MAS (Licence No. CMS101371)
What are futures?Â
Futures are contracts that allow buyers and sellers to agree on the price and quantity of an asset that will be delivered or paid for at a future date. Futures can be based on commodities, such as oil, corn, or gold, or financial instruments, such as stock indexes, currencies, or bonds. Futures are traded on exchanges, where they are standardized and regulated.
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Futures can be used for different purposes, such as hedging or speculating. Hedging is a way of reducing the risk of unfavorable price changes in the future by locking in a price today. For example, a farmer can sell futures contracts for their crops to guarantee a certain income regardless of the market conditions at harvest time.
Speculating is a way of profiting from favorable price changes in the future by betting on the direction of the market. For example, a trader can buy futures contracts for a stock index if they expect the index to rise in the future.
Types of Futures
Commodity
Financial
Futures: Main Functions and Benefits
01
Price Discovery
Price discovery is the process of finding the equilibrium price of an asset based on the current and expected supply and demand conditions. Futures markets facilitate price discovery by providing a transparent and competitive platform for trading standardized contracts. Futures prices reflect the market’s expectations of the future value of the underlying asset, as well as the current and future market conditions. By observing the futures prices, market participants can obtain valuable information about the future direction and volatility of the spot prices, and adjust their production, consumption, or investment decisions accordingly.
02
Risk Hedging
Risk hedging is the practice of reducing or eliminating the exposure to unfavorable price movements of an asset. Futures markets enable risk hedging by allowing market participants to lock in a predetermined price for buying or selling an asset at a future date. By doing so, they can transfer the price risk to another party who is willing to take the opposite position in the futures contract. For example, a wheat farmer who is worried about the price decline of wheat can sell wheat futures contracts to secure a fixed selling price for his crop. Conversely, a bread maker who is concerned about the price increase of wheat can buy wheat futures contracts to secure a fixed buying price for his raw material.
03
Asset Allocation
Asset allocation is the process of distributing one’s wealth among different types of assets to achieve a desired return and risk profile. Futures markets facilitate asset allocation by providing a variety of financial instruments that can suit different investment objectives and strategies. Futures contracts can be used to gain exposure to different asset classes, such as commodities, currencies, interest rates, and stock indices, with a relatively small amount of capital due to the leverage effect. Futures contracts can also be used to diversify one’s portfolio by taking advantage of the low or negative correlation between different asset classes. Furthermore, futures contracts can be used to enhance one’s portfolio performance by exploiting arbitrage opportunities or implementing speculative strategies.
Advantages of Futures
Futures have several advantages over other types of investments, such as stocks or options. Some of the advantages are:
Leverage
Futures allow you to control a large amount of money with a small amount of money. For example, if the value of a futures contract is $100,000 and the initial margin is $10,000, then you can control $100,000 worth of futures contracts with only $10,000, which gives you a leverage ratio of 10:1. Leverage can amplify your profits or losses depending on the direction of the market movement.
Futures and Stocks
Comparison
Futures | Stocks |
|---|---|
Futures markets are open and transparent, with daily transactions and positions disclosed to the public | Stock markets are relatively opaque, with insider trading and market manipulation more common |
Futures prices are based on the value and supply and demand of the underlying commodity or financial asset | Stock prices are based on the performance and expectations of the listed company |
Futures profits and losses are settled daily and require margin maintenance | Stock profits and losses are not settled until the transaction is completed |
Futures Contract
A futures contract is a type of financial agreement that allows buyers and sellers to trade an asset at a fixed price and date in the future. Futures contracts are standardized and traded on exchanges, where the prices are determined by supply and demand.
Futures contracts are standardized in terms of the commodity type, quantity, quality, grade, delivery time, delivery place, and other terms. The only variable is the price. The standardization of futures contracts is usually designed by the futures exchange and approved by the national regulatory authority. Standardization facilitates the trading and clearing of futures contracts, as well as the comparison and evaluation of futures prices.
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Let’s take a look at an example of a commodity futures contract.
Farmer
Suppose you are a farmer who grows corn and you want to lock in a price for your crop that you will harvest in six months. You can sell corn futures contracts for the delivery month of September at the current market price of $5 per bushel. Each corn futures contract represents 5,000 bushels of corn, so you decide to sell 10 contracts, which means you agree to deliver 50,000 bushels of corn in September at $5 per bushel.
Manufacturer
On the other hand, suppose you are a cereal manufacturer who needs corn as a raw material and you want to secure a price for your input that you will use in six months. You can buy corn futures contracts for the delivery month of September at the current market price of $5 per bushel. You decide to buy 10 contracts, which means you agree to receive 50,000 bushels of corn in September at $5 per bushel.
Futures Contract
By entering into this futures contract, both parties have hedged their price risk and eliminated the uncertainty of future price fluctuations. The farmer is guaranteed to sell his corn at $5 per bushel regardless of whether the spot price goes up or down in six months. The cereal manufacturer is guaranteed to buy corn at $5 per bushel regardless of whether the spot price goes up or down in six months.
Benefit & Loss
However, both parties also have given up the opportunity to benefit from favorable price movements. If the spot price of corn rises above $5 per bushel in six months, the farmer will lose money because he could have sold his corn at a higher price in the spot market. The cereal manufacturer will gain money because he could have bought corn at a higher price in the spot market. Conversely, if the spot price of corn falls below $5 per bushel in six months, the farmer will gain money because he could have bought back his corn at a lower price in the spot market. The cereal manufacturer will lose money because he could have sold his corn at a lower price in the spot market.
Of course, both parties do not have to wait until the expiration date to close out their positions. They can buy or sell the same number of contracts in the opposite direction before maturity and settle their profits or losses based on the difference between the initial and final prices. For example, if the farmer sells 10 contracts at $5 per bushel and later buys back 10 contracts at $4 per bushel, he will make a profit of $1 per bushel or $50,000 in total. If the cereal manufacturer buys 10 contracts at $5 per bushel and later sells 10 contracts at $4 per bushel, he will incur a loss of $1 per bushel or $50,000 in total.