Page 43 - DMGT513_DERIVATIVES_AND_RISK_MANAGEMENT

Derivatives & Risk Management

Notes trading of rice and silk. It wasn't until the 1850s that the U.S. started using futures markets to buy
and sell commodities such as cotton, corn and wheat. Today's futures market is a global
marketplace for not only agricultural goods, but also for currencies and financial instruments
such as treasury bonds and securities (securities futures). It's a diverse meeting place of farmers,
exporters, importers, manufacturers and speculators.

4.1 Introduction to Futures

A futures contract is a type of derivative instrument, or financial contract, in which two parties
agree to transact a set of financial instruments or physical commodities for future delivery at a
particular price. If you buy a futures contract, you are basically agreeing to buy something that
a seller has not yet produced for a set price. But participating in the futures market does not
necessarily mean that you will be responsible for receiving or delivering large inventories of
physical commodities - remember, buyers and sellers in the futures market primarily enter into
futures contracts to hedge risk or speculate rather than to exchange physical goods (which is the
primary activity of the cash/spot market). That is why futures are used as financial instruments
by not only producers and consumers but also by speculators.
A future contract is a standardized agreement between the seller (short position) of the contract
and the buyer (long position), traded on a futures exchange, to buy or sell a certain underlying
instrument at a certain date in future, at a pre-set price. The future date is called the delivery date
or final settlement date. The pre-set price is called the futures price. The price of the underlying
asset on the delivery date is called the settlement price.
Thus, futures is a standard contract in which the seller is obligated to deliver a specified asset
(security, commodity or foreign exchange) to the buyer on a specified date in future and the
buyer is obligated to pay the seller the then prevailing futures price upon delivery.

Did u know? How to price a future contract?

Pricing can be based on an open cry system, or bids and offers can be matched electronically.
The futures contract will state the price that will be paid and the date of delivery.

4.1.1 Nature of Future Contracts

A futures contract gives the holder the right and the obligation to buy or sell. Contrast this with
an options contract, which gives the buyer the right, but not the obligation, and the writer
(seller) the obligation, but not the right. In other words, an option buyer can choose not to
exercise when it would be uneconomical for him/her. The holder of a futures contract and the
writer of an option, do not have a choice. To exit the commitment, the holder of a future position
has to sell his long position or buy back his short position, effectively closing the position.
Futures contracts or simply futures are exchange-traded derivatives. The exchange acts as
counterparty on all contracts, sets margin requirements, etc.
Futures contracts, unlike forwards, are traded on organized exchanges. They are traded in three
primary areas:

1. Agricultural Commodities
2. Metals and Petroleum, and
3. Financial Assets (individual stocks, indices, interest rate, currency)

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