Futures

Futures are contracts that derive value from an underlying asset such as a traditional stock, a bond or stock index. Both parties need to pay an initial margin amount (a fraction of the total exposure) with the exchange. The contracts are marked to market; that is, the difference between the base price (the price the contract was entered at) and the settlement price (usually an average of the prices of last few trades) are deducted from or added to the account of the respective parties. The next day the settlement price is used as the base price. The investor can close out the position at any time before maturity but must be responsible for any profit or loss made from the position.

Futures and derivatives help increase the efficiency of the underlying market because they lower the unforeseen costs of purchasing an asset outright. For example, it is much cheaper and more efficient to go long in the S&P 500 futures than to replicate the index by purchasing every stock. Studies have also shown that the introduction of futures into markets increase the trading volumes in underlying as a whole. Consequently, futures help reduce transaction costs and increase liquidity as they are viewed as an insurance or risk management vehicle.

A role futures play in financial markets is that of price discovery. Future market prices rely on a continuous flow of information and transparency. A lot of factors impact the supply and demand of an asset and thus its future and spot prices. This kind of information is absorbed and reflected in future prices quickly. Future prices for contracts nearing maturity converge to the spot price, and thus, the future price of such contracts serve as a proxy for the price of the underlying asset. Future prices also indicate market expectations.