This week the markets among other things have been watching with interest the futures ‘roll’. You may have heard of this term and not know what it means so the following is a brief explanation.
A futures contract is an agreement to buy or sell something on a future date. Its roots are from agricultural days when producers and users of crops required the certainty of pricing at a point in the future. It has evolved into other commodities and financial products such as bonds, currencies etc.
Futures contract trading is centralised on an exchange which makes all the contracts homogenous. In other words a bought contract can be on-sold to another party via the exchange because all of the attributes of each contract are identical. The ‘fair value’ of a futures contract is the cost of buying the underlying commodity, funding the purchase, receiving any dividends or coupons and holding the position to the expiry date. If the futures price is below this ‘fair value’ then the market will buy the futures contract rather than the physical commodity. If the futures contract is above fair value then most likely the market will buy the physical commodity and fund the position.
The physical commodity and the futures price must by definition be equal on the expiry date.
Most contracts are traded on a quarterly basis and this historically has concentrated trading around four dates a year – March, June September and December. This concentration increases liquidity which in turn increases the ‘price discovery’ and pricing efficiency for market participants.
So what happens when a futures contract expires? Each open contract is settled on the expiry date. In some cases this is by exchanging the physical commodity for cash in other cases it is settled by cash against a well-known benchmark.
For those that wish to maintain their exposure to a market via a futures contract they must look to close out the expiring contract (e.g. the December contract) and open the following quarterly contract (i.e. March). This process is known as the futures ‘roll’.