
  If an exchange facilitates the trading of futures contracts and nobody intends to take delivery of the product, nor do they own it so they can deliver it, then how are the contracts issued? 


Say I want to buy a future contract that allows me to buy coffee at a given price in December 2013. Technically, this contract allows me to buy 37,500 pounds of coffee at the specified price in December 2013. I have two options. If the contract already exists in the market (this contract does), I can simply purchase the contract in the market. If it doesn't exist, however, the process works like this: 

I approach a futures commission merchant, who sends the buy order to a broker on the trading floor/pit or to the exchange order system. Assuming someone else has put in a sell order for the same commodity, expiration, etc. the orders are matched at the agreed upon price, and the futures contract is created.

Also, the FCM reports the trade to the exchange's clearing house, which guarantees the trade and removes counter-party risk. In other words, if the price of coffee changes dramatically, and one of the parties in the trade cannot meet its buy or sell obligation, there isn't a default. The clearing house settles the trade.


  Is there a fixed number of contracts that are created and traded, or is there an "unlimited" number of contracts? 


No, there is no fixed number. The Wikipedia article on futures exchanges sums this up:


  Futures contracts are not issued like other securities, but are "created" whenever Open interest increases; that is, when one party first buys (goes long) a contract from another party (who goes short). Contracts are also "destroyed" in the opposite manner whenever Open interest decreases because traders resell to reduce their long positions or rebuy to reduce their short positions.





  If none of the traders intend to take delivery nor do they want to deliver, then where do the sellers get the contracts to sell? How does that process work? 


The futures market doesn't consist of only traders. The terminology that you usually hear are speculators and hedgers. Speculators are the traders you're thinking of, while hedgers are farmers, oil producers, or companies that rely on commodities. All of these groups enter the futures market in order to lock in a future price at which to buy or sell the products they need, in order to protect themselves from future price swings.

For example, if I'm an oil producer like ExxonMobil, the price of oil significantly affects my future revenue. The price of Brent crude oil is currently around $108/barrel. If this price increases to $120/barrel in a year, they may earn much more revenue. However, if the price drops to $80/barrel, however, their revenue stream is negatively affected. Therefore, I go to the futures market and sell a futures contract that expires in one year and allows me to sell oil for $108/barrel.

If the price of oil jumps to $120/barrel in one year, I would have been better off without a futures contract. However, if the price drops to $80/barrel, I saved myself a considerable loss. This is how the futures market lowers risk and helps to smooth commodity prices in the long run. 

Who takes the other side of the trade? Consider an airline company that knows it will need oil1 for its planes in a year. The airline company will earn more revenue if the price of oil drops to $80/barrel (the exact opposite of ExxonMobil), but lose revenue if the price jumps to $120/barrel. The airline may decide to enter the futures market and agree to buy oil at $108/barrel in one year, thus completing the trade. The futures contract is created and traded in the market.2 3

Expiration

When the contract expires, the buyer/seller either takes delivery of the commodity or the contract is settled for cash between parties. As maturity nears, the price of the contract usually converges to the spot price. Consider our example oil contract, which was created at $108/barrel. If in one year, the spot price of oil has increased to $120/barrel, the contract's price will converge to $120/barrel. Exxon received $108 for its sale of the contract, and now owes $120 in cash or $120 in oil. The cost of its hedge was $12. The airline company bought the contract for $108, and now receives $120. It profited $12 from its hedge, so Exxon would pay the airline company $12. Exxon could sell oil for $120/barrel, but because of the cost of its hedge, it's only receiving $108/barrel, exactly the price it locked in by selling the contract in the first place.

Consider what happens if the price of oil had decreased to $80/barrel. Exxon received $108 for its sale of the contract, and now owes only $80, for a profit of $28. The airline company, however, paid $108, but only received $80 in return, for a loss of $28, so the airline company would pay Exxon $28. Similar to above, Exxon can only fetch $80/barrel for its oil in the spot market, but because it earned $28/barrel by selling a futures contract, it's really receiving $108/barrel for the barrels in the contract.



1 In reality, planes don't run on oil; they run on jet fuel. Since there isn't a futures contract for jet fuel, the airline could study the past relationship between prices of jet fuel and oil in order to estimate the future price of jet fuel, given a future price of oil. Since the company can lock in the price of oil through a futures contract, they'll lock in a price of oil that, based on their estimated model of jet fuel/oil prices, will give them enough funds to purchase the appropriate amount of jet fuel.

2 It's also important to understand that not all hedgers will operate this way. It's certainly possible for a company to hedge too much, and therefore not benefit at all if the price swings in their favor. This has happened to airline companies in the past; even when oil prices have fallen, they haven't benefited because their hedges were expensive enough to outweigh the potential gain. However, had the price increased dramatically, their hedge would have been highly effective. 

3 Also, in this simple example, two companies may choose to bypass the futures market all together and create an over-the-counter (OTC) contract instead. For example, ExxonMobil could agree to sell oil to a specific company at $108/barrel in one year, without entering the futures market at all. This option may be cheaper than entering the futures market, but futures markets also have the benefit of clearing houses to mitigate counterparty risk. If Exxon agrees to sell oil to a company, which then goes bankrupt, Exxon is protected if the hedging was done through the futures market. In the OTC market, this protection isn't always there. OTC contracts can be useful, however, if (for example), the company wants to make or take delivery of a commodity at a different location than that specified in the standardized contracts available on an exchange.

How are futures contracts setup at an exchange?
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