Futures Contracts — The No-Nonsense CFA Level I Explainer (but Make It Fun)

"If options are drama, futures are blunt-force instruments." — your slightly unhinged TA

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Hook: Imagine a very committed promise

You are a wheat farmer in July worried about November prices. Or you are an airline in January worried about jet fuel in June. You want a promise: lock a price today and stop sweating. That’s the emotional heart of a futures contract — a standardized, exchange-traded promise to buy or sell an asset at a future date for a price agreed today.

We already met options (asymmetric payoffs) and learned no-arbitrage pricing. Now we’re adding futures to the family: linear payoff, daily settlement, margin mechanics, and deep links to interest rates — the stuff Fixed Income prepared you for.

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What is a futures contract? (Quick & Clean)

• Definition: A futures contract is an exchange-traded agreement to buy (long) or sell (short) a specified asset at a set future date and price.
• Key differences from forwards: standardized, traded on exchanges, marked-to-market daily, and backed by margin accounts.

Standard features

• Contract size (how many units)
• Expiration / delivery month
• Tick size (minimum price movement)
• Margin requirements (initial & maintenance)

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How pricing works — the cost-of-carry idea (remember no-arbitrage)

Think: if you can buy the asset now or agree to buy later, no free lunches allowed. The futures price reflects carrying costs and benefits.

Base formula (continuous compounding):

F0 = S0 * e^{(r + c - y)T}

Where:

• F0 = futures price today for delivery at T
• S0 = spot price today
• r = risk-free interest rate (annual, continuous)
• c = storage costs / other carrying costs (as a rate)
• y = convenience yield (benefit of holding the physical asset)
• T = time to maturity (in years)

If the asset pays income (like dividends for stocks), treat that as a negative carry (reduce the forward/futures price).

Example: Spot S0 = 100, r = 5% (0.05), T = 0.5 year, no storage or convenience yield →

F0 = 100 * e^{0.05*0.5} = 102.53 (approx)

Why? Because buying the asset now ties up capital; the futures price compensates the seller for that.

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Mark-to-market and margins — the daily drama

Unlike forwards, futures are settled daily.

• Each day gains/losses are posted to margin accounts (variation margin).
• Initial margin: you post when opening the position.
• Maintenance margin: if your account falls below this, you get a margin call.

Mini example: You go long 1 futures contract at 1000. Next day price = 1010. You receive margin credit for +10. If price drops to 980 afterwards, you lose 30 and might face a margin call.

Why daily settlement matters: it reduces credit risk and avoids large end-of-contract exposure — but it introduces liquidity pressure (must meet margin calls).

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Payoff profiles — linear & symmetric (vs options)

• Futures payoff = linear. If you are long, payoff at settlement = Spot_T - F0 (ignoring margin mechanics). Short payoff = F0 - Spot_T.
• Contrast with options (we covered this): options have limited downside for buyer and unlimited upside potential — asymmetric.

Simple numeric payoff table:

Position	Formula at settlement (ignoring MTM)	Nature
Long futures	S_T - F0	Unlimited profit/loss (linear)
Short futures	F0 - S_T	Mirror image

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Hedging applications — who uses futures and why?

• Short hedger (producer): Farmer sells futures to lock price and protect against price decline.
• Long hedger (consumer): Airline buys futures to lock fuel price and protect against price rise.

Hedge effectiveness depends on basis:

Basis = Spot price - Futures price

As expiration approaches, basis typically converges toward zero (spot ≈ futures). Residual basis risk is the hedger’s enemy.

Example: Farmer sells futures at 5.00, spot in November = 4.75, futures at close = 4.80. Net realized price ≈ 4.95 (rough example showing basis effect).

Question: Why not just use forwards? Answer: margining and liquidity. Exchanges reduce counterparty risk but require daily liquidity for margins.

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Arbitrage example — the logic you’ll be tested on

If F0 > S0*e^{rT}, arbitrageur can:

1. Borrow S0*e^{-rT} (i.e., borrow money today), buy the asset, short futures. Profit today = difference.
2. Reverse if F0 < S0*e^{rT}.

The CFA exam loves these no-arbitrage constructions. Keep them tidy: buy/borrow or sell/lend to lock risk-free profit if mispriced.

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Special considerations: commodities & treasury futures

• Commodities: include storage costs and convenience yields (e.g., oil in a pipeline — convenience yield may be high). That’s why the (r + c - y) term matters.
• Interest-rate-sensitive instruments (e.g., Treasury futures): futures relate to bond prices; carry is connected to yield curve and coupon income. CFA Level I focuses on the basic relationships; you’ll encounter conversion factors and delivery options later in deeper courses.

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Quick compare: Futures vs Forwards vs Options (tiny table)

Feature	Futures	Forwards	Options
Traded	Exchange	OTC	Exchange/OTC
Settlement	Daily MTM	At maturity	At exercise (or MTM for some)
Standardization	High	Low	Varies
Payoff	Linear	Linear	Asymmetric
Counterparty risk	Low (exchange)	Higher	Varies

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Final exam-safe checklist (memorize this)

• Futures priced by cost-of-carry: F0 = S0 * e^{(r + c - y)T}
• Mark-to-market daily; margins matter (initial & maintenance)
• Payoff is linear and symmetric (long = S_T - F0)
• Hedgers: short hedger = producer; long hedger = consumer
• Basis = S - F (converges to 0 at expiry)
• Arbitrage binds pricing: if mispriced, buy/short and carry to profit

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Closing (the motivational mic drop)

Futures are the boring, reliable sibling of exotic derivatives — not flashy like options, but brutally effective. They fuse what you learned in Fixed Income (interest rates and carry) with the no-arbitrage mindset from Pricing Derivative Securities. If options are the rom-com, futures are the contract lawyer who keeps everyone honest.

Key takeaway: understand the cost-of-carry, how daily settlement changes risk, and how hedgers use these contracts to neutralize price risk. Once you see futures as "now vs later, priced by carrying costs," the rest is bookkeeping — but very important bookkeeping.

Go forth and dominate the problem sets. And remember: margin calls are your portfolio's public embarrassment — avoid them by sizing hedges sensibly.