Introduction to futures

Question 1

what is a forward contract?

Answer 1

an agreement between two parties to trade a specific asset at a future date with terms/price agreed today.

A future contract is a marketable forward contract.

• traded on centrally regulated exchanges/electronically.

Buying a contract is called going long and selling one is called going short

Question 2

How is marketability provided?

Answer 2

• list hundreds of standardised contracts
• establishing trading rules
• provide clearing houses to guarantee and intermediate contracts

Question 3

what is a long position?

Answer 3

when you agree to buy the contracts underlying asset at a specified price, with payment and delivery to occur on the expiration/ delivery date.

Question 4

what is a short position?

Answer 4

when you agree to sell the contracts underlying asset at a specified price, with delivery and payment occurring at expiration.

Question 5

what are future contracts for?

Answer 5

• used to speculate or hedge
• speculating means that you instigate a future trade that will profit from your expectation of the market in the future.
• if you think market will rise = go long
• if you think market will fall = go short

Question 6

What is the clearinghouse?

Answer 6

This guarantees each contract acting as a financial intermediary by breaking up each contract after the trade has taken place.

Question 7

what is minimum performance bond requirements?

Answer 7

to trade we must have an account and you can make daily profit or losses.

in cases where we make losses we make sure to fulfil the obligation there is a mechanism called minimum performance bond which means if our account falls below a certain amount we have to top it up.

Future contracts have no inital value as they are an agreement. Future traders are required to post some security/good faith money with their brokers.

Question 8

What is initial margin?

Answer 8

• amount of cash to be deposited by investor on the day the position is established
• amount of margin is determined by the margin requirement or “performance bond”. its like a threshold value if fall below must top up.

Question 9

what is long hedging?

Answer 9

• involves taking a long position in a futures contract.
• usually taken to protect against an increase in the price of an underlying commodity or asset.
• a firm would hedge against a price if they anticipated buying an asset or commodity in the future and were anticipating a price risk when they need to buy the asset.

Question 10

what is short hedging?

Answer 10

• usually taken to protect against any price falls in the underlying asset or commodity.
• a firm would hedge against a price fall if they anticipated selling an asset in the future.

Question 11

what are the risks associated with hedging?

Answer 11

• quality risk = when the commodity or asset is being hedged is not identical with the one underlying the futures contract.
• timing risk (basis) = when the delivery date on the futures contract does not coincide with the date the assets/ liabilities to be bought or sold.

quantity risk = what is expecting more /less