Question

a) Explain the basic differences between the operation of a currency forward market and a futures market.

b) For a derivatives marke to function most efficiently, two types of economic agents are needed: Hedgers and Speculators. Explain about hedgers and speculators with the help of an example

Answer 1

a) Explain the basic differences between the operation of a currency forward market and a futures market.

Forward Contracts vs. Futures Contracts: An Overview

Forward and futures contracts are similar in many ways: both involve the agreement to buy and sell assets at a future date and both have prices that are derived from some underlying asset. A forward contract, though, is an arrangement made over-the-counter (OTC) between two counterparties that negotitate and arrive on the exact terms of the contract—such as its expiration date, how many units of the underlying asset are represented in the contract, and what exactly the underlying asset to be delivered is, among other factors. Forwards settle just once at the end of the contract. Futures, on the other hand, are standardized contracts with fixed maturity dates and uniform underlyings. These are traded on exchanges and settled on a daily basis.

Forward Contracts

The forward contract is an agreement between a buyer and seller to trade an asset at a future date. The price of the asset is set when the contract is drawn up. Forward contracts have one settlement date—they all settle at the end of the contract.

These contracts are private agreements between two parties, so they do not trade on an exchange. Because of the nature of the contract, they are not as rigid in their terms and conditions.

Many hedgers use forward contracts to cut down on the volatility of an asset's price. Since the terms of the agreement are set when the contract is executed, a forward contract is not subject to price fluctuations. So if two parties agree to the sale of 1000 ears of corn at $1 each (for a total of $1,000), the terms cannot change even if the price of corn goes down to 50 cents per ear. It also ensures that delivery of the asset, or, if specified, cash settlement, will usually take place.

Because of the nature of these contracts, forwards are not readily available to retail investors. The market for forward contracts is often hard to predict. That's because the agreements and their details are generally kept between the buyer and seller, and are not made public. Because they are private agreements, there is a high counterparty risk. This means there may be a chance that one party will default.

Futures Contracts

Like forward contracts, futures contracts involve the agreement to buy and sell an asset at a specific price at a future date. The futures contract, however, has some differences from the forward contract.

First, futures contracts—also known as futures—are marked-to-market daily, which means that daily changes are settled day by day until the end of the contract. Furthermore, a settlement for futures contracts can occur over a range of dates.

Because they are traded on an exchange, they have clearing houses that guarantee the transactions. This drastically lowers the probability of default to almost never. Contracts are available on stock exchange indexes, commodities, and currencies. The most popular assets for futures contracts include crops like wheat and corn, and oil and gas.

The market for futures contracts is highly liquid, giving investors the ability to enter and exit whenever they choose to do so.

These contracts are frequently used by speculators, who bet on the direction in which an asset's price will move, they are usually closed out prior to maturity and delivery usually never happens. In this case, a cash settlement usually takes place.

b) For a derivatives marke to function most efficiently, two types of economic agents are needed: Hedgers and Speculators. Explain about hedgers and speculators with the help of an example

Hedging vs. Speculation: An Overview

Speculators and hedgers are different terms that describe traders and investors. Speculation involves trying to make a profit from a security's price change, whereas hedging attempts to reduce the amount of risk, or volatility, associated with a security's price change.

Hedging involves taking an offsetting position in a derivative in order to balance any gains and losses to the underlying asset. Hedging attempts to eliminate the volatility associated with the price of an asset by taking offsetting positions contrary to what the investor currently has. The main purpose of speculation, on the other hand, is to profit from betting on the direction in which an asset will be moving.

Hedging

Hedgers reduce their risk by taking an opposite position in the market to what they are trying to hedge. The ideal situation in hedging would be to cause one effect to cancel out another.

For example, assume that a company specializes in producing jewelry and it has a major contract due in six months, for which gold is one of the company's main inputs. The company is worried about the volatility of the gold market and believes that gold prices may increase substantially in the near future. In order to protect itself from this uncertainty, the company could buy a six-month futures contract in gold. This way, if gold experiences a 10 percent price increase, the futures contract will lock in a price that will offset this gain.

As you can see, although hedgers are protected from any losses, they are also restricted from any gains. The portfolio is diversified but still exposed to systematic risk. Depending on a company's policies and the type of business it runs, it may choose to hedge against certain business operations to reduce fluctuations in its profit and protect itself from any downside risk.

To mitigate this risk, the investor hedges their portfolio by shorting futures contracts on the market and buying put options against the long positions in the portfolio. On the other hand, if a speculator notices this situation, they may look to short an exchange-traded fund (ETF) and a futures contract on the market to make a potential profit on a downside move.

Speculation

Speculators trade based on their educated guesses on where they believe the market is headed. For example, if a speculator believes that a stock is overpriced, he or she may short sell the stock and wait for the price of the stock to decline, at which point he or she will buy back the stock and receive a profit.

Speculators are vulnerable to both the downside and upside of the market; therefore, speculation can be extremely risky.

Hedgers try to reduce the risks associated with uncertainty, while speculators bet against the movements of the market to try to profit from fluctuations in the price of securities.

Hedging vs. Speculation Example

It's important to note that hedging is not the same as portfolio diversification. Diversification is a portfolio management strategy that investors use to smooth out specific risk in one investment, while hedging helps to decrease one's losses by taking an offsetting position. If an investor wants to reduce his overall risk, the investor shouldn't put all of his money into one investment. Investors can spread out their money into multiple investments to reduce risk.

For example, suppose an investor has $500,000 to invest. The investor can diversify and put money into multiple stocks in various sectors, real estate, and bonds. This technique helps to diversify unsystematic risk; in other words, it protects the investor from being affected by any individual event in an investment.

When an investor is worried about an adverse price decline in their investment, the investor can hedge their investment with an offsetting position to be protected. For example, suppose an investor is invested in 100 shares of stock in oil company XYZ and feels that the recent drop in oil prices will have an adverse effect on its earnings. The investor does not have enough capital to diversify their position; instead, the investor decides to hedge their position by buying options for protection. The investor can purchase one put option to protect against a drop in the stock price, and pays a small premium for the option. If XYZ misses its earnings estimates and prices fall, the investor will lose money on their long position but will make money on the put option, which limits losses.