Futures

Question 1

Define futures

Answer 1

Futures contracts legally binding, standardised forward contacts between 2 parties (buyers and sellers)

1 party agrees to sell & other party agrees to buy predetermined quantity of specific assets @ fixed price (price agreed today)

Closed out on fixed future date (3 months)

i.e - airlines use to guarantee petrol price in advance (certainty)

Question 2

Characteristics

Answer 2

Traded on recognised/ regulated exchanges through specialist brokers (exchange traded derivatives)

Delivery is physical or cash settled / included in contract specifications (contract terms and administrate procedures)

Brought/ sold in standard contract size

Standard unit of futures trading/ legally binding/ both parties must fulfil respective obligations

• seller provide set quantity of asset @ future date
• buyer contracts to purchase @ agreed price @ future date (no immediate transfer of ownership)

Closed out fixed date and price (point where profits made or losses incurred)

Users of futures not buying or selling underlying asset merely opening long/short position at which point they’ll acquire obligations to deliver/ pay

Question 3

Example

Answer 3

Now

Petrol costs £10,000

Investor purchase petrol future deal for £10,000

3 months

Petrol price £12,000

Investor buys petrol £12,000

Sells future back to trader £12,000

£2000 profit made

Airline uses futures contract to guarantee petrol price in advance/ protect position

Question 4

Outline details needed in contract specifications

Answer 4

The underlying asset - diversified range of FI, commodities, bonds and indices (poor & poor 500)

Unit of trading - standard contract sizes/ min size = 1 contract / size is determined by underlying asset and exchange where futures traded

I.e coffee = 10 tonnes = 1 contract
I.e gold = 100 ounces = 1 contract

Fixed future date - specific date which future closes (settlement date) where counterparties must fulfil outstanding obligations (physical delivery or cash settlement)

Last trading day - occurs few days before delivery date and affords future contract seller a period of time to make asset available

The price agreed today - known receipt/ buyers and sellers want price certainty in relation to quantity and quality of asset
(Initial margin account set up with clearing house)

Contractual obligations - written contract for right (without obligation) to buy or sell underlying asset and future date for predetermined fixed amount

• Parties trying to benefit (buyer make profit or hedge position; seller obtain price certainty for goods)
• buyer acquiring obligation to purchase (long the future)
• seller acquiring obligation to sell asset (short the future)

Question 5

Users of futures

Answer 5

Banks 
Brokers
Insurance companies 
Investment companies 
Pension funds 
Trading companies 
Trusts 
Hedge funds 
HNWIs (classification of financial services industry to denote families/ individuals with high net worth of liquid assets) 

• must demonstrate understanding of sufficient funding & understanding of product; risks and Margin accounts required by CH

Question 6

Uses of futures

HEGDER

Answer 6

Hedging
-strategy employed by hedgers to seek protection from possibility of price volatility in assets (eliminate risks)

-long hedge is buying futures to protect purchase price of asset that they’re planning on buying (anticipate price rise)
I.e manufactures buying materials

• a short hedge is selling futures or protect value of asset which they hold/ or acquire then sell (anticipate price to fall)

Question 7

Uses of futures

SPECULATORS

Answer 7

Speculators

• open positions to either buy or sell to make profit from price movements in the asset
• no interest in owning
• open short/long positions based on anticipation how price will move
• risks can be colossal but not unlimited (may have to purchase at higher price)
• profits made when price of futures is less than agreed price
• Limited ; lifespan is contract, resources of speculator, point before settlement speculator decides to close deal

Question 8

What are margin accounts

Answer 8

Initial margin is the amount the clearing house will take for the opening of contact and trading the futures on regulated exchanges

(small % of asset price)

Provides protection in case of default

Further maintenance margins taken to maintain agreed price up to settlement - will take form buyers if market price falls below agreed amount; taken from sellers if price rises above

Question 9

Outline function of clearing houses

Answer 9

All futures traded through regulated futures exchange through the use of clearing houses

UK - LCH.Clearnet group

Act as counterparties to all transactions (middle man to guarantee all fulfilment of obligations)

Functions;

• act as registrar
• act as counterparty: eliminate risks
• provide settlement mechanism
• guarantee performance of contracts
• close out contracts even if party defaults
• control margin accounts

Question 10

Extra points on futures

Answer 10

Futures positions monitored daily on price movements / prevent investors position closing due to insufficient funds to meet margin calls

Investor opens long position they want price to rise

Investor opens short position they speculate price will fall (go short the future); close out positive, sell future and buy asset in spot market to make profit