Question

Explain why for speculation, the purchase of an option may be more attractive than a futures contract or the outright purchase of the underlying asset such as a bond.

(Give example(s) as appropriate)

Answer 1

Futures are derivatives contracts that derive value from a financial asset such as a traditional stock, bond, or stock index, and thus can be used to gain exposure to various financial instruments including stocks, indexes, currencies, and commodities. Futures are a great vehicle for hedging and managing risk; If someone is already exposed to or earns profits through speculation it is primarily due to their desire to hedge risks.

Future contracts are traded in huge numbers every day and hence futures are very liquid. The constant presence of buyers and sellers in the future markets ensures market orders can be placed quickly. Also, this entails that the prices do not fluctuate drastically, especially for contracts that are near maturity. Thus, a large position may also be cleared out quite easily without any adverse impact on price.

In addition to being liquid, many futures markets trade beyond traditional market hours. Extended trading in stock index futures often runs overnight, with some futures markets trading 24/7.

Futures are very important vehicles for hedging or managing different kinds of risk. Companies engaged in foreign trade use futures to manage foreign exchange risk, interest rate risk by locking in a interest rate in anticipation of a drop in rates if they have a sizeable investment to make, and price risk to lock in prices of commodities such as oil, crops, and metals that serve as inputs. Futures and derivatives help increase the efficiency of the underlying market because they lower unforeseen costs of purchasing an asset outright. For example, it is much cheaper and more efficient to go long in S&P 500 futures than to replicate the index by purchasing every stock