The financial term ‘derivative’ is a generic term for any instrument which is based on an underlying financial instrument or commodity. The term covers, most commonly, futures and options contracts. For instance, a commodity future is an instrument derived from the commodity markets—the markets which operate for the purchase and sale of corn and other grains, metals, oil and so on. In the same way, an index option is derived from an index.

Confusingly, the name ‘futures‘ is often used in an equally all-encompassing way, and certainly the term ‘managed futures‘ covers the use of all types of derivative products. This report focuses predominantly on managed futures, meaning investment in futures and options instruments.

Despite the fact that this is an industry which is so strongly associated with creating risk, the roots and the principal use of the derivatives markets are, ironically, firmly in the business of protecting against risk.

And First There Was Grain …

Arguably, the origins of the futures industry stem from rice contracts in 16th-century Japan, where the landed classes raised money by selling rice in advance of delivery to the rice merchants. However, the modern origins of futures, certainly as an exchange-based industry, lie in the productive fields of the grain belt in the US in the first half of the last century and the cruel exigencies of supply and demand. Price fluctuations for grain were violently volatile which had a serious and noticeable effect on the economy by causing an increase in the price of food.

At harvest time in the last century, the prairie-based farmer hauled his wagon load of grain to Chicago, and once there hunted for a buyer—along with everyother farmer who had hauled his wagon load of grain to Chicago. In the way of these things, the price went firmly down as the farmer was forced to accept whatever was offered for his crop—or worse as he was forced to watch it spoil and be dumped in Lake Michigan. Come the late spring and early summer, harvest stocks were used up, available grain was in great demand and short supply, and the wise grain merchant who still had supplies made a lot of money—while everybody else suffered.

Not surprisingly, bitter disputes flourished in this chaotic environment, while price fluctuations for grain were violently volatile. In turn, this had a much more serious, or certainly more recognisable effect, on the economy by causing an increase in the price of food.

The problem gradually became so serious that a group of Chicago businessmen decided to try to do something about it and in 1848, 82 merchants representing every important business interest in Chicago met above a flour store on South Water Street and founded the Chicago Board of Trade (CBOT).

The Constitution, written in 1848 stated that the aims of the CBOT were:

i. to maintain a commercial exchange

ii. to promote uniformity in the customs and usages of merchants

iii. to inculcate principles of justice and equity to trade

iv. to facilitate the speedy adjustment of business disputes

v. to acquire and disseminate valuable commercial and economic information

vi. generally to secure for its members the benefits of co-operation in the furtherance of their legitimate pursuits.

The Concept of ‘To Arrive’ Contracts

At this point, the commercial sector in Chicago—and indeed that in the City of London in the UK—was using a ‘to arrive’ contract more and more. This form of agreement was the forerunner of today’s futures contract. It allowed agricultural buyers and sellers to specify delivery of a particular commodity at a predetermined later date at a price that was fixed at the time of the deal.

As futures contracts became more sophisticated, they created an increasingly protective barrier against erratic price movements and so reduced the farmer’s or the grain merchant’s exposure to risk. To arrive contracts became increasingly common in all types of commodity markets: corn, sugar, metals —gold, for instance—and so on.

Possibly related posts: (automatically generated)
The Origins of the Futures Industry (part 1)

• The Origins of the Futures Industry (part 2)
• The Evolution of Managed Futures Funds
• The Origins of the Futures Industry (part 3)
• Principles of Futures Contract Pricing (T1)
• Selecting a Baseline Measurement for CTA Success Part 3
• Why We Have Futures Contracts
• Regulation of Managed Futures Funds in Europe Part 4
• Regulation of Managed Futures Funds in the US and Japan
• The Case Against Managed Futures
• Managed Futures