Futures Contracts: An Introduction

Posted on Aug 30, 2024 in Economy

Futures Contracts

A futures contract is a contract, much like a forward, with the difference being that it is not agreed upon directly between two parties but through an organized exchange, which requires that contracts be standardized.

Future Elements:

  • Cost of delivery, which is the price agreed to exchange the asset.
  • Date of expiry of the contract.
  • The asset on which to make the contract, which is known as the underlying asset.
  • The place that will deliver the asset.
  • The amount of the underlying stipulated by contract, known as notional.

Clearing House

It is an established institution that guarantees both parties to implement the operation. As soon as the negotiation is consummated, the House is interposed between the buyer and seller. That is, it acts as a purchaser for the seller and the seller to the buyer.

What Instruments Are Traded in the Futures Market of the Santiago Stock Exchange?

The stock market traded two types of contracts: futures IPSA, whose asset is the Selective Price Index (IPSA), and the dollar futures contracts, whose asset is the dollar.

Observed Characteristics of Instruments in the Futures Market

  • Liquidity: This depends mainly on the occurrence of market participants, taking them their respective counterparts. This condition is assured in this market by standardizing contracts.
  • Performance: In this case, there are two operators.
    • Hedgers: Are investors looking to cover the risk involved in a change in the price of an asset. The most typical case is that of the exporter or importer who sells or buys futures contracts for U.S. dollars to secure an exchange rate determined to give an appropriate return on their business. Therefore, these agents minimize the risk because they are compensated to participate in future and spot markets simultaneously.
    • Speculators: These are investors who do not have to endorse a position on the assets traded in the contract. Their foray into the market involves taking all the risk, which means a change in futures prices. In this case, the return is only known at the time of settling the contract.
  • Risk: This variable is linked to the aforementioned officials. Hedgers use this market to fully cover the risks of price changes. On the contrary, speculators assume the risk associated with price changes.

Operation of the Futures Market in Chile

  1. Lack of market liquidity.
  2. Future size of the Chilean market.
  3. Misinformation and investor education.
  4. Constraints affecting the Pension Fund Administrators (AFPs) to operate in this market.
  5. Authority intervention in the volatility of the nominal exchange rate.
  6. Excessive regulation of the Futures Market Exchange.

Operations with Futures

The existence of futures contracts on various underlying assets can take positions in different markets through a set of operations that can be classified as follows:

  • Speculation: From certain expectations on the future price of an underlying asset, an operation of speculation is to anticipate the market by making the corresponding position in the future:
    • Bullish expectations: purchasing futures
    • Expectations bass players: forward sale
  • Coverage: This is a technique to reduce the market risk of a particular position, i.e., the possible loss caused by an unfavorable movement in the price of an asset.
  • Arbitration: Two different financial assets that generate the same future performance must have, at all times, comparable prices. In those cases where we met this basic principle, we could perform an operation of arbitration: the possibility of making a profit without risk by performing two operations simultaneously opposing the purchase and sale in two different markets.

Forward Contracts and Features

  • A forward contract is an agreement to buy or sell a given asset at a specified price on a specified future date. The forward contract is not traded on a market. They are usually private agreements between two financial institutions or between a financial institution and one of its clients “over the counter” (OTC).
  • The counterparty agrees to buy the underlying asset at a specific date at a specified price, takes a “long,” and that counterparty agrees to sell the underlying asset for the same date and agreed price assumes a “short position.”
  • The price agreed in the forward contract is called the “delivery price.” This is chosen so that, at the time of signing the contract, the value is zero for both parties. This means that there is no cost to take a long or short position.
  • The forward price of a contract is the delivery price that would apply if the contract was negotiated today. However, over time, the contract price varies as the delivery price remains constant. At the date of maturity of the contract, positions are settled through physical delivery of the underlying or, usually, by settlement.
  • The maturity value of a long position in a futures or forward contract on a unit of the asset is ST – K, where ST is the spot price of the asset at the date of expiry of the contract, and K is the “delivery price” or forward price agreed at the beginning of the contract. Furthermore, the final value of a short position in a forward contract on a unit of the asset is K – ST.

Operation of Market Margin Agents

  • Speculators: The future or forward contracts can be used to speculate by taking a long or short position in the market.
  • A position in forward contracts in order to cover their risk (e.g., exporter/importer who wishes to hedge its currency risk). Through the use of forwards, they were able to eliminate the risk associated with either an open position in currencies, commodities, or rates and thus determine the profitability of the business.
  • Referees: Another group of participants in a market are the arbitrators. The arbitration is to obtain a profit or risk-free profits through simultaneous transactions in two or more markets.