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3. Derivative markets: futures

3.1. Learning outcomes

After studying this text the learner should / should be able to:

• Define a futures contract.

• Understand the constituents of the definition of futures contracts.

• Understand the payoff (risk) profile of futures contracts.

• Understand the characteristics of the futures market, such as getting out of a position in futures, and cash settlement versus physical settlement.

• Understand the concepts of margins, marking to market and open interest.

• Comprehend the principles applied in the pricing of futures contracts (fair value).

• Calculate the fair value prices of futures contracts.

• Understand the concepts of convergence, basis and carry cost in relation to basis.

• Understand the motivation for undertaking deals in futures, particularly hedging, and the participants in the futures market.

• Comprehend basis and spread trading.

3.2. Introduction

In the previous section on forwards, we defined a forward market as a market where a transaction (buy or sell) on an asset is concluded now (at T+0) for settlement on a date in the future at a price determined now. A forward contract may therefore be defined as a contract between a buyer and a seller at time T+0 to buy or sell a specified asset on a future date at a price set at time T+0. We also identified the advantages and disadvantages of forward markets. We also covered variations on this main theme, such as FRAs, FIRCs and repos.

Essentially, futures contracts are standardized forward contracts, and they developed because forward contracts have some disadvantages, the most obvious one being that forward contracts are difficult (usually impossible) to reverse. There is also a need for efficient price discovery which means that liquidity needs to be enhanced, and this only comes about when activity in the market increases, and in pursuance of this contracts need to be standardised in terms of quality, quantity and expiry date. Once this need is satisfied an exchange is an appropriate market form, and an exchange mitigates risk, which further enhances the breadth and depth of the market.

This does not mean that all forward markets are destined to become futures markets. In some markets reversibility of deals is not crucial and customisation in terms of quantity and expiry is required. The best example is the outright forward forex market where commercial transactions (importing and exporting) require customisation and rarely require reversal.

Futures are discussed in the following sections:

• Futures defined.

• An example.

• Trading price versus spot price.

• Types of futures contracts.

• Organisation of futures markets.

• Clearing house.

• Margining and marking to market.

• Open interest.

• Cash settlement versus physical settlement.

• Payoff with futures (risk profile).

• Pricing of futures (fair value versus trading price).

• Fair value pricing of specific futures.

• Basis.

• Participants in the futures market.

• Hedging with futures.

• Basis trading.

• Spread trading.

• Futures market contracts.

• Risk management by a futures exchange.

• Mechanics of dealing in futures.

• Economic significance of futures market.

3.3. Futures defined

3.3.1. Introduction

A futures contract may be defined as a contractual obligation in terms of which one party to the deal undertakes on T+0 to sell an asset at a price (determined on T+0) on a future date, and the other party undertakes to buy the same asset at the same price on the same future date. This sounds pretty similar to the forward contract. It is, but the differences are that the contracts are standardised, the underlying assets are standardised, and the contracts are exchange-traded, because these qualities render the contracts marketable (sort of - later we will see that futures are marketable in the sense that they can be "closed out" by undertaking an equal and opposite transaction).

As noted, essentially the futures markets of the world developed to overcome the disadvantages of forward markets. By their very nature, forward markets are OTC markets (mostly), whereas futures markets are all formalised in the form of financial exchanges, the members of which effect all trading, and the exchange guarantees all transactions by interposing itself between buyer and seller.

The definition of a future may now be extended: a standardised contract which obligates the buyer to accept delivery of, and the seller to deliver, a standardised quantity and quality of an asset at a pre-specified price on a pre-stipulated date in the future.

It may be useful to break up this definition into its constituents:

• Standardised contract between two parties.

• Buyer and seller.

• Delivery.

• Standardised quantity.

• Standardised quality.

• Asset.

• Price.

• Expiry date.

• Market price.

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