Question

1.What is the settlement price, opening price and closing price for futures? What is open interest?

2.Why hedgers cannot achieve perfect hedging when using futures?

Answer 1

A Future contract is the agreement between buyer and seller to buy or sell any particular underlying asset at a specified date and at specified time. Underlying asset can be a commodity or any financial instrument. These contracts happen through future exchanges in order to reduce to the risk of price fluctuation.

Settlement price is the average price across the certain period of the future contract such as say across a trading day of future contract to thereby taking the opening price and closing price of the contract. Opening price is the price of the futures future when market has opened in the day and closing price is the price at the end of the day, that is when market has closed. One should not confused them with settlement price as the settlement price is the average price of the future over a trading day or over a specific span of time within a trading day. For example, settlement price can be calculated as volume weighted average of 60 seconds of trading between 12:01:00 PM to 12:02:00PM.

Open interest is the total number of future contracts that has not been exercised or expired or yet pending for delivery. Hence, the total number of futures outstanding contracts represent the open interest. One thing to be noted is that for every future contract, there is a buyer and a seller, so in order to make the count we need to either consider the buyer side or the seller side. The open interest position tells about the increase or decrease in the number of total of future contracts outstanding. If a buyer and seller has initiated the contract , then the open interest will increase by one and if the contract is accomplished, then it will decrease by 1. Now, increase in open interest means new money is entering into the market and decrease in open interest means money is flowing out of market, increasiing to the liquidity of seller.

2) Hedging is a strategy of reducing the risk of loss from investments made. It can be acheived through future contracts, swap, options and forward contract s. These are also called derivatives. In other words it's like a insurance policies for which you have to pay some fees. Ans if no loss occurs, you end up loosing your fees.

A perfect hedge means there is no risk in the position taken through derivatives and it's 100% risk free. This is practically not viable. There is always a 100% inverse correlation in the underlying assets to acheive perfect hedge. Means, suppose you invested in infrastructure stocks, which going down due to infrastructure market slowdown. Now, to mitigate this you invested in food sector stocks, which is booming, you are covering the loss from food industry stocks. Every income from food industry stocks me mitigate s the every loss from infrastructure stocks. This is 100% inverse correlation and this rarely exist. This happens because of various other factors in the economy such as inflation, economic slow down, government regulations,etc.

Other way of Hedging is by options. That the infrastructure stocks will be sold at specified price at specified date. Now, if price of stocks goes up, you will be at loss and if it goes down then, buyer may not exercise option.