FUTURES

commercial contract calling for the purchase or sale of specified quantities of a commodity at specified future dates. The origin of futures contracts was in trade in agricultural commodities, and the term commodity is used to define the underlying asset even though the contract is frequently completely divorced from the product. It therefore differs from a simple forward purchase or sale in the cash market, which involves actual delivery of the commodity at the agreed time in the future. From very early times, and in many lines of trade, buyers and sellers have found it advantageous to enter into contractstermed futures contractscalling for delivery of a commodity at a later date. Dutch whalers in the 16th century entered into forward sales contracts before sailing, partly to finance their voyage and partly to get a better price for their product. From early times, U.S. potato growers in Maine made forward sales of potatoes at planting time. The European futures markets arose out of import trade. Cotton importers in Liverpool, for example, entered forward contracts with U.S. exporters from about 1840. With the introduction of the fast transatlantic Cunard mail services, it became possible for cotton exporters in the United States to send samples to Liverpool in advance of the slow cargo ships, which carried the bulk of the cotton. Futures trading within the United States in the form of to arrive contracts appears to have commenced before the railroad days (1850s) in Chicago. Merchants in Chicago who bought wheat from outlying territories were not sure of the arrival time and quality of a delivery. The introduction of to arrive contracts enabled the sellers to get a better price for their product and buyers to avoid serious price risk. Futures trading of this sort in grains, coffee, cotton, and oilseeds also arose in other centres such as Antwerp, Amsterdam, Bremen, Le Havre, Alexandria, and Osaka between the 17th and the middle of the 19th centuries. In the process of evolution, to arrive contracts became standardized with respect to grade and delivery period, with allowances for grade adjustment when the delivered grade happened to be different. These developments helped to enlarge the volume of trade, encouraging more trading by merchants who dealt in the physical commodity and also the entry of speculators, who were interested not in the commodity itself but in the favourable movement of its price in order to make profits. The larger volume of trading lowered the transaction costs, and by stages the trading became impersonal. The rise of the clearinghouse depersonalized the buyer-seller relations completely, giving rise to the present form of futures trading. Lalgudi Sivasubramanian Venkataramanan commercial contract calling for the purchase or sale of specified quantities of a commodity at specified future dates. The origin of futures contracts was in trade in agricultural commodities, and the term commodity is used to define the underlying asset even though the contract is frequently completely divorced from the product. It therefore differs from a simple forward purchase or sale in the cash market, which involves actual delivery of the commodity at the agreed time in the future. The common characteristics of futures markets are that they can be made in any commodity that enters into trade on a scale large enough to provide the necessary liquidity, that is available to a broadly standard specification, and that is traded in free market conditions that allow price fluctuations based on the interplay of supply and demand factors and that preclude dominant producers from controlling the market. A futures contract represents a binding agreement to buy a commodity at a specified price on a specified future date. Thus it is possible for a trader to obtain a guarantee for the price he will have to pay for a commodity in the future. A market is made in futures contracts, involving trading in the obligations inherent in the contracts. Futures developed originally to provide cheap forms of banking and insurance. Farmers in the United States, for example, were able to sell their harvest in advance on the Chicago commodity futures markets at a lower dealing cost than the interest rates charged by the banks. More recently, financial futures have extended the same principle by providing protection for the investor or businessman against changes in interest rates, allowing him to fix the cost today of raising debt that he knows he will need tomorrow when interest rates may have become unfavourable. Bankers and financiers can also use futures to insure against changes in interest rates and currency exchange rates. Futures contracts have been common in the markets for agricultural commodities for a very long period, but it was only in 1972 that financial futures, which treat money as simply a commodity, developed in Chicago, the home of agricultural futures. There are two basic types of traders in a futures market: hedgers and speculators. Both are necessary to the market in order to generate a sufficient volume of two-way business. Hedgers seek to avoid or minimize the financial risks associated with their current commercial activity by in effect taking out an insurance policy in the shape of a futures contract against adverse price or interest-rate movements. On the other hand, the speculator, in the expectation of making a profit, seeks risk by committing his funds to back his own view of higher or lower prices or interest rates. It is the speculators who supply the necessary liquidity to the futures markets and are instrumental in allowing buyers to be matched with sellers, although the actual contracts are made through the market's central clearinghouse. It is the intervention of the clearinghouse that removes the credit risk and permits standardization of contracts to allow easy buying and selling. Additional reading Glenn G. Munn, F.L. Garcia, and Charles J. Woelfel, Encyclopedia of Banking and Finance, 9th ed., rev. and expanded (also published as The St. James Encyclopedia of Banking & Finance, 1991), provides comprehensive definitions, many with bibliographies. Edward I. Altman and Mary Jane McKinney (eds.), Handbook of Financial Markets and Institutions, 6th ed. (1987), is a thorough compilation. Detailed information on a variety of markets is provided in Francis A. Lees and Maximo Eng, International Financial Markets: Development of the Present System and Future Prospects (1975), a descriptive treatment; Charles R. Geisst, A Guide to the Financial Markets, 2nd ed. (1989), for the general reader; Frank J. Fabozzi and Frank G. Zarb, Handbook of Financial Markets: Securities, Options, and Futures, 2nd ed. (1986); and Perry J. Kaufman, Handbook of Futures Markets: Commodity, Financial, Stock Index, and Options (1984), including the history, regulation, and mechanics of futures trading. Further discussion of financial futures is found in Mark J. Powers and Mark G. Castelino, Inside the Financial Futures Markets, 3rd ed. (1991), an explanation of the exchanges and their functions; and Nancy H. Rothstein and James M. Little (eds.), The Handbook of Financial Futures: A Guide for Investors and Professional Financial Managers (1984), a discussion of the market's development, organization, and regulation. J.R. Hicks, Value and Capital, 2nd ed. (1946, reissued 1975), contains a short discussion of the theory of normal backwardation, also known as the Keynes-Hicks hypothesis. Holbrook Working, New Concepts Concerning Futures, Markets, and Prices, American Economic Review, 52(1):431459 (June 1962), presents his theories on the role of hedging and the functions of futures markets. The instability of markets for primary commodities is the theme of the Argentinian economist Raul Prebisch, Towards a New Trade Policy for Development (1964). Recent work on the specific methods and rules of the major world exchanges is included in John Buckley (ed.), Guide to World Commodity Markets, 5th ed. (1986). Basic works on commodity futures trading include Gerald Gold, Modern Commodity Futures Trading, 7th rev. ed. (1975); and Bruce G. Gould, The Dow Jones-Irwin Guide to Commodities Trading, rev. ed. (1981). See also Barry P. Bosworth and Robert Z. Lawrence, Commodity Prices and the New Inflation (1982), comparing the experiences of the United States, West Germany, and Japan, and offering policy proposals; and Robert L. Rothstein, Global Bargaining (1979), utilizing the 197477 United Nations conference on trade and development negotiations to develop an international commodity policy. An extensive summary of work on commodity futures trading is provided by James B. Woy, Commodity Futures Trading: A Bibliographic Guide (1976).