The investment world has many well-known and lesser-known terms. Think of stocks, bonds, options, futures, or swaps. In a special series, we explain the characteristics and history of the various investment categories. In this episode, Alex Tiebout, Expert Portfolio Manager at APG, discusses a lesser-known instrument: the future contract, which is a derivative instrument.
The future in brief
What is it?
A future, also known as a forward contract, is a financial contract between two parties.
When did it originate?
As early as the sixteenth century, farmers entered into price agreements with traders about future harvests.
What else is involved?
Like other derivatives, it’s not suitable for individual or non-financially savvy investors or companies.
What is it?
A future is a derivative. This means that it’s a derivative product, based on the price of an underlying value. That value could be a stock, but may also be an index, exchange rate, interest rate, or commodity. Trading in financial derivatives involves major risks, especially when it comes to futures. Price fluctuations on the stock exchange or commodity markets may lead to enormous profits or essentially unlimited losses.
In a future or forward contract, the seller and buyer enter into binding agreements on the price of a product or financial service on a specific day in the future. These may include physical goods such as oil, metals, or agricultural products, as well as interest-related products such as bonds, the value of stocks, and currency exchange rates. Basically, there are two types of futures: a long future, where the buyer is obliged to purchase the underlying product at a certain price on the agreed date. There’s also a short future, where the seller must sell the underlying product at the agreed price.
What else is involved?
The principle of the futures contract is simple, but in practice it turns out to be very complicated. Like other derivatives, it’s not suitable for individual or non-financially savvy investors or companies, as banks and brokers consistently warn. “I completely agree,” says Alex Tiebout, who has worked at APG since 2010, and previously worked as a trader on the ABN Amro trading floor. “The risks can be enormous. Price fluctuations on the stock exchanges and futures markets and in the commodity markets are the biggest risk factors. Strange things can happen on the stock exchanges, influenced by factors such as wars or natural disasters. The risks are hard to assess. You really need substantial reserves if you want to invest in futures.”
“Futures are concluded on the basis of the underlying value of the specific product or service. For example, a grain producer, as the seller of the futures contract, agrees with an investor, bank, or hedge fund to deliver a batch of grain on November 1 for one million euros. If, on that day, the batch of grain is only worth eight hundred thousand euros on the market, the future buyer must still pay that one million, resulting in a loss of two hundred thousand euros. In this case, the grain producer is the one that benefits.’
So, how do you finance futures?
It’s not as if the buyer has a physical batch of grain in its backyard. “No, futures don’t represent physical value. You don't settle anything except for closing costs. In contrast to stocks and bonds, or when purchasing oil or metals, which you pay for outright, futures are settled on the agreed date at the agreed price. So, you can finance them without actual money, allowing you to buy a large quantity at once. This is called leveraging. Accordingly, the losses and profits can be really large, depending on the rise or fall of the underlying value.”
Here’s another example: Suppose you buy 200 futures for a grain contract at 100 euros each. If the market price on the agreed day is 80 euros, then you still must buy them at 100 euros. So, you’d lose 16,000 euros, since futures are settled in cash on the agreed day. “Exactly, and that’s what makes futures so risky.”
When did it originate?
As early as the sixteenth century, farmers entered into price agreements with traders about future harvests. They wanted to hedge their risks. A well-known example was the Tulip Futures Exchange in Amsterdam. In 1865, the Chicago Board of Trade, a futures exchange with the first standardized wheat futures, was founded. Nowadays, most futures are traded electronically on stock exchanges worldwide, including on the Amsterdam stock exchange.
Speculation or security
Futures are often associated with speculators. “That is certainly the case with investors,” says Tiebout. “But companies, organizations, and pension funds mainly want to hedge risks against changing exchange rates or interest rates. They want to be sure that they can buy or sell stocks or products on a certain day for a guaranteed amount. To achieve this, they’re prepared to incur costs and potentially take losses. At APG, this is also our guiding principle when we work with derivatives: hedging risks for pension funds and their participants. In the event of an (expected) crisis and a subsequent decline in the stock markets, futures are a suitable product to offset declining stock markets. Futures are liquid products and can be easily bought or sold.
To anticipate declining stock markets, futures can be (temporarily) sold to compensate for potential stock declines. As a result, the physical stock portfolio doesn’t have to be temporarily reduced, something that’s often associated with high costs. So, futures are part of our total portfolio, which includes stocks, bonds, etc.; the total package is designed to provide stability and security.”