Question

Futures markets are used for hedging and for speculation. What is the difference between these activities? Why do speculators often use futures rather than cash markets? How would you use futures to profit from an expected rise in bond yields? From an expected rise in stock prices?

Answer 1

Hedging is a method to reduce the amount of risk on existing position. It involves taking an offsetting position in a derivative to balance the gain or loss. Where as speculation is a method involves making profit from change in future price by taking on additional risk.

Speculators often use futures rather than cash market for speculation. This is because futures provide them an exposure to leverage, which magnifies the amount of profit which could be earned and also due to fast movement of prices in future market than in cash market.

If the bond yield is to rise in future, then it means that the prices will decline because there is an inverse relationship between the two. So we will sell bond future contract which will help us to make profit, and offset the contract before expiry so that the gain or loss could be net settled through traders account.

If the stock prices are to rise in future, then we should buy future contract to buy the stock in future. If the price of the stock increases before the expiry of the contract , then we can enter into an offsetting contract before expiry and net the gain in our traders account. This is how you can make profit by entering into futures. For example:- It's January and you enter into a futures contract to purchase 100 shares of IBM stock at $50 a share on April 1. The contract has a price of $5,000. But if the market value of the stock goes up before April 1, you can sell the contract early for a profit.