Definition of futures market
The Futures Market is one in which contracts are traded in which the parties undertake to buy or sell a certain asset in the future (agricultural product, mineral, financial asset or currency), defining in the present the quantity, price and expiration date of the operation.
For example, if you buy a contract for a product in January that expires in May, at a price of $ 1,000, it means that you agree to receive a predefined quantity of that product on the expiration date, for which you must pay $ 1,000..
In practice, a very small percentage of all futures contracts reach maturity, since at any time before that date, the commitment to buy or sell can be extinguished by performing the reverse operation on the Stock Exchange. In that case, the difference between the price at which the contract was opened and the price at which the inverse operation was carried out represents the profit or loss of its participation in futures.
What futures markets exist in the world?
Futures contracts can be signed on agricultural products (wheat, coffee, soybeans), minerals (gold, silver, copper, oil), financial assets (stock price indexes, fixed income instruments, interest rates) and currencies, requiring necessarily a standardization of the quantity and quality of the product that is negotiated.
Who participates in the futures markets?
People or companies that participate in futures markets can be divided into two categories:
- Hedgers: They are those agents who wish to protect themselves from the risks derived from possible fluctuations in the prices of the products that affect them, the financial instruments that make up their assets, or the foreign currencies in which they have agreed to their transactions or commitments. Consequently, hedgers are risk averse. Investors in general: They are agents who are willing to assume the risk of price variability, motivated by the expectations of making a capital gain. The small amount of investment necessary to operate in this market is an incentive for investors who wish to act in it.
For hedgers, the future represents a protection in the profitability of their businesses against damages that could occur if the price of an asset or product moves in the opposite direction than expected.
As an example, a company that has a debt in dollars and whose income is in Bolivians wants to protect itself from the dangers of a devaluation. To do this, you must buy dollar futures contracts, which will allow you to set the exchange rate at which you must pay your debt during the term of the contract.
Alternatively, an institutional investor who maintains a portfolio of shares, may take a selling position in the future market of stock indices in order to protect the profitability of his portfolio against the eventual generalized drop in share prices.
On the other hand, investors who wish to obtain an adequate profitability in this market can carry out various operational strategies taking advantage of the multiplier effect of requiring only a percentage of the total commitment.
In fact, since the initial margin payment for the opening of a futures contract represents only a fraction of it, a small price variation can result in a considerable profit or loss in relation to the initial deposit.
Futures markets are of such particular characteristics that they require daily monitoring of the evolution of prices and the volume traded. Even when the market is unstable, this control should be done hour by hour, since price fluctuations can have a considerable impact on investor positions.
Below is a presentation with the most relevant concepts of this text.
futures-marketHistorical background of futures markets
Futures markets have been developed to help stakeholders in the grain trade chain improve their trading and purchasing practices.
The significant price variation generated by a seasonal supply determined by the harvest season and a constant demand throughout the year, the inadequate facilities to store the merchandise, the disputes between buyers and sellers due to the lack of classification and weight regulations and measure made evident the creation of a broad market available to all buyers and sellers, the futures markets.
The existence of these markets dates back to ancient times, since China, Arabia, Egypt and India operated with many of the current characteristics.
The first recorded use of these markets was in Japan in 1697. In the Tokugawa era, feudal lords had to spend half a year in Edo (present-day Tokyo), where the government was located, in order for the emperor to watch over them and thus avoid a rebellion. At that time the rent was paid in rice and the feudal lords were forced to maintain two deposit houses, one in the country and the other in the city. As they frequently had to face an emergency, they began to issue tickets (certificates of deposit). Merchants began to buy these tickets to anticipate needs (coverage).
The receipts were administered first by public officials and later by the merchants themselves. Over time merchants began to move towards ticket sales and credit. Before long, many merchants became rich.
One of them was Yodoya, who in Osaka dominated the entire rice trade. His home became the center where many merchants met to exchange information and negotiate. The price of Yodoya was considered the prevailing one in Osaka. We can say that this was the first merchandise market, formed in Japan around the year 1650. In 1697 Yodoya moved to Dojima and from then on his house was known as the “Dojima Rice Market”. The characteristic of this market is that it only allowed future transactions. In 1730 the empire recognized this market that had been developed by a merchant. The market was declared legally permitted and protected by the high authorities of the empire. It had extremely orderly and clear rules and is the direct antecedent of the futures markets as we know it today.In that same century, domestic commodity markets already existed in the United States, but in 1848 the Chicago Board of Trade was founded, today the most important futures market in the world.
The production of cereals and oilseeds reached important volumes that generated significant exportable balances and there was no quotation that reflected the value of the products as well as the conditions in which the harvests had to be negotiated, the Statutes of the Association were approved in 1907 of Cereals of Buenos Aires. A daily round was held from 11:30 to 12:30 from Monday to Saturday, listing Linen, Wheat and Corn in contracts of 100 tons.
What are Futures Markets for?
The basic objective of a Futures Market is to offer an efficient price protection mechanism for people or companies exposed to adverse price fluctuations in their most relevant assets. In simple terms, futures markets make possible the transfer of risks, which in their absence should be assumed by the economic agents themselves.
Additionally, due to their nature, futures prices reflect the expected price levels for the different assets in the coming months, which provides very good information for the decision-making of economic agents and constitutes an important contribution to the economic projections and financial planning, both in the public and private sectors.
Finally, futures are attractive investment instruments, since they can present a considerable return on invested securities.
In the futures price, it incorporates market expectations about the probable evolution of the price of the underlying asset.
Let a commodity have a spot price S and a one-year futures price of F. Suppose that it is possible to take out a loan at an annual interest rate of r without any limitation. Assuming that there are no storage costs for the merchandise, and ignoring margins, it can be stated that the futures price is equal to the current spot price plus an additional component that takes into account interest rates:
F = S (1 + r). If this identity is not met, there would be the possibility of establishing arbitrations. Suppose the futures price was above that level, that is, F> S (1 + r); In this case, an arbitrageur could:
Selling a futures contract and borrowing S dollars at an interest rate r and buying a unit of merchandise on the spot market for price S. These operations offset each other, at zero total cost. At the time of contract expiration, the merchandise is delivered at the agreed price and the loan principal is returned: S (1 + r). The result is that the arbitrageur will earn a risk-free profit: F - S (1 + r).
Only a very small part of the futures contracts that are concluded conclude with the delivery of the traded asset or merchandise. Most contracts are settled (before the clearing house) by taking a position that counteracts them before the delivery date arrives. For example, be the buyer of a futures contract who can sell it at any time before the delivery date. In this way, it would offset its position in the underlying asset, by having purchase and sale contracts.
Role of the Bag
The Stock Exchange is the physical place where negotiations take place, also providing the necessary means for them to be carried out efficiently.
The Stock Exchange also regulates and controls the Market, and provides the Market and investors with the widest and most timely information for decision-making.
Futures operations are carried out through Stock Brokers, who are duly registered intermediaries and serve as a link between clients and the Exchange.
Unlike an operation in the cash market, in which it is required to deliver the total amount of the operation or have the total amount of the traded asset, in future transactions, only an initial margin corresponding to a fraction of the total amount of the operation, which has a significant multiplier effect on the gains or losses of futures transactions.
Initial margin.- It is a fixed amount of money that is equivalent to a percentage of the value of the contracts, which clients must deliver in the stock market for each open interest they maintain in the future market. The initial margin can be constituted in money, fixed income instruments and financial intermediation and other highly liquid instruments.
Variation margin.- The value of a future position is updated daily, taking it to the market closing price. The net difference of the price change is debited from the current account of the position with loss and credited to the account of the position with profit.
The losses that occur must be paid daily in money, while the gains will also be paid daily in money.
How are futures contracts settled?
The settlement process can be carried out early or at maturity. It will be carried out in advance by executing an inverse future operation to the one determined in the open interest, that is, making a purchase when you have a sell position or a sale when you have a buy position. This liquidation may mean a total or partial decrease in open interest.
At the maturity of the exchange instrument, all open interests are definitively settled, using for the valuation and determination of the gains and losses, the spot market reference price of the target asset.
Financial markets on commodities
The term commodity is equivalent to raw material, that is, to raw, unprocessed material, covering a wide spectrum of agricultural, metallic and energy products, although it also includes strictly financial assets.
A financial market in raw materials is not necessarily linked to the delivery of the physical. The genuine purpose is the trade on paper where the operations are documented to achieve a hedging or speculative purpose but are settled in order to obtain profits or losses in money. The acquisition of the physical is normally carried out in the cash market.
The conditions that a raw material must meet in order to be traded in a futures market are:
- There must be volatility in the price: if there is no volatility there is no risk in such a negotiation, nor is there the possibility of a speculative profit. Not all raw materials have sufficient volatility. It must be sufficiently homogeneous: the homogeneity of the raw material will allow it to be contracted according to well-defined characteristics, that is, they can be standardized in quality and delivery conditions. This was a major limitation in the implementation of futures markets in the meat sector. It must have a competitive market structure: a large number of buyers, sellers and operators are required. In turn, a trading volume is required to support the futures market.
Futures markets play an important role as an information service.
It is a recognized fact that futures markets improve the quality and quantity of information on a certain commodity traded and allow greater efficiency in price information.
Functioning of the Term Market of Buenos Aires SA (MAT)
The MAT establishes and enforces the rules, which must be approved and supervised from 9/17/93 by the National Securities Commission with the intervention of the Ministry of Agriculture, Livestock, Fisheries and Food in matters related to the specific nature of the product in question, to ensure that the operation is carried out within a framework of absolute transparency. For this reason, transactions in the trading wheel are made out loud. One of the advantages of this system is that the price is made public and in this way the sellers are sure to have a large number of buyers competing with each other, and the buyers, a large number of sellers.
The Trading Round is the meeting of the operators, at the MAT site, on the days and within the hours set by the Market Board. There, any operator can accept a sale offer or a purchase offer simply by shouting the word ANOTE, with which the operation is agreed. At the same time the price of said operation is published on the electronic board of the trading room, allowing operators to have the information and full transparency in prices. MAT quotes are an unavoidable reference source for decision making.
The only ones who can register operations in the MAT are its shareholders, who must comply with all the rules established by the market. Any violation to them will make you liable to severe penalties or even result in the suspension or revocation of the privileges to operate.
To be a MAT shareholder, it is an essential requirement to be a member of the Bs. As. Cereal Exchange, and it must also be accepted by the Board of Directors. Each shareholder cannot own more than three shares. Among a company, its members, managers, proxies and employees, may not have more than eight shares.
Those who are not shareholders of the MAT may register operations through them, as long as they are authorized to register operations on behalf of third parties. Eg. runners, etc.
The MAT does not influence the price formation process, it is neither a buyer nor a seller of contracts; These functions are reserved for operators who represent supply and demand.
The MAT is an entity that records and guarantees futures and options operations.
Cash, forward and future contracts
The cash contract is one in which a buyer and a seller agree on the price of a product of a certain quality and quantity for immediate delivery.
The quality and quantity of the merchandise and the delivery terms are agreed between buyer and seller. The fulfillment of the contract depends on the good faith of both.
The forward contract is one in which the seller agrees to deliver a product to the buyer at a certain future date. When the contract is agreed, both agree on both the quality and quantity of the merchandise as well as the time and place of delivery and the price. In this case, like the previous contract, performance depends on the good faith of both parties.
The future contract is one by which the commitment is acquired to deliver or receive merchandise of a certain quantity and quality in a place, future month and also determined price.
Although the forward contract and the futures contract are contracts between two parties, to deliver merchandise at a future date, in the latter the quantity, quality, date and place of delivery are standardized. The price is the only thing that is negotiated.
The counterpart of the participants is the futures market that guarantees compliance with it. Trading takes place daily at the trading wheel.
The coverage
Hedging is a price protection for the purpose of minimizing losses in the production, storage, processing and marketing of a product.
This protection is achieved by buying or selling futures contracts.
Hedging with futures contracts offsets the position in the physical or cash market with an opposite position in the futures markets. By not using the benefit of the coverage provided by the markets, a producer, collector, cooperative, processor or exporter is speculating in the cash market.
The reason that cash positions are hedged with futures positions is because cash prices (current price of the product) and future prices (price negotiated between buyers and sellers in a futures market) vary in the same direction, although not in the same magnitude, and also because as the expiration of a futures contract approaches, both prices tend to converge. This parallel price movement manifests itself because both markets (cash and futures) are influenced by the same price-making factors.
There are two types of coverage: sale and purchase. Sales coverage is used by those who seek to protect the future sale price of a product against a possible decrease in it. This cover is used by a producer for his crops or by a silo operator who is storing grains.
Purchase coverage is used by those who try to protect the future purchase price of a product against a possible rise. It can be used by a silo operator that has not yet purchased grain or by an exporter to cover the cost of the products that it has promised to deliver abroad.
Cancellation of futures contracts
Futures contracts can be canceled in two ways:
- For compensation, with the delivery of the merchandise.
Cancellation for compensation
Cancellation by compensation consists of making a future contract taking a position opposite to that of the contract to be canceled. For example, a producer sells a January wheat contract; To cancel it for compensation, you must buy January wheat. With this last operation, he cancels his original sale operation, detaching himself from the commitment assumed with the futures market.
An exporter buys May corn; To cancel this compensation contract, he must sell May corn.
This way of canceling contracts is based on the behavior of the cash or spot market prices and the futures market. Let us remember what was said above about the behavior of prices in both markets:
- The prices of the cash and future markets oscillate in the same direction, although not in the same magnitude. As the month of expiration of the futures contract approaches, both prices tend to converge, that is, the difference is practically zero.
Observing the figure, we can confirm the above for the March 98 wheat position in the port of Bs.As., compared to the value of wheat in cash.
Futures prices are generally higher than cash prices, such differences reflect the maintenance cost for a future delivery and the transportation cost between the location of the cash product and the futures market. Therefore, when the expiration date of the future contract arrives, the difference must be the cost of transporting the merchandise.
Using the cancellation for compensation we disengage from the commitment to receive or deliver the merchandise through the futures market, and the only thing we obtain is a result for the difference between the prices of both contracts.
This difference will be compensated with the operation that we do in cash, delivering or receiving the merchandise in our locality or in the negotiated place.
Cancellation by delivery of the merchandise
Cancellation with the delivery of the merchandise can only be made in the month of expiration of the contract.
In the MAT during the month of expiration of the contract and until the round prior to the last five, the seller has the option of expressing or not his intention to deliver the merchandise through the market, submitting a form the "Delivery Offer", where he will state the product, the quantity, the place of delivery and if there is a deliverer representing him. The MAT selects a buyer at random, allowing him to sell the delivery offer during the day, that is, to make a cancellation for compensation. If the buyer accepts the offer, he returns it to the MAT for registration.
All contracts that were open on the day of the first round of the last five of the month, must be canceled with the delivery of the merchandise, following the procedure developed above.
Sales coverage
The objective of establishing a short or sell hedge is to protect the value of a crop or the value of some inventory by making a sale contract in the futures market.
The purpose of this market operation is to act as a temporary substitute for the sale of the physical product at a later date.
The one with sales coverage owns, or will soon be, the physical product, but will sell it at a future date. For example, a soybean producer can establish a sales coverage for the month of May, but in reality he still does not own the soybeans because he does not harvest it. A grain trader can establish a sales hedge even if he has not received the soybeans yet, but he does know the purchase price.
Since these people have opposite positions in the two markets - they have sold in one and bought in another - the price fluctuation in one of the markets generally compensates for the fluctuation in the other market, due to the parallel relationship of prices between the markets. of physical and future products.
Purchase coverage
The goal of establishing a long or buy hedge is to protect the cost of a product by making a purchase contract in the futures market.
The purpose of this market operation is to act as a temporary substitute for purchasing the physical product at a later date.
This coverage is used by exporters, processors, and collectors who set a price for their physical purchases at a future date.
By having opposite positions in the futures and spot markets, any price fluctuation in one of the markets is generally offset by the fluctuation in the other market.
Base
The difference between the price of a particular physical product at a certain location and the futures price of the same product is known as the basis.
This difference is due to many factors and varies from one place to another due to the fact that the cash price is not the same in all locations. We can state the factors that influence the local base of a product:
- local supply and demand for the product general supply and demand for substitute products and comparable prices availability of transport and equipment structure of transport prices availability of storage space availability of storage space quality factors and packing capacity expectations of interest rates
Fluctuations at the base
The fluctuations in the basis are usually less than the fluctuations in cash prices and future prices. This allows us to establish a hedging strategy.
If we define the base as the arithmetic difference between the price of the physical or cash and the price of the future, then the more positive the base, the higher the price of the physical product. The more negative the basis, the lower the price of the physical product.
Guarantee
The futures markets, being guarantors of the operations registered in the trading wheels, must take certain precautions so as not to endanger their social assets. For this reason the futures markets establish a guarantee system to minimize the risk they run as guarantors.
These systems are not necessarily the same in all markets, but each market will establish the guarantee system it deems appropriate.
The MAT adopted a system of guarantees that consists of: Margin and Differences
- Margin is a fixed sum that buyers and sellers of futures contracts must deposit into their accounts to ensure contract performance. When the operation is canceled, the MAT returns the deposited margins. Margins can be deposited using the following instruments:
- cash bank bonds government securities fixed-term transferable endorsed in favor of the MAT
The margins and differences are demanded by the market from its operators, who are solely responsible for their deposit. Notwithstanding this, they may require their clients to replace the guarantees deposited in the MAT.
Conclusions
A futures contract is an agreement to make a certain exchange at some point in time. The agreed date of completion of the exchange differs from the date of the agreement.
Euromarkets have contributed to creating a global capital market, benefiting the growth of the world economy. However, different traders may disagree on the values of the options if they differ on the future volatility of the underlying asset. Although the expression trading volatility is associated with trading options, they are a bet on volatility, although they are also a risk management tool.
Futures contracts are contractual obligations by which the buyer agrees to pay a negotiated price for the merchandise and the seller agrees to deliver it for that price at the time the contract expires.
The terms that are standardized in the contract are the quality, quantity, time and place of delivery of each product. The only thing to be determined by the parties is the price, which is freely negotiated between buyers and sellers.
Futures markets serve two main economic functions: they discover or inform about the future price of a product. In this way, for example, the producer who sows wheat, knows at the time of sowing what will be the expected price at which he will be able to sell his harvest.
They allow risk transfers: The so-called hedgers (or hedgers) can transfer the risks of price fluctuations to speculative agents who are willing to assume them. In this way, futures markets allow an efficient distribution of risk between hedgers and speculators.
Today there are a large number of futures and options contracts that are traded in markets around the world. These contracts range from agricultural products to Treasuries, oil, gold, frozen shrimp, fertilizers, stock indices, currencies and interest rates.
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To conclude, we suggest the following video-course in which Professor Xavier Puig, from Pompeu Fabra University, makes a didactic explanation about the futures market, presenting its basic concepts and delving into topics such as speculation with futures, hedging with futures., trading with futures in practice and futures on stock indices. Excellent material to better understand how these financial instruments operate. (6 videos, 2 hours and 38 minutes)
