Futures are financial derivatives that are standardized contracts to buy or sell an underlying asset at a predetermined price on a future date. They possess several distinct features and properties:
1. Standardization: Futures contracts are highly standardized, with predetermined terms, including the quantity and quality of the underlying asset, delivery date, and delivery location. This standardization ensures uniformity and facilitates trading on organized exchanges.
2. Underlying Asset: Every futures contract is based on a specific underlying asset, which can include commodities (e.g., crude oil, gold), financial instruments (e.g., stock indices, interest rates), or other assets (e.g., currencies, weather conditions).
3. Contract Size: Each futures contract specifies a fixed quantity or contract size of the underlying asset. For example, one crude oil futures contract may represent 1,000 barrels of oil.
4. Delivery Date: Futures contracts have a set expiration or delivery date when the contract must be settled. Delivery can be physical, where the actual asset is delivered, or cash settlement, where the price difference is paid.
5. Delivery Location: For physically settled contracts, a specific delivery location is designated where the underlying asset is to be delivered. This location can vary depending on the exchange and contract.
6. Price: The futures price is the price at which the buyer and seller commit to trade the underlying asset on the delivery date. It is agreed upon at the inception of the contract.
7. Margin Requirements: Futures contracts require an initial margin deposit to initiate a position. Traders must maintain a margin account to cover potential losses, and daily margin calls may be issued based on market movements.
8. Leverage: Futures provide significant leverage, as traders can control a larger position with a relatively small margin deposit. While this amplifies potential profits, it also increases potential losses.
9. Daily Settlement: Futures contracts have daily settlement prices, which are used to determine gains or losses for the trading day. These prices are based on market conditions and can lead to daily margin calls.
10. High Liquidity: – Futures markets are generally highly liquid, with a large number of participants actively trading. This liquidity makes it easier to enter or exit positions.
11. Price Transparency: – Real-time price information and trading data are readily available in futures markets, ensuring transparency and enabling quick reactions to market developments.
12. Risk Management: – Futures are commonly used for risk management purposes. Participants can hedge against price fluctuations by taking opposing positions in futures contracts.
13. Market Regulation: – Futures markets are subject to regulatory oversight to ensure fair and transparent trading. Regulators establish rules and monitor market activity.
14. Price Discovery: – Futures markets play a vital role in price discovery, as they reflect market sentiment, expectations, and the supply and demand dynamics of the underlying asset.
15. Speculation: – Traders use futures contracts for speculation, seeking to profit from price movements without a direct interest in the underlying asset.
16. Diverse Asset Classes: – Futures markets cover a wide range of asset classes, from agricultural commodities to financial indices, offering participants various investment options.
17. Expiration and Rollover: – For traders looking to maintain positions beyond the current contract’s expiration, they can roll over into the next contract month to avoid physical delivery.
18. Tax Advantages: – In some jurisdictions, futures trading may offer tax advantages, such as favorable capital gains tax treatment.
What is the Convergence Property of Futures?
The convergence property of futures refers to the tendency of the futures price to approach and eventually become equal to the spot price of the underlying asset as the delivery date of the futures contract approaches. In other words, it reflects the process by which the futures price and the spot price converge and align with each other over time.
Here’s how the convergence property works:
- Initial Divergence: When a futures contract is first created, the futures price may differ from the current spot price of the underlying asset. This initial difference can be attributed to factors like interest rates, carrying costs, dividends (for equity futures), and market sentiment.
- Arbitrage Opportunities: Traders and arbitrageurs actively monitor the relationship between the futures and spot prices. When they observe a significant difference between the two, they may execute arbitrage strategies to profit from the price discrepancy. For instance, if the futures price is significantly higher than the spot price, traders might sell the futures contract and buy the underlying asset to take advantage of the price differential.
- Market Forces: Over time, the actions of traders, investors, and arbitrageurs in response to price discrepancies help drive the futures price and the spot price closer together. As the contract’s delivery date approaches, the influence of these market forces intensifies.
- Convergence at Expiration: By the time the futures contract approaches its expiration or delivery date, the futures price tends to converge with the spot price. If the contract is physically settled, the two prices will ideally be equal, and the trader will either take or make delivery of the underlying asset at the agreed-upon price. If the contract is cash-settled, the cash payment will reflect the convergence of the two prices.
What are the different types of Hedging strategies used in Futures?
Futures are commonly used in various hedging strategies to manage and mitigate price risks associated with underlying assets. Here are several common hedging strategies that involve the use of futures contracts:
- Long Hedge:
- Objective: To protect against rising prices of the underlying asset.
- Strategy: Go long (buy) a futures contract for the same underlying asset.
- Example: A wheat farmer goes long wheat futures to lock in a minimum selling price for their crop.
- Short Hedge:
- Objective: To protect against falling prices of the underlying asset.
- Strategy: Go short (sell) a futures contract for the same underlying asset.
- Example: An airline goes short on jet fuel futures to secure a maximum purchase price for future fuel needs.
- Cross Hedge:
- Objective: To hedge an asset with a futures contract on a related but not identical asset.
- Strategy: Use futures contracts for a closely correlated asset as a proxy hedge.
- Example: A silver mining company might hedge its exposure to silver prices by trading gold futures, which have a strong price correlation.
- Dynamic Hedging:
- Objective: Continuously adjust hedges as market conditions change.
- Strategy: Regularly trade futures contracts to maintain a targeted hedge ratio.
- Example: An investment fund dynamically hedges its portfolio against market fluctuations using S&P 500 futures.
- Delta Hedging:
- Objective: Neutralize the directional risk associated with options positions.
- Strategy: Adjust the number of futures contracts to offset changes in the option’s delta.
- Example: A trader holds a long call option and goes short an equivalent amount of futures contracts to delta hedge.
- Basis Hedging:
- Objective: Hedge the difference (basis) between the spot and futures prices of an asset.
- Strategy: Take positions in both the underlying asset and its corresponding futures contract.
- Example: A soybean processor hedges the basis risk by holding soybeans and short soybean futures.
- Calendar Spread:
- Objective: Hedge against price fluctuations between different delivery months.
- Strategy: Simultaneously take opposite positions in two different contract months of the same commodity.
- Example: A natural gas company goes long the winter-month natural gas futures and short the summer-month futures to hedge against seasonal price variations.
- Crack Spread:
- Objective: Hedge the price difference between crude oil and its refined products.
- Strategy: Simultaneously take positions in crude oil and the products (e.g., gasoline, diesel) futures.
- Example: A refinery uses crack spread to hedge against refining margin fluctuations.
- Butterfly Spread:
- Objective: Hedge against price volatility and reduce risk.
- Strategy: Combines multiple futures contracts to create a balanced position.
- Example: A trader uses a butterfly spread to hedge against potential price fluctuations by holding three futures contracts with varying maturities.
What important Role do Futures play in Market Making?
Price Discovery:
- Continuous Information Flow: Price discovery relies on a constant influx of information from various sources worldwide. Factors such as politics, climate, debt situations, and societal behaviors continuously impact supply and demand for assets.
- Role of Futures Markets: Futures markets are instrumental in determining spot prices for assets. They are more active than the spot market, making the information derived from them more reliable. These markets often deal with geographically dispersed underlying assets, resulting in multiple spot prices.
- Options and Volatility: Options contribute to price discovery by reflecting how market participants assess market volatility. When investors anticipate high market volatility, the premiums (purchase prices) of options tend to rise.
- Transparency: Transparency is crucial for price discovery. Derivative markets typically provide real-time price information and trading data, allowing market participants to react quickly to new information and efficiently incorporate it into market prices.
Risk Management:
- Hedging and Speculation: Derivatives are used for risk management, which includes both hedging and speculation. Investors may use derivatives to either increase their risk exposure for higher expected returns or protect themselves from unwanted risks.
- Additional Risks: Derivative securities introduce additional risks to investors, often associated with their complexity and potential for significant gains and losses. Options, for instance, offer substantial profit potential but are suitable primarily for sophisticated investors with a high-risk tolerance.
- Professional Utilization: Professional traders and money managers are well-trained to effectively use derivatives. They manage risks stemming from factors like the expiration time of the instrument, market timing, market direction, market volatility, and transaction costs.
- Expiration Dates: Derivative instruments have expiration dates, and as each day passes, their time value decreases. For example, in the case of options, the decline in time value alone reduces their value.
- Market Prediction: Successful trading in derivatives often hinges on accurately predicting the market’s direction and, if possible, the extent of the move within a specific time frame. This requires a deep understanding of market dynamics and trends.
- Investor Sophistication: Understanding these risks and the proper use of derivatives is essential for investors. It’s vital for them to be aware of the risks involved and be well-prepared, especially when dealing with complex derivative instruments.
- Market Liquidity: The liquidity of derivative markets is another factor that aids in risk management. Highly liquid markets offer ease of entry and exit, reducing the risk associated with illiquid assets.