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Futures

The financial futures markets were established in the 20th century for trading in contracts which allow hedging operations. Operations in these markets are also made by speculators and arbitrageurs. The largest stock exchanges in futures are:

  • London International Financial Futures and Options Exchange (LIFFE)
  • Chicago Board of Trade (CBOT)

A Futures Contract provides the right and obligation to buy or sell an asset at the set time in the future under the terms agreed at the current time. These contracts may be freely sold and bought. The necessary market liquidity is provided through standardization and the large number of contracts of various types.

Futures are standard both in terms of delivery and in the basic assets allowed in the delivery. Trade techniques under different stock exchanges vary somewhat. Futures operations may be carried out under the terms of “marginal” trade – buyer and seller make a deposit of 5 to 15% of the contract value to guarantee execution of the obligations. This sum of the initial (performance) margin is calculated constantly, and if it drops to a loss-making position below a certain level – the support margin (about 65%) - the investor receives a margin call about the necessity to invest an additional sum (the variation margin) to restore the initial sum. Those dealing with such contracts take a “long position”, and those that sell such contracts take a “short position”. The financial press publishes quotes and the number of open contracts. American futures stock exchanges, upon approval by the Commodities Futures Trading Commission (CFTC), set limits for possible daily quote changes.

Futures operations uses a system of orders, similar to other asset markets:

  • A market order means an order to immediately buy or sell a contract at the current market quote.
  • A limit order has a limit price of execution. The limit order for purchase should be executed by a broker at a price not higher than the indicated limit price. The sell order should be executed at a price not lower than the indicated limit price.
  • Stop order is an order which enters the market when it reaches the indicated stop price. Upon the issuing an order to buy, the stop price should be above the current market price (for sell order - below).
  • Stop limit orders can indicate two prices. Execution will be completed only within the market values from stop price to limit price.

The difference between the current market (spot) price and, accordingly, the asset futures price is called the futures contract basis. Depending on whether the net difference is positive or negative between the uncollected interest and benefits, provided there are no expenses related to owning of the asset, the futures price may be above or below the spot price.

Depending on the type of asset, futures contracts are subdivided into:

  1. Futures Contracts for Stock Indexes
    An investor may be worried about the possibility of a reduction in the value of his shares. He can reduce his loss risk through a futures contract for a stock index. The first ever contract was signed in London for FTSE 100. The most popular, judging by the sales volume and number of open positions, is a futures contract for Standard & Poors 500 (S&P 500). For investors interested in Japanese securities, hedging is available via a future on the Nikkei 225. Purchase of an index contract is similar to investing into a widely diversified securities portfolio. Such an operation does not change the portfolio and is shown on out-of-balance accounts, which allows managers of institutional investment funds to better control financial reports. If the fluctuation of prices for a futures contract and hedged financial instruments do not coincide, then one should use the hedge ratio. The current shares portfolio does not coincide in its content with the index. Deviation of a performance by a specific share price from the price fluctuations on the overall stock market is shown via a beta ratio. Depending on its value, when hedging, one should use greater or smaller numbers of contracts. Speculative and arbitrage operations support the stability and liquidity of a market. If it wasn’t for these, the futures prices would be formed by the demand of hedgers in short contracts. However, speculators fill the gap between the demand for long and short positions and prevent drastic variations in prices. On the other hand, arbitrageurs help reduce the gap between current and future prices.
  2. Interest Futures
    The major goal for an investor using interest futures is to hedge the risk of change on interest rates. Short-term interest futures are quoted under the basic index price - 100 minus interest rate. The prices are set under the forward-forward rate. Just like with any other futures type, the overwhelming majority of short-term interest futures contracts are closed before the time of their execution. The risk may be transferred not to another hedger but to a speculator who is prepared to manage risk. Securities portfolio managers control the allowed risk of losses from changing interest rates by long-term state securities. Hedging with the assistance of futures, whose profits can compensate the loss by securities, is one of the most popular methods for risk compensation. Portfolio managers change the number and quality of open contracts in accordance with a market’s situation.
  3. Currency Futures
    Futures contracts for currency are assessed under the parity of interest rates and currency rates (interest - rate parity). The parity is equal to the future monetary profit from asset investments nominated in various currencies. Revenue rates (R) for state risk-free securities are used for the calculation. If one invests into USA securities, then in a year the revenue will be 1 + RUSA , and for GB = 1 + RGB. Mutual relations between these sums: 1 + RUSA / 1 + RGB, multiplied by the current spot exchange rate will determine the current rate of a futures contract. The futures prices will be higher then the spot price if US risk-free rate is higher, and vice-versa.

    Do not mix up futures contracts with options. There is a possibility that upon expiration the option will worth nothing and can be simply discarded. The buyer’s loss will equal the paid premium. A future should be closed with a reverse action or with an asset delivery. Accordingly, unlimited by specific frames, loss or profit is determined by the current market prices at the time of the positions’ closing. For practical calculations, one should take into consideration the transaction expenses of the operations and market access terms.

 

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