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

Some of Definations of futures contract :

1. There exists in the market a quoted price F(t,T), which is known as the futures price at time t for delivery of J at time T.

2. The price of entering a futures contract is equal to zero.

3. During any time interval {\displaystyle [t,s]} [t,s] , the holder receives the amount {\displaystyle F(s,T)-F(t,T)} F(s,T) - F(t,T) . (this reflects instantaneous marking to market).

4. At time T, the holder pays F(T,T) and is entitled to receive J(delivery). Note that F(T,T) should be the spot price of J at time T

The present situation of businesses calculate the level of risk management in much greater value than ever before. The last two decades have witnessed many-fold increase in the volume of international trade and business due to the wave of globalization and liberalization sweeping across the world. This has led to rapid and unpredictable variations in financial assets prices, interest rates and exchange rates, and

subsequently, to exposing the corporate world to an unwieldy financial risk.

Derivatives are risk management tools that help an organization to effectively transfer risk. The derivatives provide an effective tool to the problem of risk and uncertainty due to fluctuations in interest rates, exchange rates, stock market prices and the other underlying assets.The derivative markets have become an integral part of modern financial system.

A derivative is merely a contract between two or more parties. Its value is
determined by fluctuations in the underlying asset. The most common underlying assets include stocks, bonds, currencies etc..., futures contracts and forward contracts are most common types of derivatives.

Taking an example, the S&P CNX NIFTY futures are traded on National
stock exchange. This provides them transparency, liquidity, anonymity of trades and also eliminates the
counter party risks due to the guarantee provided by National Securities Clearing Corporation limited.

2. While lesser known oil benchmark prices have traded below zero in the past, the fact that the May 2020 WTI Crude Oil Futures Contract settled at -$37.63 per barrel on the close marks another unique market dislocation in the current environment.

What actually happened?

The front month West Texas Intermediate Crude Oil contract, May 2020 WTI Crude, was nearing the last days to trade the contract prior to going into the delivery phase. The day saw a complete collapse in prices, with no bids at certain times of the day. For context, the previous day’s close was $18.27 per barrel, meaning there was a one day fall of $55.90. The following is a one month time series for this contract.:

If we look into the bottom line the price collapse was just a fraction of a number of events falling at the same time..

Some of the Reasons to negetive realm:

1. A significant oversupply of oil based upon a collapse in demand in the US for energy as a result of lockdowns throughout the country.

2. The oil benchmark relies on there being sufficient spare capacity at Cushing to take delivery, but this has been falling recently due to oversupply.

3. The May 2020 oil contract was approaching expiry, so liquidity was drying up and most commodity traders and major indices had already rolled contracts into June 2020 and beyond.

4. With a lack of storage, lack of liquidity and significant long volume on one side of a physically deliverable market, prices collapsed to a point that incentivised buyers, who could physically take delivery and store it, to step into the market.

This situation is a short-term, idiosyncratic dislocation in one particular oil market in which a lack of available storage converged with a long holder of oil needing to offload this position at any price.

The imposition of lockdowns throughout the US saw the prices gradually diverge at the beginning of March as traders priced in firstly a short-term supply shock, then a much more significant collapse in demand as lockdowns were imposed globally. Additionally, as storage has filled up in Cushing, the May contract repriced to incentivise buyers who are able to take physical delivery and store this oil.

Although there are certain disadvantages of futures but at the same time the advantages they have, make them essential to be traded in the market. Using futures and forward contracts, an individual can hedge various types of risks like commodity risk, interest rate risk, and currency risks etc.