Futures Contracts in Risk Management Companies Can Use Trading on a US Exchange - Essay Example

Futures contracts in risk management companies can use trading on a US exchange Executive Summary Futures contractsrequire two parties in order to be executed. It requires a buyer and a seller for complete transactions. The main reason for engaging in a futures exchange is to prepare stakeholders for any eventuality and be in a position of making appropriate decisions. The commodity items that are used in these transactions are intangible. These commodities include stocks, indexes and treasury bonds. A successful futures trade is referred to as a Cognito while an inverted futures trade is called a backwardation. Table of Contents Executive Summary 2 Introduction 4 Literature Review 5 Commodity futures charts 7 Crude Oil & Natural Gas 7 Refined Products 8 Emissions 8 Gold 8 Silver 8 Futures Contract Case study 8 Natural rubber futures trading in Thailand 8 Conclusion 11 References 12 Introduction A futures contract is an accord between two parties who have agreed to buy or sell a particular commodity of an agreed quantity. The agreement is based on a future transaction in which the commodity will be paid for in future at a time agreeable by both of the parties. This term is common in finance. These contracts are done on mutual consent negotiated at futures exchange acting as an intermediary. The partner who has agreed to purchase the asset in question is referred to as a long whereas the party who sells the given asset is said to short. The price agreed upon by both of the parties is the strike price. This means that the parties have agreed that the price is fair, and they will follow the accord. In this type of transaction, the buyer hopes that the price quoted in the transaction would rise in the future while the seller hopes that the price would decrease in the future. After the deal is sealed the buyers and the sellers would monitor the activities of the futures until the specified date comes. This trading method does not incorporate the usual products for trading. Literature Review A number of articles, journals and books have been written to discuss this for of trading. Usually the commodities that are involved are items that include; treasury bonds, currency, stocks and other intangible financial commodities. Sometimes futures’ trading is based on referenced commodities like interest rates (JORION, 2011, 39). The parties taking part in a futures trade do it to reduce the risk of losses that could be incurred by either of the parties. The parties are required to set up an agreeable amount of money known as the margin to cushion them. In the case the futures price keeps changing every day, the difference between the daily futures price and the first agreed upon price is settled by the margin that had been deposited by the buyer and the seller. This difference also referred to as the variation caters for and covers the daily profits and losses incurred by both the buyer and the seller. Once the margin variation goes beyond the initial deposited margin, a margin alert is made to the owner of the account to restock the account so that both the buyer and the seller have an appropriate daily profit and loss amounts. This exercise is referred to as marking to market (JAMES, 2008, 97). After all this done, the price that is traded upon is the spot value since both the profits and losses incurred by both seller and buyer has been settled. On the day of the specified contract, both of the parties are required to fulfill their part of the bargain and deliver commodity as per the contract (Frazer & Simkins, 2010, 302). In case it was cash that was involved in the trade, the party who incurred the loss is supposed to pay the party that made a profit. In the event one of the parties is not willing to proceed with the transaction, he or she has an option. They can take the opposite position on another futures contract and using the same asset but the date and time remain the same. The difference that comes after that is then a profit or a loss. Taking the side of one of the parties is a sign that one of the traders is conceding that whatever predictions they made might be wrong. When one is involved in a futures contract with an objective of reducing the price risk, the activity is referred as hedging. It is not recommended to hedge out all risks that are faced by a business. It may not make sense as the applications are not the same. One such risk is the quantity that involves that the business restrategizes its activities so as to cover the risk. When a client hedges with futures, he or she is expected to take the opposite position that is held in a cash market. Firms holding a long cash position then sells the assets that they have, they are said to have a short hedge to protect them. On the other hand firms hold a short cash position then sells their assets to protect from upward price experience is the cash market are said to have a long hedge. This is likened to an anticipatory hedge, where the client is sure that the prices are expected to rise so they take measures to protect from the upward price exploitation. When the price that had been stated in the futures contract differs from the price that is tagged in the product in the cash position the event is called a cross hedge. A single firm can hold both of the two risk management strategies at the same time (AL-AMINE, 2008, 78). They can hold the short hedge and long hedge but for or different prices. In the absence of a futures contract, a cross contract is applied. It is recommended to use assets whose prices changes are as high as the estimated spot asset price. It is very vital for anyone who is about to engage in any contract to assess the liquidity of that particular asset. When delivering the asset for the contract, it should be done in proper consideration of the date that the hedge has been lifted. The different types of hedges in stabilizing prices are stripped hedges and a stock hedge. A strip hedge is applicable when there are different delivery dates of the futures contracts. A stack hedge is applicable where the most notable or applicable where the most nearby and liquid contract is used. It is rolled over to the next to nearest contract as time goes by. An instance that is applicable to the futures contract is a firm the exports a certain quantity of oil and realizes that the price would rise or fall (KOLB & OVERDAHI, 2010, 307). If the price rises, the firm would apply a long hedge to reduce the risk and if the price fells the firm would apply a shot hedge to help them reduce the risk. The firm can decide to categorize their contracts for specific quantities at specific times (CHANCE & BROOKS, 2010, 304). For instance, 7 contracts to be delivered for every quarter of the year. This instance of delivery is called a strip hedge. If the firm trades a certain quantity of contracts say 50 for a specific time period like a month. Then offset them on the second month while trading other contracts. This trading process is called a stacked hedge. The trading sessions tend to alternate with one another. The end of one transaction session is the end of another transaction session. Immediately one transaction ends, the other one starts immediately. Commodity futures charts Crude Oil & Natural Gas Commodity Units Price Change % Change Contract Time(ET) Crude Oil (WTI) USD/bbl. 87.95 -0.33 -0.37% Jan 13 07:26:44 Crude Oil (Brent) USD/bbl. 111.02 -0.36 -0.32% Jan 13 07:26:35 TOCOM Crude Oil JPY/kl 54,680.00 -70.00 -0.13% Apr 13 07:30:18 NYMEX Natural Gas USD/MMBtu 3.77 -0.13 -3.36% Dec 12 07:26:3 Refined Products Commodity Units Price Change % Change Contract Time(ET) RBOB Gasoline USd/gal. 273.84 -0.55 -0.20% Dec 12 07:25:43 NYMEX Heating Oil USd/gal. 306.99 -0.72 -0.23% Dec 12 07:25:43 ICE Gasoil USD/MT 955.50 +1.00 +0.10% Jan 13 07:26:35 TOCOM Kerosene JPY/kl 67,440.00 -10.00 -0.01% May 13 07:30:19 Emissions Commodity Units Price Change % Change Contract Time(ET) ICE ECX Emissions EUR/MT 7.00 -0.01 -0.14% Nov 12 04:14:12 Gold Commodity Units Price Change % Change Contract Time(ET) COMEX Gold USD/t oz. 1,750.20 -1.20 -0.07% Dec 12 07:23:42 TOCOM Gold JPY/g 4,630.00 +1.00 +0.02% Oct 13 07:28:59 Gold Spot USD/t oz. 1,751.05 -1.95 -0.11% N/A 07:33:30 Euro Spot EUR/t oz. 1,350.48 -0.66 -0.05% N/A 07:33:53 British Pound Spot GBP/t oz. 1,093.41 -0.35 -0.03% N/A 07:33:51 Japanese Yen Spot JPY/t oz. 143,776.42 -651.53 -0.45% N/A 07:34:00 Indian Rupee Spot INR/t oz. 97,433.70 +308.70 +0.32% N/A 07:33:28 Silver Commodity Units Price Change % Change Contract Time(ET) COMEX Silver USD/t oz. 34.24 +0.03 +0.10% Mar 13 07:23:44 TOCOM Silver JPY/g 90.00 +0.10 +0.11% Oct 13 06:49:01 US Dollar Spot USD/t oz. 34.20 +0.11 +0.32% N/A 07:33:50 Euro Spot EUR/t oz. 26.37 +0.11 +0.42% N/A 07:33:53 British Pound Spot GBP/t oz. 21.36 +0.11 +0.52% N/A 07:34:02 Japanese Yen Spot JPY/t oz. 2,807.67 +1.08 +0.04% N/A 07:34:05 Indian Rupee Spot INR/t oz. 1,902.99 +13.96 +0.74% N/A 07:33:50 Futures Contract Case study Natural rubber futures trading in Thailand This case study was performed to analyze the progress of the natural rubber futures that were traded at the agricultural futures trade of Thailand. Theories and numerical evidence are also to be examined to look into the trading in detail. Thailand is the world’s largest producing Natural Rubber in the World. With the intention of reducing the price risk it is looking into strategies to reduce uncertainty in the rubber market ( Coyle, 2007, 211). They also intend to improve the price innovation mechanism while providing Thailand with a clear picture of the current and the future trading dynamics. This move helps to reduce uncertainty and enable the market players have confidence in their products. Apart from rubber, the futures market also has contracts for white rice and tapioca starch of premium grade. These two products together with the rubber are considered to be traded in the Agricultural Futures Exchange of Thailand (AFET). The contracts are divided into six contract months that are nearest the contract month. These trading ventures should help create an efficient and effective trading system that would serve as an indicator for the market players in times of uncertainty. It can also be used as an instrument to help hedge the price risk and future price trends that causes uncertainty. The trading platform referred to as the bourse has several members including; 17 brokers and two brokers. Buyers and sellers who are not members complete their trades through brokers who are trusted by the bourse. There are already three futures markets in the world. They include the Tokyo Commodity Exchange (TOCOM) The Osaka Mercantile Exchange and the Singapore Commodity Exchange the Singapore commodity exchange is also another active futures market. Studies have shown that there is a relationship between several contracts in the Natural Rubber market (FABOZZI, 2001, 335), They are all linked to the operations of hedging. Futures prices are determinant factors for physical prices. The movements and occurrences of the two prices are similar considering the fact that futures pricing is widely used for physical trading all around the world. The prices are poised to increase when the demand is high and decreases when the prices are low. Sometimes the futures prices and physical do not move at the same rate even though they move towards the same direction (GEMAN, 2008, 108). The difference between the two may vary considering their increase or decrease. The increase in the interest rates while everything else remains constant may result in lower physical prices but with higher futures prices. These two contracts are interrelated such that the futures prices lead or guide the physical prices. When the physical market is in constant situation, the prices of spot and nearby futures price remain low as well as the, distant futures. This process is referred a normal contago or a forwardation market. The opposite situation is called a backwardation otherwise known as an inverted market. The reason why the contago situation is normal is that the stockholders tend to sell their inventories in a bid to make more profits. The inverted process turns out to be the opposite. This operation is likely to depress the spot process and stimulate the futures price. The occurrence of a premium is most likely especially when the available supply becomes tight as compared to the current demand. Limiting a premium on the spot price is dependable on the extent of the scarcity of a certain commodity at that particular time (BORODOVSKY, et al, 2000, 112). Discounting on the futures depends on the supply and demand situation. Theses discounts are also influenced by seasonal changes that occur from time to time. There is evidence on the activities carried out for the purpose of indicating what to expect on Natural Rubber. There is a chance of a backwardation happening due to the inelastic nature of the tyre market. This is as a result of hedgers being short in futures and they are willing to pay speculators who are long in futures and are always willing to take the risk premium (PAPADOPOULUS, 2011, 311). Once the market becomes efficient it is reasonable to state that the effect of storage and carrying will result in Natural Rubber being in a normal market. Evidence from the Japanese futures market indicates that the spot and distant prices move in the same direction. The normal market responds positively to the period when the prices seem to reduce. The inverted market responds positively to a period of rising prices. Conclusion A successful futures market requires several factors to succeed. For instance, the contract that is in trade must conform to conditions that relate to the physical market. This is likely to limit the chances of price distortion operations. Futures markets are operated so as to provide information for making manufacturing decisions. It is a necessity to have a future strategy that will last long enough to inform the market stakeholders about the risks they might face. This would enable them decisions that would protect their business interests. References AL-AMINE, M. A.-B. M. (2008). Risk management in Islamic finance: an analysis of derivatives instruments in commodity markets. Leiden, Brill. Bloomberg. (2012). Stock futures. http://www.bloomberg.com/markets/stocks/futures/. Last accessed 26/10/2012. BORODOVSKY, L., & LORE, M. (2000). The professionals handbook of financial risk management. Oxford [u.a.], CHANCE, D. M., & BROOKS, R. E. (2010). An introduction to derivatives and risk management. Mason, Ohio, South-Western Cengage Learning. COYLE, B. (2000). Currency futures. Canterbury, Financial World Pub. and BPP. England, Wiley. http://www.books24x7.com/marc.asp?bookid=29483. FABOZZI, F. J. (2001). 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