Futures contract


Futures markets were designed to solve all the three problems (listed in Question 4) of forward markets. Futures markets are exactly like forward markets in terms of basic economics. However, contracts are standardised and trading is centralized (on a stock exchange). There is no counterparty risk (thanks to the institution of a clearing corporation which becomes counterparty to both sides of each transaction and guarantees the trade). In futures markets, unlike in forward markets, increasing the time to expiration does not increase the counter party risk. Futures markets are highly liquid as compared to the forward markets.
Benefits of Futures Trading
1) Invest - take a view on the market and buy or sell accordingly.
2) Price Risk Transfer- Hedging - Hedging is buying and selling futures contracts to offset the risks of changing underlying market prices. Thus it helps in reducing the risk associated with exposures in underlying market by taking a counter- positions in the futures market. For example, an investor who has purchased a portfolio of stocks may have a fear of adverse market conditions in future which may reduce the value of his portfolio. He can hedge against this risk by shorting the index which is correlated with his portfolio, say the Nifty 50. In case the markets fall, he would make a profi t by squaring off his short Nifty 50 position. This profi t would compensate for the loss he suffers in his portfolio as a result of the fall in the markets.
3) Leverage- Since the investor is required to pay a small fraction of the value of the total contract as margins, trading in Futures is a leveraged activity since the investor is able to control the total value of the contract with a relatively small amount of margin. Thus the Leverage enables the traders to make a larger profi t (or loss) with a comparatively small amount of capital.
Options trading will be of interest to those who wish to :
(i) Participate in the market without trading or holding a large quantity of stock.
(ii) Protect their portfolio by paying small premium amount.
Benefi ts of trading in Futures and Options :
(i) Able to transfer the risk to the person who is willing to accept them
 (ii) Incentive to make profi ts with minimal amount of risk capital
(iii) Lower transaction costs
(iv) Provides liquidity, enables price discovery in underlying market
(v) Derivatives market are lead economic indicators.

Friday, 02nd Oct 2015, 09:01:46 AM

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