Futures – An overview

1. Future markets play an important role in the world of finance. Many kinds of futures instruments have been developed and the use of futures has received a great deal of attention.
2. An agreement between two parties to exchange an asset for cash at a price that is specified today represents a forward contract.
3. A standardized forward contract is a futures contract. While there is no secondary market for forward contracts, the futures contracts are traded on organized exchanges. Forward contracts usually end with deliveries whereas futures contracts are settled with the differences. Forward contracts do not require a margin, whereas futures contracts require a margin. Forward contracts are settled on the maturity date, whereas futures contracts are ‘marked to market’ on a daily basis.
4. Broadly, there are two types of futures, commodity futures and financial futures. A commodity futures contract is a futures contract in a commodity like cocoa or aluminium while a financial futures contract is a future contract in a financial instrument like Treasury bond or currency.
5. Equity futures are of two types: stock index futures and futures on individual securities. Both the types of equity futures have been introduced in India by the National Stock Exchange and the Bombay Stock Exchange.
6. Futures contracts can be priced using the principle of arbitrage. This means that a price (or a range of prices) is so derived that it is not possible to earn risk less profits without investment by creating positions involving the futures contract and underlying asset.
7. A stock index futures contract is a futures contract in a stock index.
8. The S&P 500 contract is perhaps the most popular stock index futures contract in the US. In India, stock index futures have been introduced recently and the Nifty futures are currently the most popular stock index futures in India.
9. The theoretical price of the stock index futures, as well as futures on an individual stock, is:

F0 = S0(1+ rf –d)T
10. A Treasury bond futures contract is a contract for delivery in future of Treasury bonds (government bonds) having certain features.
11. The theoretical price of a Treasury bond futures contract is
F0 = (S0 –PVC) (1+ rf) T
12. The futures price of a perishable commodity is influenced by two factors mainly: (a) the expected spot price of the underlying commodity, and (b) the risk premium associated with the futures position.
13. The participants in the futures market are either hedgers or speculators.
14. Hedgers are parties who are exposed to risk because they have a prior position to the commodity or the financial instrument specified in the futures contract. Hedgers buy or sell futures contracts to protect themselves against the risk of price changes.
15. Speculators do not have a prior position that they want to hedge against price fluctuation. Rather they are willing to assume the risk of price fluctuation in the hope of profiting from them.
16. The futures market offers the following attraction to the speculator: leverage, ease of transactions, and lower transaction costs.
17. Futures and options perform three very useful economic functions: risk transfer, price discovery, and market completion.
18. There is a widespread belief among regulators, bureaucrats, and politicians that derivatives are employed mainly for speculative purposes and they accentuate the volatility in the underlying cash markets. Many in the profession strongly disagree with this view. They argue that the volatility in the underlying cash market is the impetus for introducing derivatives and not the consequence thereof.
19. Empirical evidence suggests that the volatility in the underlying cash markets diminishes with the introduction of derivatives.