Futures contracts are derivative securities-this may sound too complicated and scary. In fact, if you believe that futures and other derivatives will increase the volatility of financial markets and are responsible for the financial instability of the market or the larger economy, you are not alone. Derivatives are blamed on the 2008 financial collapse, but should they be subject to harsh judgments? maybe not. Instead, we need to understand them, how they are traded, their advantages and disadvantages, and the differences between these tools.
Derivatives come in various shapes and sizes, some of which are more vague and complicated than others. Here, we will study futures contracts-which enable holders to pay for the delivery of certain assets in the future at today’s prices. These contracts are traded on exchanges and are highly regulated-making them the most harmless and most widely used derivative contracts.
- Futures contracts allow hedgers and speculators to trade the price of assets that will be delivered on the current future date.
- Futures are called derivative contracts because their value comes from the underlying asset to be delivered.
- Futures are standardized and traded on regulated exchanges, making them highly transparent and liquid. Other types of derivatives, such as forwards or swaps, are traded over the counter and are more opaque.
Futures are contracts that obtain value from underlying assets (such as traditional stocks, bonds, or stock indexes). Futures are standardized contracts traded on central exchanges. They are an agreement between two parties to buy or sell something at a certain price on a certain date in the future, called the “future price of the underlying asset”. The party who agrees to buy is called a long position, and the party who agrees to sell is called a short position. The two parties are matched in quantity and price. The parties to a futures contract do not need to exchange physical assets, but only exchange the future price difference of the maturing asset price.
Both parties need to pay the initial margin amount (a small part of the total exposure) to the exchange. The contract is priced at the market price; that is, the difference between the base price (the contract signing price) and the settlement price (usually the average of the last few transaction prices) is deducted or added from the accounts of both parties. The settlement price of the next day is used as the base price. If the new basic price is lower than the maintenance margin (predetermined level), both parties need to deposit additional funds into their accounts. Investors can close their positions at any time before maturity, but they must be responsible for any profits or losses incurred by the positions.
Futures are an important tool for hedging or managing different types of risks. Companies engaged in foreign trade use futures to manage foreign exchange risks, investment interest rate risks, and lock interest rates when expected interest rates fall, as well as price risks for commodity prices such as oil, crops, and metals used as inputs.
Futures and derivatives help improve the efficiency of the underlying market because they reduce the unforeseen costs of directly purchasing assets. For example, doing long in S&P 500 index futures is much cheaper and more efficient than copying the index by buying each stock. Research also shows that the introduction of futures into the market will increase the overall underlying transaction volume. Therefore, futures are regarded as an insurance or risk management tool, thus helping to reduce transaction costs and increase liquidity.
Futures and price discovery
Another important role of futures in financial markets is price discovery. Future market prices depend on the continuous flow and transparency of information. Many factors will affect the supply and demand relationship of assets, thereby affecting their future and spot prices. This information will be quickly absorbed and reflected in future prices. The future price of a contract that is close to expiration tends to be the spot price. Therefore, the future price of this type of contract can be used as a proxy for the price of the underlying asset.
Future prices also indicate market expectations. For example: In the case of an oil exploration disaster, the supply of crude oil may fall, so the price will rise in the near future (may rise a lot). However, futures contracts with a later expiration date may remain at their pre-crisis levels, as supply is expected to eventually normalize. Contrary to popular belief, future contracts will increase liquidity and information dissemination, leading to higher transaction volumes and lower volatility. (Liquidity and volatility are inversely proportional.)
Despite the advantages, futures contracts and other derivatives also have considerable disadvantages. Due to the nature of margin requirements, people can assume a large amount of risk exposure, which means that small fluctuations in the wrong direction can lead to huge losses. In addition, daily mark-to-market may cause unnecessary pressure on investors. People need to judge the direction and minimum extent that the market will move.
Derivatives are also “time-wasting” assets because their value will decline as the expiry date approaches. Critics also believe that futures and other derivatives are used by speculators to bet on the market and take undue risks. Futures contracts also face counterparty risks, but they are significantly reduced due to the existence of the Central Counterparty Clearing House (CCP).
For example, if the market moves far in one direction, many participants may default and the exchange will have to take risks. However, the clearing house can better handle this risk. They reduce the risk by marking to the market every day, which is the advantage of futures over other derivatives.
In addition to futures, the derivatives field also includes over-the-counter (OTC) or privately traded products. These may be standardized or tailored for mature market participants. Forward is such a derivative product, except that they are not traded on a central exchange and mark the market from time to time, it is like a futures. These unregulated products are mainly subject to credit risk, because the counterparty may default when the contract expires.
However, these tailor-made products only account for about 15% of the trillion-dollar industry, and there is evidence that the standardized part of the over-the-counter market performs very well. A good example is Lehman Brothers’ derivatives ledger, which accounts for 5% of the global derivatives market. 80% of the counterparties of these transactions completed settlement within 5 weeks after bankruptcy in 2008.
Futures are excellent tools for hedging and managing risk; they enhance liquidity and price discovery. However, they are complex and you should understand them before conducting any transaction. Calls for regulation of standardized derivatives (based on exchanges or over-the-counter transactions) may have a negative impact, which is to exhaust liquidity to repair things that are not necessarily damaged.