A product future is a financial instrument that allows investors to bet on the price of products without actually having to buy them.
Trading of these futures contracts allows companies and producers of commodity goods (such as wheat or coffee) to protect themselves against changes in prices, allowing them more certainty about the level of future income generated by their business.
It is beneficial for raw materials like cotton, where prices can fluctuate dramatically during the months between harvesting and sale of the final product.
Helpful example
Imagine a chocolate company stockpiles 25 tonnes of cocoa at a cost to them of £2million a year.
The current market price for cocoa is £3 per kilo, but they expect it to rise sharply next summer when there will be high demand for cocoa to make chocolate in the run-up to Christmas.
Suppose they do not hedge their position (i.e. contract out the future price by buying a product future) and cocoa prices increase.
In that case, they will lose money because they need to buy more expensive raw materials later while being hit with reduced margins on their chocolate sales during the festive season.
They could mitigate this cost if they contracted out a product future through an appropriate age, which would have allowed them to protect themselves against this risk of fluctuations in price without buying actual stocks of cocoa or going into debt by borrowing against next year’s cocoa supply.
Product futures are traded on the London International Financial Futures and Options Exchange (LIFFE).
In the UK, UKLA would trade any future contract through them.
The European Union (EU)
The UK is a member of the European Union, and most legislation regarding futures trading in the UK has been harmonised with that in other EU markets.
It includes MiFID, which sets out several rules for investment firms dealing in product futures.
In particular, it requires investment firms to hold certain capital levels, be authorised by the UK regulator, the Financial Conduct Authority (below), and comply with their requirements for ongoing business conduct.
It also includes position limits on how much an individual can control within a specific instrument or commodity class. This way, it prevents anyone from cornering the market with their orders.
The development of product futures
Product futures were initially developed by the Chicago Mercantile Exchange but have been increasingly used outside of US markets, where the UK is a leading user.
Such products allow farmers, commodity producers and manufacturers to reduce risk from wild market swings with a lower barrier of entry than actually purchasing goods or raw materials.
It has led some experts such as The Economist magazine’s commodities editor Ed Crooks to question whether product futures trading had played a role in increased volatility in food prices during the 2007-8 world food crisis.
The usage of product futures
Product futures are available for various products, including UK agricultural, UK metals and UK energy markets.
While UK exchanges have not traditionally traded these types of product futures, the launch in 2012 of the UK’s first Agricultural based future has opened up the UK market to trade certain international product futures.
The expanded access should provide farmers with increased liquidity by allowing them to hedge their positions more effectively.
Moreover, future trading should provide greater price transparency which would benefit all producers and consumers through increased efficiency.
Contracts are bought and sold electronically via online platforms or telephone, similar to other financial instruments such as currencies or shares, so investors do not require large sums upfront before gaining exposure to commodity prices.
Product futures can be used for speculation and hedging, although the UK market typically has smaller speculators than other commodity markets.
It is due to UK investors’ preference for mutual funds and other retail investment vehicles compared to the US, where individual financial instruments are more widely traded.
UK law requires that product futures dealing be conducted through organised exchanges or clearinghouses, which act as guarantors against losses should one party default on their obligations; between two individuals, they cannot trade contracts directly.
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