Futures

November 23, 2010Futuresby EconomyWatch

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Futures or futures contracts are derivatives bought or sold on a futures exchange. Futures are contracts tobuy or sell a particular commodity at a specified price on a certain date in the future. The underlying asset could be commodities, energy, currencies, government bonds or other financial instruments. The future date on which the contract is executed is known as the final settlement date or the delivery date. The predetermined price is known as the settlement price. The mechanism for settlement is provided by the clearinghouse of the futures exchange.

Common Features of Futures

The common features of futures are:

  • Futures are exchange-traded derivatives.

  • Futures are highly standardized. This standardization is ensured by specifying (a)

  • The underlying asset – The particular asset as well as the quantity are specified in the futures contract.

  • The currency - The currency in which the contract is to be executed is also specified.

  • Settlement - The delivery month and the last trading date are also mentioned in the contract.

  • Futures are used for hedging, particularly in a bear market. Those who have an interest in the underlying asset can protect themselves from the risk of price changes via futures contracts.

  • Futures have lower transaction costs than other debt instruments.

  • They also have high liquidity, since buyers and sellers of futures contracts can be found easily.
  • Pricing of Futures

    When the price of the underlying commodity in a futures contract is higher than the spot (immediate) price, the situation isknown as contango. When the price of the underlying commodity for future delivery is lower, the situation is known as backwardation.

    The price of a futures contract can be calculated with the following formula

    futures

    where,

    F(t) = future value

    S(t) = present value

    t = time

    T = maturity

    r = rate of return


    Futures: Types of Settlement

    There are two types of settlements in the futures market – physical settlement and cash settlement. A futures contract is physically settled if the underlying asset is actually delivered in exchange for the settlement price. This is not the case with cash settlement, where no physical delivery of the underlying asset takes place. Instead, the futures contract is settled for money depending on what the market value of the contract is expected to be at maturity. Speculators opt for cash settlements, which those with interest in the underlying commodity opt for physical settlement.

    The futures market is not for the novice trader. It is critical that you check your financial situation, investing goals and risk appetite before venturing into futures trading.