Grade 12 Lesson 5: Derivatives: Futures

Derivatives are financial instruments whose value is derived from an underlying asset, such as stocks, bonds, commodities, or currencies. They provide exposure to the price movements of the underlying asset without requiring ownership of the asset itself. Derivatives serve multiple purposes, including managing risk, hedging, speculating, and enhancing investment strategies. They allow market participants to take positions on the future price movements of assets, facilitating price discovery and liquidity.
Derivatives come in various types, including futures contracts, options contracts, swaps, and forward contracts, providing market participants with a range of tools for risk management, speculation, and investment strategies. In this lesson we will explore Futures.

Introducing Futures
Futures contracts are agreements between two parties to buy or sell an asset (the underlying asset) at a specified price (the futures price) on a future date (the expiration date). These contracts are standardized and traded on organized exchanges, ensuring transparency and liquidity.

Example
As a wheat farmer, you want to secure a price for your harvest in three months. You enter into a futures contract with a buyer for 100 bushels of wheat at $10 per bushel, with an expiration date in three months. Both parties deposit an initial margin with a futures broker. If, on the expiration date, the price of wheat rises to $12 per bushel, the buyer purchases the wheat from you at the agreed price, resulting in a profit of $2 per bushel for the buyer. However, if the price falls to $9 per bushel, you still sell the wheat at $10, thereby avoiding a larger loss that would have occurred if you had sold in the spot market at the lower price. The futures transaction helps to hedge against potential price declines, securing a predetermined price for your harvest and protecting your profitability as a farmer, while providing the buyer with a fixed future price.

Key participants in the futures market:
-- Hedgers: Hedgers use futures contracts to manage or mitigate price risk associated with the underlying asset. For example, like in the above example, a farmer might use futures contracts to lock in a price for their crops, ensuring a predictable income regardless of market fluctuations.
-- Speculators: Speculators aim to profit from price movements in the futures market without intending to own the underlying asset. They take positions based on their predictions of future price movements, seeking to buy low and sell high for profit.
-- Arbitrageurs: Arbitrageurs exploit price differences between the futures market and the spot market to make riskless profits. They buy low in one market and sell high in the other to capture the price differential, ensuring efficient pricing across markets.

Benefits of futures contracts:
-- Price discovery: Futures prices reflect market expectations and provide insights into the future values of the underlying assets. They serve as benchmarks for cash market prices.
-- Liquidity: Futures markets are liquid, with numerous participants actively trading contracts. This liquidity ensures that traders can easily enter or exit positions at competitive prices.
-- Hedging opportunities: Futures contracts enable market participants to protect against adverse price movements in the underlying asset. Hedgers can lock in prices, mitigating the risk of price fluctuations and ensuring stability in their operations.
-- Enhanced investment strategies: Futures contracts provide opportunities for investors to implement various investment strategies, including spreading (simultaneously buying and selling related contracts to profit from price differentials) and portfolio diversification.

Risks of futures contracts:
-- Price volatility: Futures markets can be volatile, with rapid price movements leading to significant gains or losses. Traders should be prepared for potential fluctuations in the value of their positions.
-- Counterparty risk: Futures contracts are typically traded on organized exchanges where clearinghouses act as intermediaries. However, there is still a risk of the counterparty involved in the contract defaulting on their obligations.

In summary, Futures contracts play a crucial role in managing risk, providing price discovery, liquidity, and hedging opportunities. Whether you are a hedger, speculator, or arbitrageur, futures contracts offer a way to participate in the market and benefit from price movements without owning the underlying asset. Remember to carefully consider the benefits and risks associated with futures trading and continue exploring the exciting world of finance and equities!

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