The futures markets are the motorways of modern markets. Motorways are efficient and get you where you want to go much more quickly and economically than ordinary roads. But with the hedgers' juggernauts in the slow lane and the speculators' sports cars in the fast lane, there is little patience for those who do not know where they are going. In the first of two articles, Ian Rankine looks at how the futures markets have developed from their early beginnings in the nineteenth century.

The biggest futures markets today are in Chicago simply because this is where they started. In the early 1800's the Midwest of the U.S.A. was primarily involved in the growing of grain and corn. Grain passed from farmers to wholesalers to merchandisers and so on down the supply chain, but the market swung from glut to shortage, aggravated by poor storage and transportation facilities. To secure a supply, wholesalers began to enter into contracts with farmers for delivery of grain at harvest time. The farmers were not actually paid ahead of delivery but the price per bushel was fixed in advance. Such a one-to-one arrangement today would be called a forward contract.

As the market expanded and the wholesalers concentrated in Chicago, more and more of these contracts were swapped between the wholesalers. For example, if Buyer A, having agreed a contract with a farmer for delivery at $3 a bushel, found, before the harvest, that he could buy from another fanner at $2.50 a bushel, he might try to sell on his original contract to (unsuspecting!) Buyer B and deal with the cheaper farmer. As delivery and payment were still in the future, the swap could take place with ease.

The main difficulty with this secondary type of trading was that the quantity, the quality and the delivery details of the various contracts entered into by farmers and buyers were diverse. The idea was conceived of setting a standard contract specification guaranteed by an Exchange. The futures contract had evolved.

The concept of standardised contract terms is still very much at the heart of today's futures markets. Wheat futures, as traded on the Chicago Board of Trade today, require delivery of a fixed quantity of wheat (5,000 bushels per contract) of established quality ("No.2 soft red", "No.2 hard red winter, etc) to one of the registered and approved warehouses in the Chicago Switching District. Delivery is to take place between dates which are pre-fixed by the exchange. Of course, in practice, there can be no guarantee that any one particular farmer's wheat will grow to the specified standards. There is, therefore, a system of price factors which enable adjustments to be made for any variation in quality. Substitutions and differentials are set by the Exchange.

Financial Futures

The two Chicago futures exchanges--The Chicago Mercantile Exchange (CME) and the Chicago Board of Trade (CBT)--are fierce competitors. As the agricultural markets reached the point where further growth in futures became increasingly difficult, they both applied their experience to other areas. In particular, the phenomena] expansion of the U.S. financial services industry in the 1970s and 1980s provided an ideal environment for new products. The CBT introduced a futures contract based on the U.S. 20-year bond in 1977. It proved to be attractive to a wide variety of market participants and volumes rocketed way beyond the original hopes of Exchange officials. The CME, already trading Treasury Bill and other debt futures, was the first to launch a futures contract on the S&P 500 share index. Again it was hugely successful.

The key elements: standardised features defining quantity-quality-delivery were where these Exchanges could apply their experience. The potential for growth in business throughput was not lost on other financial exchanges in the U.S.A. and elsewhere. By the end of the 1980's all the major markets in government bonds, equities and currencies had established futures contracts running alongside.

Examples of some of the active contracts today are:

Interest Rates--Three-month dollar interest rates--the world's most active future; three-month Deutschemark interest rate; three-month yen interest rate; three-month sterling interest rate; three-month French Franc interest rate; three month Italian Lira interest rate.

Bonds--U.S. Treasury 20-year bond; German Treasury 10-year bond; Japanese Government 10-year bond; UK 15-year gilt; French Treasury 10-year bond; Italian Treasury 10-year bond.

Currencies--Deutschemark/dollar; Japanese Yen/dollar; Swiss Franc/dollar; British Pound/dollar; French Franc/dollar. Equity Indices--S&P 500 Index (U.S.A.); Nikkei 225 Index (Japan); CAC 40 Index (France); FTSE-100 index (UK); DAX Index (Germany). The quantity and quality in these contracts rarely change, once defined by the Exchange, but the delivery dates will come and go. Most financial futures trade on the March-June-September-December cycle. For example, the "June" Swiss Franc contract on the Chicago Mercantile Exchange requires the delivery of SF125,000 per futures contract to a bank designated by the Exchange's clearing house on Friday, 20th June 1997. The next available delivery month requires delivery on Friday, 19th September 1997.

Delivery For "Notional" Contracts

Delivery in the currency markets is straightforward. Money is a very simple commodity but bonds are rather more complicated. In bond futures, the contract usually concerns a "notional" bond. For example, the long gilt contract traded in London (on LIFFE) requires the delivery of <156>50,000 (nominal) gilt with a 9% coupon and between 10 and 15 years to redemption.

In practice, there is no guarantee that any gilt-edged security in issuance actually matches these requirements, so the exchange publishes a list of deliverable gilts. These cover most of the stocks with 10 to 15 years to maturity at the delivery date and price adjustments are published to cope with the differing maturity dates and different coupons so that the buyer of the contract receives the same value whatever actual gilt is delivered.

Cash Settled Contracts

With the equity index and the short-term interest rate contracts "delivery" is simplified by a system of cash settlement. In other words, an index point (in the case of equities) or a basis point (in the case of the interest rate) is ascribed a pre-set value by the Exchange and contracts taken to delivery merely settle the difference between the price paid at the time the contract was traded and the ultimate settlement price. Technically this type of contract is known as a contract for differences.

If you were to buy one FTSE-100 Index December futures contract at 3540.0 and you continued to hold the position into the final settlement day and the official settlement price was 3580.0 then you would receive a cash credit of <156>1000.00. The FTSE future is valued at <156>25 per index point, so the calculation is 125 x (3580-3540) = <156>25 x 40 = <156>1000.

Take care to find out the value of an Index point for a particular contract before you trade--they are not all the same! The FTSE-100 future has a value of <156>25 per point. The FTSE Mid 250 Index future and FTSE-100 Index options have a value of <156>10 per point. Note also that some people talk in terms of the tick value. A tick is the minimum price movement allowed by the exchange. For all the UK index products this is half an Index point. In other words, although the underlying FTSE-100 Index is calculated to the nearest 0. 1, the Index future can only be traded in steps of 0.5. The tick value of the FTSE-100 is, therefore, <156>12.50 (i.e. 0.5 x <156>25) while the tick value in the options is <156>5.00 (i.e. 0.5 x <156>10). Do not confuse one tick with one full Index point move in the Footsie pits. A full point (which is the unit in which most traders tend to think) equals <156>25.00 in the future and <156>10.00 in the options.

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