Question

Compare and contrast the risks of investing in futures compared to traditional investments such as shares and bonds.

Answer 1

ANSWER:

Futures- Futures are the standardized and legal derivative contracts that are bought and sold at a predetermined price and a specific date in future. Futures contracts are used for hedging purpose, hedging is the technique of mitigating risk.

There are two types of Equity futures contracts-

Stock futures- Underlying asset is share

Index futures- Underlying asset is index or a benchmark

Apart from that Commodity and currency futures are also traded widely.

Risks of investing in futures compared to traditional investments such as shares and bonds-

1. Futures are riskier than stocks and bonds because futures prices depend upon the prices of underlying assets, underlying asset can be commodity, currency, stock etc.
2. Futures are highly liquid contracts, their prices keep fluctuating, they go up and down very quickly.
3. Futures are traded on leverage basis. Investors invest only initial margin and rest trade is done on margin basis, if price fluctuates and there is mark to market loss, investors get margin calls and they have to deposit maintenance margin otherwise their position is squared off and investors lose the money.
4. Futures have expiry date, all futures contracts have to be squared off or rolled over before or on the expiry while investing in stocks and bonds do not have any expiry dates, stocks can be bought and kept for short and long term while bonds have maturity dates.