Futures Market Flashcards
Derivatives
- Financial asset whose value is derived from the value of underlying assets; underlying assets - commodities
- Types of derivatives - forwards, futures, options, swaps
- Can be used to reduce risk; look for high return by bearing risk; look for risk free arbitrage
forwards
A forwards contract is an agreement between 2 parties to undertake an exchange of certain assets at an agreed date in the future at a pre-agreed price
- For seller and buyer: both right and obligation
- Delivery date, price, quality and quantity predetermined
Forwards price and spot price
- Spot price: price for immediate delivery
- Forwards price: the price for future delivery
Delivery price is in fact the forwards price when a forwards contract is signed; the forwards price changes all the time because of market expectation changes
Long position and short positions
- The buyer of a forwards contract takes a long position
- The seller of a forwards contract takes a short position
Example;
- Crisp producer buys potato from potato suppliers
- Worry- volatile potato price - volatile profit margin
- Need a more predictable potato price; for better production planning and efficient budgeting
- Sign a forwards contract with potato supplier
Characteristics;
- Tailor made: quality, quantity, delivery date. price determined in the futures market
- Traded on over the counter markets
- Counter markets may default
- Available for long term maturity
- Difficult to reverse or cancel
Futures
Futures contract is a STANDARDISED agreement between 2 parties to undertake an exchange of a fixed quantity of commodities or financial assets at am agreed price on a specified date in the future
- Standardised version of a forwards contract: quantity, quality, date etc
- For seller and buyer: both right and obligation
- Delivery date predetermined
- Delivery price, quality and quantity predetermined
Futures price
- Expectation of the sport price that will prevail at the time of delivery
- Prefixed delivery price is the futures price at when futures contract is bought or sold
- Futures price changes constantly as market expectations change constantly
- As a futures contract reaches expiry, futures price, converges into the spot price
Long position and short position
- Buyers have long, sellers have short
- One can hold both positions
Close a position
- Before a delivery, most positions closed
- Close a position by selling N futures contract
Characteristics;
- Delivery price, quantity and date predetermined
- Clearing house; buyer and seller do not meet directly, reduces risk of default
- Standardised contract rather than tailor made
- Traded on exchanges
- Easy to reverse/ close
Futures trading highly risky
- Gearing effect: one only needs to put in the cash required for margins in order to trade the entire value of the contract. No need to put in entire value of contract
Settlement
- Some futures contract are held for physical delivery of the underlying
- Most settled by an offsetting transaction before the date of delivery
Short term interest and futures
- Underlying: interest rate on short term deposit to be stated at the date of expiry
- Buyer buys the right to make a 3 month deposit at an agreed interest rate
- Settlement by cash
- Price is quoted as a price index defined based on interest rate.
Derivative users based on their purposes
- Hedgers - hedge against unwanted changes in the value of underlying. Hedgers transfer risk to speculators
- Speculators - take positions to obtain a profit based on price change
- Accept high risk in hope for high rewards
- Important for futures market; risk takers, provide liquidity, seek and process information - Arbitrageurs - exploit price differences on the same or similar instruments
