We conclude this series of posts with a brief look at the role that futures markets and exchanges play in global financial systems and in society. Virtually all participants in the financial markets have heard of futures markets, but many do not understand the role that futures markets play. Some participants do not understand how futures markets function in global financial systems and often look at futures with suspicion, if not disdain.
In earlier posts, we discussed the purposes of derivative markets. We found that derivative markets provide price discovery and risk management, make the markets for the underlying assets more efficient, and permit trading at low transaction costs. These characteristics are also associated with futures markets. In fact, price discovery is often cited by others as the primary advantage of futures markets. Yet, all derivative markets provide these benefits. What characteristics do futures markets have that are not provided by comparable markets as forward markets?
First recall that a major distinction between futures and forwards is that futures are standardized instruments. By having an agreed-upon set of homogeneous contracts, futures markets can provide an orderly, liquid market in which traders can open and close positions without having to worry about holding these positions to expiration. Although not all futures contracts have a high degree of liquidity, an open position can nonetheless be closed on the exchange where the contract was initiated. More importantly, however, futures contracts are guaranteed against credit losses. If a counterparty defaults, the clearinghouse pays and, as we have emphasized, no clearinghouse has ever defaulted. In this manner, a party can engage in a transaction to lock in a future price or rate without having to worry about the credit quality of the counterparty. Forward contracts are subject to default risk, but of course they offer the advantage of customization, the tailoring of a contract’s terms to meet the needs of the parties involved.
With an open, standardized, and regulated market for futures contracts, their prices can be disseminated to other investors and the general public. Futures prices are closely watched by a vast number of market participants, many trying to discern an indication of the direction of future spot prices and some simply trying to determine what price they could lock in for future purchase or sale of the underlying asset. Although forward prices provide similar information, forward contracts are private transactions and their prices are not publicly reported. Futures markets thus provide transparency to the financial markets. They reveal the prices at which parties contract for future transactions.
Therefore, futures prices contribute an important element to the body of information on which investors make decisions. In addition, they provide opportunities to transact for future purchase or sale of an underlying asset without having to worry about the credit quality of the counterparty.
THE ROLE OF FUTURES MARKETS AND EXCHANGES
FUTURES PRICING: A RECAP
We have now examined the pricing of short-term interest rate futures, intermediate- and long-term interest rate futures, stock index futures, and currency futures. Let us recall the intuition behind pricing a futures contract and see the commonality in each of those special cases. First recall that under the assumption of no marking to market, at expiration the short makes delivery and we assume that the long pays the full futures price at that point. An arbitrageur buys the asset and sells a futures contract, holds the asset for the life of the futures, and delivers it at expiration of the futures, at which time he is paid the futures price. In addition, while holding the asset, the arbitrageur accumulates costs and accrues cash flows, such as interest, dividends, and benefits such as a convenience yield. The value of the position at expiration will be the futures price net of these costs minus benefits and cash flows. The overall value of this transaction at expiration is known when the transaction is initiated; thus, the value at expiration is risk-free. The return from a risk-free transaction should equal the risk-free rate, which is the rate on a zero-coupon bond whose maturity is the futures expiration day. If the return is indeed this risk-free rate, then the futures price must equal the spot price compounded at the risk-free rate plus the compoupd value of these costs net of benefits and cash flows.
It should also be noted that although we have taken the more natural approach of buying the asset and selling the futures, we could just as easily have sold short the asset and bought the futures. Because short selling is usually a little harder to do as well as to understand, the approach we take is preferable from a pedagogical point of view. It is important, nonetheless, to remember that the ability to sell short the asset or the willingness of parties who own the asset to sell it to offset the buying of the futures is critical to establishing the results we have shown here. Otherwise, the futures pricing formulas would be inequalities-limited on one side but not restricted on the other.
We should remind ourselves that this general form of the futures pricing model also applied in earlier posts in our discussion of forward contracts. Futures contracts differ from forward contracts in that the latter are subject to credit risk. Futures contracts are marked to market on a daily basis and guaranteed against losses from default by the futures clearinghouse, which has never defaulted. Although there are certain institutional features that distinguish futures from forwards, we consider those features separately from the material on pricing. Because the general economic and financial concepts are the same, for pricing purposes, we treat futures and forwards as the same.
Pricing futures contracts when there is a convenience yield
Now consider the possibility that the asset might generate nonmonetary benefits that must also be taken into account. The notion of nonmonetary benefits that could affect futures prices might sound strange, but upon reflection, it makes perfect sense. For example, a house is a common and normally desirable investment made by individuals and families. The house generates no monetary benefits and incurs significant costs. As well as being a possible monetary investment if prices rise, the house generates some nonmonetary benefits in the form of serving as a place to live. These benefits are quite substantial; many people consider owning a residence preferable to renting, and people often sell their homes for monetary gains far less than any reasonable return on a risky asset. Clearly the notion of a non-monetary benefit to owning an asset is one most people are familiar with.
In a futures contract on an asset with a nonmonetary gain, that gain must be taken into account. Suppose, for the purpose of understanding the effect of non-monetary benefits on a futures contract, we create a hypothetical futures contract on a house. An individual purchases a house and sells a futures contract on it. We shall keep the arguments as simple as possible by ignoring the operating or carrying costs. What should be the futures price? If the futures is priced at the spot price plus the risk-free rate, as in the original case, the homeowner receives a guaranteed sale price, giving a return of the risk-free rate and the use of the home. This is clearly a good deal. Homeowners would be eager to sell futures contracts, leading to a decrease in the price of the futures. Thus, any non-monetary benefits ought to be factored into the futures price and logically would lead to a lower futures price.
Of course, in the real world of standardized futures contracts, there are no futures contracts on houses. Nonetheless, there are futures contracts on assets that have non-monetary benefits. Assets that are often in short supply, particularly those with seasonal and highly risky production processes, are commonly viewed as having such benefits. The non-monetary benefits of these assets are referred to as the convenience yield. Formally, a convenience yield is the non-monetary return offered by an asset when in short supply. When an asset is in short supply, its price tends to be high. Holders of the asset earn an implicit incremental return from having the asset on hand. This return enables them, as commercial enterprises, to avoid the cost and inconvenience of not having their primary product or resource input on hand. Because shortages are generally temporary, the spot price can be higher than the futures price, even when the asset incurs storage costs. If a trader buys the asset, sells a futures contract, and stores the asset, the return is risk free and will be sufficient to cover the storage costs and the opportunity cost of money, but it will be reduced by an amount reflecting the benefits of holding the asset during a period of shortage or any other non-monetary benefits.