Question

Before 1972, futures trading was dominated by agricultural commodities. The spectacular growth of financial futures now accounts for approximately 50% of all futures trading. Why are they so popular? Is there any risk?Which industry dominates the market?

Answer 1

Why financial futures are so Popular?

• The two key features of financial futures: Price Discovery and Hedging facilitated to dominate the futures trading
• Price Discovery refers to a mechanism wherein the price of a financial future is determined by market interaction. It helped merchants and consumers who intent to avoid risk of future price fluctuations to take adequate steps by engage in buy or sell of financial futures.
• Hedging is another key feature of financial future that helped the participants (users/consumers) to hedge by making an alternative investment in a commodity in another market, thereby reducing risk exposure. For Example, Mr. A (Indian businessman) has a cash receivable of $1000 in 2017 from a buyer Mr. B in US. In this case, Mr. A can take a loan of 60,000 INR ($1000) from a Bank in India, which is equivalent to 60,000 Indian Rupees ($1 = 60 Indian Rupees). The interest rate is 7% per annum. And, Mr A. invests the amount in an Bank in India, as a fixed deposit @9% in 2016. In this scenario, Mr A receives 1,200 Indian rupees as interest for the year after making payment of interest on loan taken. Mr. B pays $1000 in 2017 and value of INR appreciates to $1= 65 Indian Rupees. Hence, Mr. A repaid the loan taken from the bank in India and has an excess of 5000 Indian rupees. In this process, Mr. A is hedging using the currency futures.
• Financial futures helped to reduce transaction costs and thereby, lead way to increase in market liquidity
• Financial futures are regulated by an exchange, which ensured transparency and eliminated malpractices or frauds.

Is there any risk?

• Financial futures are not free from risks. The risks inherent in financial futures can be categorized into four:

• Leverage

It arises out of different position taken by an investor in a financial futures trading platform or market.

• Interest Rate Risk

It refers to the risk that arises out of change in interest rates. Many firms have lost money due to improper estimation of interest rates. In the example, just illustrated in the previous question, If $1 = 50 INR. Then, Mr. A would have faced a loss as he gets Rs 50000 instead of 60000 Indian Rupees. Thus, financial futures are not an exception to interest rate risk exposure.

• Settlement and Delivery

Non- timely settlement and delivery, especially in the case of cash settlement, can create a risk of non-timely settlement

• Price Discovery Risk

With the price discovery feature of financial futures, there is always a tendency for users to speculate, which always is risky and unethical.

Which Industry dominates the market?

• Stock Index futures dominate the market today.