 marks)
Question 12 (20 marks). A US company must pay €750,000 in November. In July December euro futures are €125,000 per contract, priced at 1.2100 ($ per €), tick $12.50. Assume spot and futures prices are equal throughout. (a) State the hedge, the position and the number of contracts. (4 marks) (b) The spot and futures prices in November are 1.2240. Calculate the gain on futures. (4 marks) (c) Calculate the net cost of the euros and the effective rate.
(4 marks) (d) Explain basis and basis risk. (4 marks) (e) Expected basis: sold at 1.9800 with spot at 1.9600, five months, closing after three. State the expected basis and the effect if the actual basis is 50. (4 marks)
Question 13 (10 marks). (a) A French company expects US$1,200,000. A September euro future is priced at 1.2350 and a contract is €125,000. Calculate the contracts needed. (4 marks) (b) Explain why it cannot hedge exactly. (3 marks) (c) Explain which settlement month to choose. (3 marks)
Model answers
Show the model answer to Question 11
(a) Features (4 marks). Standardised contracts; traded on an exchange; a few settlement dates a year; the exchange is counterparty to every trade; margin is required. Any four. (1 each)
(b) Margin (3 marks). Both parties pay initial margin. (1) If a position loses, variation margin must be paid. (1) So losses are covered by cash and the exchange has no credit risk. (1)
(c) Closing out (3 marks). The company wants cash gain or loss at the date of the underlying transaction, not delivery. (1.5) It closes a long position by selling and a short position by buying. (1.5)
Show the model answer to Question 12
(a) Hedge (4 marks).
- The company pays euros, so it fears a rise in the euro. (1)
- It should buy (go long) December euro futures. (1.5)
- Contracts = 750,000 ÷ 125,000 = 6. (1.5)
(b) Gain (4 marks).
- Bought at 1.2100 and sold at 1.2240: 140 ticks. (2)
- Gain = 6 × 140 × $12.50 = $10,500. (2)
(c) Net cost (4 marks).
- Spot cost.
750,000 × 1.2240 = $918,000. (1.5) - Less gain = $907,500. (1.5)
- Effective rate.
907,500 ÷ 750,000 = 1.2100, the opening rate. (1)
(d) Basis (4 marks). Basis is the difference between spot and futures prices; it shrinks to zero at settlement. (2) Basis risk is the risk that the actual basis at close-out differs from expectation, so the hedge is imperfect. (2)
(e) Expected basis (4 marks). Basis = 200 points, falling 40 a month. (1) After three months expected basis = 80. (1.5) Actual basis 50 is 30 points less, so the futures position gains or loses 30 points more or less than expected on each contract, which changes the effective rate. (1.5)
Show the model answer to Question 13
(a) Contracts (4 marks).
- Euro equivalent.
1,200,000 ÷ 1.2350 = €971,660. (2) - Contracts = 971,660 ÷ 125,000 = 7.8, so buy 8. (2)
(b) Imperfect (3 marks). Contracts are a fixed size, so the exposure is not an exact multiple. (1.5) Basis also means futures and spot prices do not move together exactly. (1.5)
(c) Settlement month (3 marks). Choose the next settlement date after the transaction. (1.5) An earlier settlement would end the hedge before the exposure ends. (1.5)
Pathfinder on Futures, margin, ticks, basis and creating a hedge
These are the ICAN Pathfinder questions that test this topic. ICAN owns the questions and the suggested solutions, so we point you to them and do not copy them. Open your Pathfinder, attempt each question under exam conditions, then check your answer against the notes above.
Neither the May 2014 nor the November 2014 Pathfinder sets a stand-alone question on futures. Practise the three steps for a hedge and the tick value calculations in the worked examples.
Revise first: Creating a hedge
Questions test expected basis and basis risk. See the section on basis and basis risk.
Revise first: Basis and basis risk
Source: ICAN Pathfinder, Strategic Financial Management. Diets covered: No stand-alone question in the May 2014 or November 2014 Pathfinder.
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