Question

3. After May 2020, what are the prospects of futures contracts as a significant risk management tool for firms? Discuss critically.

Answer 1

Defination of future contracts: -

Future contracts are standardized, legal derivate contract entered in between two parties on exchange trading mechanism where by one agrees to sell any asset like shares of a company, any commodity like gold, currency like Indian Rupee or any other asset particularly known as underlying asset at a future date for a price fixed in advance i.e. today. Contract may b eof one month, 3 month, half yearly or even annual.

Hedging: -

Hedging is a contract entered by any party to secure its position against adverse price movement of any underlying asset.

Prospects of futures contracts as a significant risk management tool: -

In today's world after the rising virus cases over the world, prices of shares, commodities and currencies are fluctuating diversly and at a very fast pace. Every investors, hedger, speculator and even business owner needs to secure its purchase price or loss. Under such conditions after May'2020, future contracts can act as one of the most commonly used risk management tool as it helps any investor, trader or business owner to fix price of any underlying asset which needs to be procured in future. Future contracts helps different class of dealer in following ways: -

1. Businessman engaged in import/ export having foreigfn currency fluctuation risk: -

Importer case: - An importer who is regularly importing products from foreign country is fearing of his home currency depreciation against the export's country i.e. value of exporter's currency in which exporter will bill is going to rise against home currency's value. In such case, importer may enter into a future currency contract for purchasing equavalent amount of foreign currency at a price set in advance today. This will enable importer to purchase products at a fixed price. Howver in case, if exporter's curency falls at the contract end date, in such case importer will not able to avail its benefits. Example, Mr. A purchases (occupies long position) $ at a future contract price of INR 74 for 3 months contract period. Now whatever will be the price of of dollor after 3 month, Mr. will purchase dollor at INR 74 only.

Exporter's case: - An exporter having fear of his home currency value depreciation with regards to countries in which he/ she exports. Due to this, person can enter into future sell option(occupies short position) whereby he will be selling dollors at a set future date according to his realizations at a fixed price. This will help exporter to book his revenue at a fixed price. Now whatever might be the prices at the time of realization, his sales revenue will be fixed at the agreed price.

2. Investors by Hedging: -

Investors use future contracts in case they are having doubt on the future share or any other underlying asset price due to high volatility. An investor having long posoition (i.e. already he has bought some securities) can enter into short future contracts i.e. agrees to sell underlying securities at a fixed future price. This will help investor to fix his/ her profit in advance. Now whatever might be the price of security at the end of contract, he wil sell the future contract and realize his fixed sale proceeds and earn fixed profits. Similarly in case of short position, an investor can take long future position to secure his/ her future profits.

3. Speculator: -

A speculator is a person who speculates underlying asset price and enters into a risky contract with the motive of earning high profits. WIth the help of future contracts, speculators can also fix the amount of losses he/ she might incur in future in case if his/ her bet goes wrong. Suppose a speculator purchases an security for $10 by making a speculation that price will rise in next three montsh to $15. In such case, speculator can undertake future sell contract of same underlying asset to sell it at $9. Now even if prices undergoes below $9. Speculator has fixed his losses at $1. In case prices remains above $11, he will create profits.