Question

1. Discuss the risks involved with trading futures contracts. Why might someone choose to accept these risks? In other words, what benefits might one get from using futures?  

b- Explain how credit default swaps (CDS) are like insurance. Sometimes when someone purchases insurance they go on to engage in riskier behavior than they otherwise would have (something we call moral hazard in economics); explain how this could be a problem with investors who purchase CDS.

Answer 1

There are various risks associated with the futures contracts. Following are the various risks involved:

1. Leveraging - This is the biggest risk involved with futures contract. Generally, investors are allowed to trade 10 or 20 times of the margin deposited, in futures contract. In other words, only 5 to 10 per cent amount of the contract value is needed to trade. In the negative scenario, change of only 5 to 10 per cent in the value of the underlying, which is normal, will make your capital zero.

2. Liquidity Risk - Futures contracts are big in size and it is not in everyone's capacity to deposit the required margin money. Also, there are higher chances the position will cut at higher losses in negative scenario.

3. Settlement/Delivery Risk - Futures have the pre-decided settlement or delivery date. We cannot hold it for years. Generally, this period varies from one to three months. There are chances we have to book unnecessary losses on the settlement or delivery date.

People chose to accept these risks to make abnormal gains on their capital. Due to the effect of leveraging people can earn even 100% on their capital in one day even if the underlying changes by only 5 to 10 per cent. This potential gain attracts people which makes them to accept the potential risk. Also, margin requirements is around only 5 to 10 in most of the cases, which means an investor do not require to block all of it's cash and can enter into the trade even with the lesser cash.

Benefits of Futures Contract:

- We can earn abnormal returns on capital, if we are traders, by the use of leveraging
- For investors, it is a very effective tool of hedging
- No blocking of cash as only 5 to 10 per cent of the cash is needed to enter into the futures contract.