investing

The futures markets: Why they matter and how they fit into the financial system

Businessman holding investing globe concept between hands | da-kuk/E+/Getty Images

da-kuk/E+/Getty Images

These days, investors are tuning into the futures market before the market opens to see if their stocks will endure yet another beating.

It's not just speculators reaching for the futures market crystal ball: Policymakers in the Treasury Department and the Federal Reserve look to the futures markets for signs of potential price moves in vital commodities such as oil and metals. Increases or decreases in commodity prices directly impact the rate of inflation, a subject of keen interest to those in charge of the economy.

Unfortunately, like all prognosticators, the futures markets are often incorrect in their estimation of future events.

Definition of futures

Essentially, futures are contracts speculating on the price of an underlying security. One party to the contract believes the value will go up and the other thinks it may go down.

"The two parties agree to pay or receive the difference between the predicted price set when entering into the contract and the actual price of the underlying (security) when the contract expires," says Robert R. Johnson, Ph.D., CFA, president and CEO of The American College of Financial Services.

"So, if the futures price for the Dow Jones Industrial Average is, say, 1,900, you would buy the contract if you thought the Dow would be above 1900 and sell the contract if you think the Dow will be below 1900," he says.

An example of how the futures market works

Brett is in charge of a huge candy company. Most of the company's profits come from delicious chocolate candy and the price of cocoa is highly relevant.

To smooth out profits, Brett uses the futures market to hedge the price of cocoa in case the price goes up in the future. Believing the price will rise, she buys a contract for 10 tons of cocoa at $2,800 per metric ton expiring in December.

The current cash price of cocoa is $2,799.

Before the contract expires in December, the cash and futures prices of cocoa climb to $2,900. Because she has a contract that allows her to buy cocoa for less than the current cash price, Brett is able to sell the contract for a nice profit. This offsets the increase in the price her business will pay for its next shipment of cocoa.

Do futures predict the future? Kind of, sometimes

The futures market failed to predict the stock market collapse in 2008. And it failed to forecast the spikes of inflation experienced between 2004 and 2008. This led former chairman of the Federal Reserve Ben Bernanke to conclude in a 2008 speech that "it does seem reasonable … to treat the forecasts of commodity prices obtained from futures markets, and subsequently the forecasts of aggregate price inflation, as highly uncertain."

But there is evidence that futures markets do predict future prices for some assets. A 2013 study by economists at the University of Wisconsin, Madison and the University of Texas, Austin found that energy futures tend to be more correct about coming energy prices than are the markets for other commodities. That outcome was in small part due to the fact that the energy futures market is well established, with many participants and lots of liquidity.

The study also found that the predictive nature of the futures market has diminished since the early 2000s.

Earlier research, in 2005, by economists at the San Francisco Federal Reserve, found that oil futures prices could be predictive of prices in the future, mostly in the near-term because, the economists hypothesized, there was more liquidity in the near-term futures markets rather than long-term.

Apparently, investors don't want to go out on a limb by betting on oil prices far into the future.

No one can consistently predict the future

When many investors want to make a deal around one price level, all of that interest can indicate that there is a consensus about what is going to happen over the next couple of months and years. That can be predictive but it's not always right.

"From my experience, that consensus is as often right as it is wrong," says Martin Froehler, CEO at Quantiacs, a platform for quantitative trading strategies.

No matter how much information participants in futures markets have, they cannot actually predict the future. Unexpected events blindside everyone.

The futures market began in agriculture but has since expanded to include all kinds of commodities and financial instruments

How consumers use the information

Big investors such as banks and mutual funds have an economic interest in when the Fed acts to raise rates. Buying or selling 30-day fed fund futures is one way to mitigate interest rate risk. For everyone else, fed fund futures can serve as a predictive guide.

"If you think the Fed will raise rates in the future, you would sell these futures. If you think the Fed will lower rates, you would buy these futures contracts," says Pete Mulmat, futures expert and host on the Tastytrade Network.

CME Group, which offers the 30-day fed funds futures, takes it a step further with its FedWatch tool.

"Basically, the FedWatch Tool takes the price of the fed funds futures at some month in the future (and) turns it into an implied interest rate for the federal funds rate," says Bluford Putnam, managing director and chief economist of CME Group.

Absolutely no knowledge of the futures market is required to gauge the sentiment of the market. Will the Fed raise interest rates at the next meeting? Investors can look at the tool and quickly see what investors in the futures market think will happen.

Of course, it all could change based on a nearly infinite number of economic circumstances which could intervene to change the current trajectory.

"Futures can be a good indicator of market sentiment, but they shouldn't be your only source of information," says Charlie Shipman, managing principal at Blue Keel Financial Planning in Weston, Connecticut.

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