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.                                                                                                                              

2. Review   and discuss the collapse of the Futures Oil Market, which   fell into the negative realm in May 2020.                                                                                      

What were the main reasons for this fall into the negative realm? Critically discuss.

Total 35 marks

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

Answer 1

A) Future contracts are contracts in which the buyer and seller agree to exchange the underlying asset at a fixed price in a future date. The buyer has the obligation to buy the underlying asset and seller has the obligation to sell that asset at a pre-fixed future date and price. Both buyers and sellers manage their risk of market uncertainity through coming in a futures contract. For example A and B comes into contract to buy a commodity 1 month after today at $50, if in future the price increases to $55 it a risk for the buyer and if the price decreases to $45 then it is a risk for seller. The main agenda for a futures contract is to mitigate that risk and set a pre defined price.

B) In oil futures market buyers and sellers take crude oil (WTI) as the underlying asset. Right from January the oil futures price started to decrease which streached till April. During this phase the oil price reduced to negative that the sellers were actually paying the buyers to buy oil. At that time, the pandemic of Covid-19 was at its peak and had affected many, with global lockdowns oil prices decreased and went to negative. Now when lockdowns are being revoked from majority of the countries and businesses coming back to life, oil futures increased.

C) During the time of January to April 2020 the Covid-19 was at its high peak which led many businesses to temporarily shut down with major shock to transportation industry and hospitality industry. With this temporary shut down no transaction of oil was taken place and traders anticipated further decrease in oil prices as the pandemic was increasing day by day. Due to this anticipation the oil futures price decreased to zero. The oil companies were incurring a lot of storage costs and so decided to sell oil in negative price through which their costs reduced by a certain aspect. With this the oil started selling on a negative price which means sellers had to pay the buyers to buy oil.

D) After now the oil futures would be traded as were being traded way before covid-19, oil futures have become positive and are expected to reach Dec 2019 price.