Futures contracts are derivatives securities, which may seem confusing and frightening. Indeed, you are not alone in believing that futures and other derivatives enhance volatility in financial markets and are to blame for financial instability in markets or the greater economy. Derivatives have been blamed for the 2008 financial catastrophe, but do they warrant such a severe verdict? Most likely not. Instead, we must comprehend them, how they are traded, their advantages and disadvantages, and how these instruments vary from one another.
Derivatives exist in many forms and sizes, with some being more hazy and intricate than others. In this section, we will examine into futures contracts, which provide the holder the potential to take possession of an item in the future for a price paid today. These contracts are exchange-traded and carefully regulated, making them one of the most common and harmless derivatives transactions.
- Hedgers and speculators may trade the price of an item that will settle for delivery at a future date in the present using futures contracts.
- Futures contracts are classified as derivatives since their value is derived from the underlying asset that will be delivered.
- Futures are particularly transparent and liquid since they are standardized and exchanged on regulated exchanges. Forwards and swaps, for example, trade over-the-counter and are less transparent.
Futures contracts are contracts whose value is derived from an underlying asset, such as a typical stock, bond, or stock index. Futures contracts are standardized contracts that are exchanged on a controlled exchange. The “future price of the underlying asset” is an agreement between two parties to purchase or sell something at a later period for a certain price. The party agreeing to purchase is said to be long, while the party agreeing to sell is known to be short. The parties are matched in terms of quantity and cost. A futures contract requires the parties to exchange just the difference in the asset price at maturity rather than a real asset.
With the exchange, both parties must pay an initial margin amount (a proportion of the entire risk). The contracts are marked to market, which means that the difference between the base price (the price at which the contract was entered) and the settlement price (typically an average of the prices of the past several transactions) is subtracted or added to the respective parties’ accounts. The settlement price is utilized as the base price the following day. If the new base price falls below a maintenance margin, the parties must deposit more monies into their accounts (pre-determined level).The investor may exit the investment at any moment before maturity, but he or she must bear the risk of any profit or loss.
Futures are a key tool for hedging or managing many types of risks. Companies engaged in foreign trade use futures to manage foreign exchange risk, interest rate risk if they have an investment to make and want to lock in an interest rate in anticipation of a drop in rates, and price risk to lock in prices of commodities used as inputs such as oil, crops, and metals.
Futures and derivatives contribute to the underlying market’s efficiency by lowering the unanticipated expenses of acquiring an item outright. For example, going long in S&P 500 futures is more cheaper and more efficient than acquiring every company in the index. Studies have also indicated that the introduction of futures into markets enhances overall trading volumes. As a result, since futures are considered as an insurance or risk management tool, they assist lower transaction costs and boost liquidity.
Futures and Price Discovery
Price discovery is another significant function that futures play in financial markets. Future market pricing are dependent on a steady flow of information and openness. A variety of variables influence an asset’s supply and demand, as well as its future and spot pricing. This kind of knowledge is rapidly absorbed and reflected in future pricing. Future prices for contracts approaching maturity converge to the spot price, hence the future price of such contracts serves as a proxy for the underlying asset’s price.
Future pricing reflect market expectations as well. For example, if an oil exploration accident occurs, the supply of crude oil is expected to decrease, causing near-term prices to increase (perhaps quite a lot).Futures contracts with longer maturities, on the other hand, may continue at pre-crisis levels since supply is projected to stabilize eventually. Future contracts, contrary to popular assumption, increase liquidity and information transmission, resulting in bigger trading volumes and decreased volatility. (Volatility and liquidity are inversely proportional.)
Despite their benefits, futures contracts and other derivatives have certain downsides. Because of the nature of margin requirements, one might take on a lot of risk, which means that a tiny movement in the wrong direction can result in massive losses. Furthermore, the daily marking to market might place unnecessary strain on the investment. One must be a competent judge of the market’s direction and minimal magnitude.
Derivatives are likewise ‘time-wasting’ assets in the sense that their value decreases as maturity approaches. Critics also claim that speculators utilize futures and other derivatives to speculate on the market and assume unnecessary risks. Futures contracts are similarly subject to counterparty risk, but at a considerably lower degree due to the central counterparty clearing house (CCP).
For example, if the market swings significantly in one way, several participants may fail on their obligations, and the exchange must shoulder the risk. Clearinghouses, on the other hand, are better able to manage this risk, and they minimize risk by marking to market every day, which is a benefit of futures over other derivatives.
Aside from futures, the realm of derivatives also includes items sold over the counter (OTC) or between private parties. These might be ordinary or highly customized for skilled market players. Forwards are a derivative product that is similar to futures except that they are not traded on a central exchange and are not marked to market on a regular basis. These unregulated products are largely subject to credit risk due to the possibility of a counterparty failing on its obligations at the contract’s expiry.
Despite the fact that these customised goods represent a tiny portion of a multi-trillion-dollar business, research shows that the standardized components of OTC marketplaces work flawlessly. The Lehman Brothers derivatives book, which represented 5% of the global derivatives market, is a prime illustration of this. Eighty percent of the trade’s counterparties resolved within five weeks of their 2008 bankruptcy.
The Bottom Line
Futures are an excellent tool for risk management and hedging; they also improve liquidity and price discovery. They are, nevertheless, difficult, and one should comprehend them before engaging in any deals. The desire for uniform derivatives regulation (exchange or OTC based) may have the unintended consequence of drying up liquidity to remedy something that is not necessarily wrong.
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