Index, interest rate and commodity futures

You can describe the three main groups of futures, what each one tracks, and how they are used for hedging and trading.

One tool, many markets

The same basic contract, a binding agreement to trade later at a price set today, is used for stock indices, government bonds, oil, gold and wheat. The mechanics from the last two lessons apply to all of them.

What differs is what drives the price and how the contract ends. This lesson introduces the three main groups and what each one is used for.

Index, rates, commodities

Index futures. An index future follows a stock index, such as the S&P 500 or the DAX. Each point is worth a set amount: 50 dollars for the E-mini S&P 500, for example, according to CME. Index futures settle in cash. They are used:

by funds to hedge a portfolio for a short period without selling the shares,
by traders to take a view on the whole market quickly and cheaply.

Interest rate futures. An interest rate future follows government bonds or short-term interest rates. Bond futures move like bonds: their prices fall when yields rise, as the lesson on interest rate risk explained. Banks, insurers and funds use them to manage the interest rate risk of their portfolios.

Commodity futures. These follow oil, gas, metals or farm goods. They often allow physical delivery, though most positions are closed before. As the rubric on commodities showed, their prices are shaped by storage, inventories, the futures curve and the cost or gain of rolling.

All three share the features of futures: large contract sizes, daily settlement, margin and the possibility of losses beyond the margin. The next lesson looks at smaller contracts designed for individual traders.

Hedge without selling

A fictional fund holds shares worth 10 million dollars, closely matching the S&P 500, which stands at 5,000. It expects a difficult month but does not want to sell.

One E-mini contract is worth 5,000 × 50 = 250,000 dollars. The fund sells 40 contracts, about 10 million dollars of exposure.
The index falls 5% to 4,750. The shares lose about 500,000.
The futures gain 250 points × 50 × 40 = 500,000, offsetting the loss.

If the index had risen instead, the shares would have gained and the futures lost. The hedge removed both the risk and the opportunity.

Common mistakes

Ignoring contract size. One future can mean hundreds of thousands in exposure.
Forgetting that bond futures fall when yields rise. The direction can confuse.
Holding commodity futures into delivery. Physical settlement is not meant for private traders.
Treating hedges as free. They give up gains as well as losses.

The takeaway

Index futures track stock indices, interest rate futures track bonds and rates, commodity futures track raw materials. Each follows its own drivers.

Check yourself

Quick quiz

4 questions. Instant feedback, nothing is saved.

1Tap the group whose prices fall when interest rates rise.

Tap the chart.

Bond futures follow bond prices, which move opposite to yields, as in the lesson on interest rate risk.
2A pension fund wants to protect a share portfolio against a fall for a few weeks without selling it. What can it do?

Gains on the sold futures offset losses in the portfolio if the market falls.
3Why do commodity futures funds often trail the spot price?

As the lesson on roll yield showed, rolling into dearer contracts reduces returns.
4How are most stock index futures settled at expiry?

Delivering hundreds of shares would be impractical, so index futures settle the difference in cash.

of 4 correct.