Futures prove to be financial derivatives that are also called forward contracts. Such a futures contract gives a seller the obligation to deliver an asset, such as a commodity, to the buyer at a pre set date. These contracts are heavily traded on major produced commodities like wheat, gold, oil, coffee, and sugar. They also exist for underlying financial instruments that include government bonds, stock market indexes, and foreign currencies.
The history of futures goes back to Ancient Greece where the first recorded example is detailed about an olive press arrangement that philosopher Thales entered into. Futures contracts become commonplace at trade fairs throughout Europe by the 1100’s. Merchants did not feel secure traveling with significant amounts of goods, so they would only bring display samples along and then sell merchandise that they would deliver in greater quantities at future dates.
Futures contracts created an enormous bubble in the 1600’s with the Dutch Tulip Mania that caused tulip bulbs to skyrocket to unthinkable levels. In this speculative bubble, the majority of money that was exchanged turned out to be for tulip futures and not the tulips themselves. The first futures exchange in the United States opened in 1868 as the Chicago Board of Trade, where copper, pork bellies, and wheat were traded in futures contracts.
In the early years of the 1970’s, futures trading grew explosively in volume. Pricing models created by Myron Scholes and Fischer Black permitted the quick pricing of futures and options on them. Investors could easily speculate on commodities prices through these futures. As the demand for the futures skyrocketed, additional significant futures exchanges opened and expanded around the world, especially in Chicago, London, and New York.
Futures trading could not happen effectively without the exchanges. Futures contracts are spelled out in terms of the asset that underlies them, the date of delivery, the last day of contract trading, transaction currency, and size of ticks or minimum permissible price changes. Exchanges have developed into major and predictable markets through their standardizing of all of these various factors for many different kinds of futures contracts.
Trading futures contracts involves major leverage. This means that they carry tremendous opportunities as well as risks. Futures, with their ability to control enormous quantities of commodities and financials, have been the root causes for many collapses. Enron and Barings Bank were both brought down by financial futures. Perhaps the most famous futures meltdown involved the Long Term Capital Management group.
Even though this company had the inventors of the futures pricing models Scholes and Black working for them, the company lost money in the futures markets so quickly that the Federal Reserve Bank had to become involved and bail out the company to stop the whole financial system of the Untied States from collapsing.