Futures contracts are derivatives securities—which may sound overly complicated and scary. Indeed, you are not alone if you believe that futures and other derivatives increase volatility in the financial markets and are responsible for financial instability in the markets or the larger economy. Derivatives have been blamed for the financial collapse of 2008, but do they deserve the harsh judgment? Probably not. Instead, we need to understand them, how they are traded, their pros and cons, and how these instruments differ from each other.
Derivatives come in all shapes and sizes, some of which are more nebulous and complex than others. Here, we will look at futures contracts—which give the holder the ability to take delivery in the future of some asset, paid for at a price today. These contracts are exchange-traded and highly regulated—making them among the most innocuous and widely used derivatives contracts.
- Futures contracts allow hedgers and speculators to trade the price of an asset that will settle for delivery at a future date in the present.
- Futures are known as derivatives contracts, since their value is derived from the underlying asset that will be delivered.
- Futures are standardized and traded on regulated exchanges, making them highly transparent and liquid. Other types of derivatives, such as forwards or swaps, trade over-the-counter and are more opaque.
Futures are contracts that derive value from an underlying asset such as a traditional stock, bond, or stock index. Futures are standardized contracts traded on a centralized exchange. They are an agreement between two parties to buy or sell something at a future date for a certain price called "the future price of the underlying asset." The party who agrees to buy is said to be long, and the party agreeing to sell is short. The parties are matched for quantity and price. The parties entering a futures contract do not need to exchange a physical asset but only the difference in the future price of the asset price at maturity.
Both parties need to pay an initial margin amount (a fraction of the total exposure) with the exchange. The contracts are marked to market; that is, the difference between the base price (the price the contract was entered at) and the settlement price (usually an average of the prices of the last few trades) are deducted from or added to the account of the respective parties. The next day the settlement price is used as the base price. The parties need to post additional funds into their accounts if the new base price falls below a maintenance margin (pre-determined level). The investor can close out the position at any time before maturity but has to be responsible for any profit or loss made from the position.
Futures are an important vehicle to hedge or manage different kinds of risks. Companies engaged in foreign trade use futures to manage foreign exchange risk, interest rate risk if they have an investment to make, and lock in an interest rate in anticipation of a drop in rates, and price risk to lock in prices of commodities such as oil, crops, and metals that serve as inputs.
Futures and derivatives help increase the efficiency of the underlying market because they lower the unforeseen costs of purchasing an asset outright. For example, it is much cheaper and more efficient to go long in the S&P 500 futures than to replicate the index by purchasing every stock. Studies have also shown that the introduction of futures into markets increases the trading volumes underlying as a whole. Consequently, futures help reduce transaction costs and increase liquidity as they are viewed as an insurance or risk management vehicle.
Futures and Price Discovery
Another important role futures play in financial markets is that of price discovery. Future market prices rely on a continuous flow of information and transparency. A lot of factors impact the supply and demand of an asset and thus it's future and spot prices. This kind of information is absorbed and reflected in future prices quickly. Future prices for contracts nearing maturity converge to the spot price, and thus, the future price of such contracts serves as a proxy for the price of the underlying asset.
Future prices also indicate market expectations. For example: In the case of an oil exploration disaster, the supply of crude oil is likely to fall, so near-term prices will rise (perhaps quite a lot). Futures contracts with later maturities may remain at pre-crisis levels, however, because supply is expected to normalize eventually. Contrary to general belief, future contracts enhance liquidity and information dissemination leading to higher trading volumes and lower volatility. (Liquidity and volatility are inversely proportional.)
Benefits notwithstanding, futures contracts and other derivatives come with a fair share of drawbacks. Due to the nature of margin requirements, one can take on a lot of exposure, which means a small movement in the wrong direction could lead to huge losses. Plus, the daily marking to market can put undue pressure on the investor. One needs to be a good judge of the direction and minimum magnitude the market would move.
Derivatives are also 'time-wasting' assets in the sense that their value declines as their maturity date approaches. Critics also contend that futures and other derivatives are used by speculators to bet on the market and take on undue risk. Futures contracts also face counterparty risk, though at a much-reduced level because of the central counterparty clearing house (CCP).
For example, if the market moves very far in one direction, a lot of parties could default on their obligation, and the exchange would have to bear the risk. However, clearinghouses are better equipped to handle this risk, and they reduce risk by marking to the market every day, and this is an advantage of futures above other derivatives.
Apart from futures, the world of derivatives is also represented by products that are traded over the counter (OTC) or between private parties. These may be standardized or highly tailored for sophisticated market participants. Forwards are such a derivative product that is just like futures except for the fact that they are not traded on a central exchange and are not marked to market regularly. These unregulated products primarily face credit risk because of the chances of a counterparty defaulting on its obligation at the expiration of the contract.
Even though these tailored products are a small percentage of a multi-trillion-dollar industry, evidence suggests that the standardized parts of OTC markets perform perfectly well. A great example of this is the Lehman Brothers derivatives book, which represented 5% of the global derivatives market. Eighty percent of the counter-parties to those trades settled within 5 weeks of their 2008 bankruptcy.
The Bottom Line
Futures are a great vehicle for hedging and managing risk; they enhance liquidity and price discovery. However, they are complicated, and one should understand them before taking on any trades. The call for regulating standardized derivatives (exchange or OTC based) could have the negative side effect of drying up liquidity to fix something that is not necessarily broken.