What it means
A futures contract is an agreement to buy or sell something at a fixed price on a future date. CME offers standardised contracts, meaning the size, quality and delivery dates are set by the exchange, so that anyone can trade them without negotiating terms.
This standardisation makes the market liquid, which means there are always buyers and sellers. Companies mostly use it for hedging, which is reducing exposure to price swings.
A cereal maker can lock in the price of wheat months ahead, an airline can fix its fuel costs, and a treasurer can protect a loan against rising interest rates. The aim is not to profit from the trade but to make future costs and revenues more predictable.
A clearing house stands behind each trade. It becomes the buyer to every seller and the seller to every buyer, which greatly reduces the chance that one party's failure will leave another unpaid.
To make this work, traders post margin, a deposit that covers possible losses, and positions are settled each day. The CME is part of a larger group that runs several exchanges, and its prices are watched around the world.
Benchmark contracts on short-term interest rates and on major stock indices influence the pricing of loans, mortgages and investments far beyond Chicago. Many financial headlines about market expectations refer to prices that originate there.
For a non-finance manager, the main point is leverage. A small margin deposit controls a much larger contract value, so gains and losses are magnified, and margin calls (demands for more money) can arrive quickly.
Anyone using these contracts needs clear policies on who may trade, what limits apply and how results are reported.
In practice
Real-world examples.
Example
A cereal manufacturer in Ohio buys wheat futures to fix the price of next season's raw materials. If wheat prices rise, the gain on the futures offsets the higher cost of buying grain.
Example
A treasurer at a mid-sized company in Texas has a floating-rate loan. She uses interest rate futures to protect against rising rates, so the cost of borrowing is more predictable for the budget.
Example
A fund manager in London holds a portfolio of US shares. She sells stock index futures to reduce her exposure for a few weeks, rather than selling each individual holding. This is quicker and cheaper, and she can remove the hedge as soon as her view changes.
Formula
Calculation
Contract value = index level x contract multiplier
Gain or loss = change in index points x multiplier x number of contracts
For illustration, consider a stock index futures contract with a multiplier of $50 per index point. If the index stands at 5,000, the contract value = 5,000 x 50 = $250,000. A 1% rise is 50 points, so the gain on one contract = 50 x 50 = $2,500. If the exchange required an illustrative margin of $12,000, the trader would control $250,000 of exposure with $12,000, which is 4.8% of the contract value; exchanges set and change real margin rates, so always check the current requirement.Case study
Seen in the real world.
This is an illustrative case about Brightfield Airlines, an invented regional carrier. Its finance director, Samira, is worried that rising fuel prices could wipe out the profit forecast for the coming year.
She works with the board to set a hedging policy and uses exchange-traded energy futures to lock in the price for about half of expected fuel needs. When fuel prices climb, the cost of the physical fuel rises, but the gains on the futures soften the blow. In this fictional story, the airline still has to pay margin during a price dip, so Samira ensures the company keeps enough cash available to meet margin calls. The board also agrees that the hedge covers only part of the fuel needs, leaving room to benefit if prices fall.
Watch out
Common mistakes.
- Thinking the exchange is only for speculators. Many users are businesses that hedge real costs and revenues, such as farmers, airlines and manufacturers.
- Ignoring margin. A small deposit controls a large contract, so losses can exceed expectations and extra cash may be demanded quickly.
- Assuming a hedge removes all risk. It trades one risk for another, such as basis risk, where the futures price and the actual price do not move exactly together.
Questions
People also ask.
Is CME an exchange or a company?
Both, since it operates exchanges and is also the name of a company that runs them. It is best known for its futures and options markets.
Do I have to take delivery of the goods?
Not usually, because most traders close their positions before expiry. Some contracts are settled in cash and others by physical delivery, depending on the product.
What does the clearing house do?
It guarantees both sides of each trade and collects margin to cover potential losses. This reduces the risk that one party's default causes others to lose money.
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