WHAT IS A FUTURES MARKET?

Most futures contracts can be described as legally binding agreements to buy or sell an investment, financial product or goods at a fixed quality, quantity and price on a specified date in the future. Put simply a futures contract binds two sides to a later transaction. Futures markets became particularly useful due to the outright risk and volatility of cash markets, for instance an exporter shipping goods abroad could shield itself against currency fluctuations in the coming months by securing a futures contract at a known quantity and price right now. This means they can predict revenue without worrying about any interference from the underlying cash market which is generally more susceptible to volatility and risk.

The price of a futures contract is based on its underlying product along with many other factors that people believe will affect that particular product over the coming months. Although all futures contracts have specific contract months for delivery, contracts can also be sold before they expire. If one did fail to act on an open position before expiration (maturity) of a contract you could find yourself taking delivery of the relevant product. It has been known for forgetful traders to receive phone calls asking where they would like one thousand barrels of oil or fifty tonnes of sugar delivered! However this situation is normally avoided by taking an offsetting position before the expiration date. In most cases today futures contracts are cash settled.

Not everyone in a Futures market wishes to take physical delivery of a contract and this has given rise to speculators. Speculators trade purely for money profits by correctly forecasting market movements. They assume their own risk and provide the liquidity to the market which in turn has provided traders with greater opportunities to make money. Hedgers use futures to protect a sale or purchase price in the underlying market, by either selling (go short) to lock in a price and obtain protection from declining prices or buy (go long) to lock in a price to obtain protection from rising prices, with the ultimate aim of reducing price risk.

Hedgers are not normally interested in where the market goes as long as they are correctly hedged and will therefore avoid risk. Hedgers tend to be big institutional firms or producers known in the market as paper. Here is an example of a futures contract and hedging:

On the next page we will look at hedging in the futures market.