Question

Critically discuss the theoretical concept of futures contracts as a risk management tool, used by any would be investor to decrease future risk exposure or market volatility.   

Answer 1

Future contracts are exchange based contracts to buy and sell underlying assets of pre specified quantity and price. The underlying assets include commodities, financial products, stock indexes, agriculture products etc.

The buyer of contract is said to have long position while the seller of the contract is said to have short position in the contract. In every future contract there is buyer and seller. The party having long position is said to contracted to buy underlying asset at pre specified price at expiration of contract. The party having short position is obligated to sell the goods to the buyer at expiration of contract.

Following are the major features of future contract which distinguish it from others:

1. Future contracts are exchange based contracts which makes it risk free as far as counterparty risk is concerned. In other words there is no counterparty risk in future contracts.
2. In future contracts exchange provide standardized contract considering the size, underlying asset maturity etc.
3. There is liquidity in future contracts as the contracts are exchange based.Stock exchane being sole active markets maintain liquidityin the contracts. There are number of buyers and sellers registered with stock exchange.
4. Future contracts are marked to market on daily basis. Gains and losses in the future contracts are computed at the end of business day and this process is know as marked to market.
5. In future contract the parties to the contracts are required to deposit the margin with stock exchange. If any day the the price of collateral drops the parties are required to deposit the additional margin know as maintenance margin which is minimum amount of collateral required to keep trading in future contracts.