Tuesday, February 24

Futures


Futures

Future contracts are agreements between two parties to buy or sell an asset (underlying) at a given point of time in the future. They are standardized contract i.e. an agreement, traded on a futures exchange, to buy or sell a standardized quantity of a specified commodity of standardized quality at a certain date in the future, at a price (the futures price) determined by the parties involved. The future date is called the delivery date or final settlement date. The official price of the futures contract at the end of a day's trading session on the exchange is called the settlement price for that day of business on the exchange.

Assume that no cash settlement was done between the two parties. A futures contract gives the holder the obligation to make or take delivery under the terms of the contract. Also both parties of a futures contract must fulfill the contract on the settlement date – it is legally binding. The seller delivers the underlying asset to the buyer, or, if it is a cash-settled futures contract, then cash is transferred from the futures trader who sustained a loss to the one who made a profit. Money lost and gained by each party on a futures contract are equal and opposite. In other words, a future trading is a zero-sum game.

Future prices are not definitive statements of prices in the future. In fact they are not even necessarily predictions of the future. But they are important pieces of information about the current state of a market, and futures contracts are powerful tools for managing risks.

Terminology
Underlying
: It is the asset or index on which a derivative is written. For example a futures index has the underlying as an index.

Delivery Date: This is the date at which the underlying will be delivered by the seller to the buyer. It is also known as final settlement date.

Future Price: This is the agreed upon or prearranged price determined by the instantaneous equilibrium between the forces of supply and demand among competing buy and sell orders on the exchange at the time of the purchase or sale of the contract. Simply, the price prearranged between the seller and the buyer.

Standardization: Futures contracts ensure their liquidity by being highly standardized, usually by specifying:

  • The underlying asset or instrument. This could be anything from a barrel of crude oil to a short term interest rate.
  • The type of settlement, either cash settlement or physical settlement.
  • The amount and units of the underlying asset per contract. This can be the notional (fictional) amount of bonds, a fixed number of barrels of oil, units of foreign currency, the notional amount of the deposit over which the short term interest rate is traded, etc.
  • The currency in which the futures contract is quoted.
  • The grade of the deliverable. In the case of bonds, this specifies which bonds can be delivered. In the case of physical commodities, this specifies the quality of the underlying goods
  • The delivery month
  • The last trading date

Types of Futures Contracts

There are a large number of futures contracts trading on future exchanges around the world.

Agricultural Commodities: This category is the oldest group of futures contracts. It includes all widely used grains such as wheat, soybeans, corn and rice. Additionally, futures are traded actively on Cocoa, coffee, orange juice, sugar, cotton, wool, wood, and cattle.

Equities: Futures are actively traded on individual stocks as well as index. These are generally cash settled i.e. no exchange of stocks happens between the contracted parties; only the party which lose (prices of stocks move against them) gives money to the party which wins. Stock index futures have been quite popular in the market. These contracts are generally indices of a combination of stocks.

Natural Resources: Futures contracts are actively traded on metals and natural resources. Metals include gold, silver, copper, aluminum etc while natural resources include crude.

Foreign Currencies: There is a very large market of futures contract traded on foreign currencies because a large number of multinational companies are concerned about the volatility (changes) in the value of currencies of different countries where they sell or buy their products. Most popular currencies are Japanese Yen (¥), British Pound (£), Euro (€) and Swiss Franc (CHF).

Source: theindianmoney.com

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