Question

A futures market is a central financial exchange where people can trade standardized futures contracts. A futures exchange provides physical or electronic trading venues, which can be organized as non-profit member-owned organizations or for-profit organizations. Futures exchanges can also be integrated under other types of exchanges, such as stock markets, options markets and bond markets.

Futures contracts are sometimes used by corporations and investors as a hedging strategy. Hedging refers to a range of investment strategies that are meant to decrease the risk experienced by investors and corporations.

Questions;

The futures market is referred to as an auction market, whereby producers and suppliers of commodities endeavour to avoid market volatility; in other words, producers and suppliers negotiate contracts with an investor who agrees to take on probable risk and reward, based on the expected volatility of the market.

1. 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

Meaning of Futures Contract-

A futures contract is a legal agreement to buy or sell a particular commodity asset, or security at a predetermined price at a specified time in the future. Futures contracts are standardized for quality and quantity to facilitate trading on a futures exchange.

The buyer of a futures contract is taking on the obligation to buy and receive the underlying asset when the futures contract expires. The seller of the futures contract is taking on the obligation to provide and deliver the underlying asset at the expiration date.

-At the maturity date the Futures Contact Can be settled by-

i.Autual delivery of goods or by

ii. Net settlement

- For example Mr. A is a farmer of Potato. Current price is $10 Per Kg of potato. He is expecting that the price will decrease to $ 5 Per Kg after 3 months. Hence to hedge the risk of falling price, he may enter into a furure contract with the Mr. B to sell the potato to Mr. B after 3 months @$ 10 Per Kg.

-Suppose after 3 month the price falls to $ 7 per Kg. Hence the contract can be executed either actual delivery of Potato by Mr. A to Mr. B @$10 Per Kg OR can be net settled. In case of Net Settlement, without taking the actual delivery Mr. B can pay the differential price $ 3(i.e, $10-$7) on the settlement date to Mr.A.

# Futures Contract as a risk management Tool-

- The market is always uncertain due to both internal and external environmental factor.Risk is always there whether it mat be commodity market,or foreign exchange market , derivative market etc.

- Future contract is an effective management tool to mitigate the future risk exposure and market volatility.

- As seen in the above example, Mr. A is able to mitigate the risk of falling in the price of the commodity by entering into future contract.

- Now lets take the example of Foreign exchange expoure rirk. For Example Mr. A has to pay $10000 one month from today . Current Exchange rate is $1= Rs. 66. So effectively Mr. A has to pay Rs.660000 at todays price. But Mr. A expectes that due to unfavourabel market factors the rate after 1 month will be $1=Rs.77. Hence he have to pay Rs.770000 after 1 month causing a loss of Rs.110000. To hedge the risk he can enter into future contrat to buy $10000 say @ $1= Rs.68. Hence after 10month he have to pay Rs.680000 instead of Rs.770000.

- Like wise Future contact can be used to mitigate the risks in various markets. But before entering into the Future market contract the investor should take into consideration the following factors-

1.Inflation factors

2. Interest Factors

3.Current market situation

4. Ability of taking the risk.

5. Tax implications etc.