Question

EXPLANATION QUESTION ABOUT FUTURES MARKETS.

1. What characteristic should a cash market have to be a candidate for a futures market?

4. What is basis risk and who is exposed to basis risk? Who is not

6. What particular risks exist in clearing OTC products compared to exchange-traded futures products?

Answer 1

A cash market needs to show certain features (all of them) to be eligible for a similarity with a futures market. Some of these features are mentioned as under:-

1. If in a certain cash market, the exchage of goods can happen on a certain future date rather than on the present day, it will bear similarity with a futures market.

2. In a cash market, the actual delivery of the underlying commodity has to happen. It is a must. One cannot square off his position notionally. If ever in a cash market, squaring off outstanding positions is allowed, it will become simlar to a futures market.

3. The full payment equal to the value of the commodity has to be made at the time of the transaction itself in a cash market. There is no concept of margin payment in a spot / cash market. As and when, a cash market allows, down payment or a margin to be paid upfront and the rest of the amount on a later date, the cash market will bear similarity to the futures market.

4. There is no fixed lot size or a fixed / standard order in a buy / sell transaction in a cash market. It means that a person can buy or sell even a single share or unit of a commodity. This is not the case in a futures market. If lot sizes, buying and selling units are standardised in a spot / cash market, it will become like a futures market.

BASIS Risk

Basis in simple layman language means the difference between the spot / current price of a commodity and its future price (on a specific date) in a point of time in future. There is always a chance that both these prices will not be the same. One being more or less than the other. The larger the difference, the higher is the basis risk. People who hedge their positions in a future or a forward market are normally exposed to a basis risk. If a person takes a certain position in the spot market and takes a reverse position in the futures market to hedge /counter his risk, he exposes himself to a basis risk.

Risks in OTC transactions are many as compared to exchange traded futures. The most prominent of them is the risk called "counter party risk" which simply means that there is a risk of the the other side of the transaction (buy / sell party) backing off the deal abruptly leaving you in a huge risk.

The second risk which arises directly from the above mentioned risk is the risk of quality of the underlying commodity. On an exchange the terms and conditions of the quality of the underlying asset are specified and have to be met. But in an OTC trade there is no such compulsion. Even if the other party comes true on his promise to buy or sell, there is always a risk about the quality of the underlying asset.

Another risk which an OTC trade is often exposed to is the risk of "Volume of trade". On an exchange traded platform there are a large number of buyers and sellers (volume of trade is guarenteed), thus ensuring free and transparent price discovery. This benefit is not available OTC as the volume of trade is generally low.