Dr Shamol Miah

Derivatives are financial instruments used by businesses to hedge against risks associated with currency exchange rates and interest rates. Businesses typically utilize futures and options contracts for this purpose. This article is written to provide a basic understanding of financial derivative to benefit students and trading individual who wants to learn about derivatives.  The following discussion will explore FUTURES contracts with examples.

FUTURES CONTRACTS

A futures contract can be defined as an agreement to buy or sell a standard quantity of a specified financial instrument or foreign currency at a specified future date at a price agreed between two parties. Futures and options both contracts are standardised, but futures contract is a binding contract locking buyer and seller into an agreed rate and an agreed amount: the buyer must complete the contract. When a company takes out a futures contract it has to place an initial margin, representing between 1 and 3 per cent of the contract value, with the futures exchange clearing house.

Example:

On £500,000 three-month sterling interest rate contracts, this could be a margin of £1,500 per contract. As the interest or exchange rate specified in the futures contract changes daily, money is either credited to or debited from the company’s margin account, depending on whether the rate change is favourable or adverse respectively. The cash-flow movements of a margin account are referred to as accounts being marked to market. If initial margin drops below a specified safety level, variation margin will be called for by the clearing house to top up the account.

Background:

Financial futures were first traded in the USA on the Chicago Mercantile Exchange (CME) in 1972. In 2007 the ‘Merc’ acquired the Chicago Board of Trade and formed CME Group, the world’s largest derivatives exchange. In the UK, the London International Financial Futures Exchange (LIFFE) was set up in 1982 to trade futures contracts. LIFFE merged with the London Traded Options Market (LTOM) in 1992 to form a unified UK derivative securities market. LIFFE was bought by Euronext in 2002 and renamed Euronext LIFFE, before merging with the NYSE in 2007 to become NYSE Euronext. In 2013 NYSE Euronext was acquired by the US-based Intercontinental Exchange group who then spun off Euronext via an IPO in 2014, retaining LIFFE under its new name of ICE Futures Europe.

Advantages and disadvantages of using futures to hedge risk

An informed decision on hedging with financial futures will consider the advantages and disadvantages of this risk management method. One advantage of futures is that, unlike options, there is no up-front premium to pay, although money must be put into the margin account. Another advantage is that, unlike forward contracts, futures are tradeable and can be bought and sold on a secondary market. This gives pricing transparency as prices are set by the futures market rather than by a financial institution. Finally, as contracts are daily marked to market, favourable interest rate and exchange rate movements are immediately credited to a company’s margin account.

Arguably the biggest drawback associated with futures is that, unlike options, they do not allow a company to take advantage of favourable movements in interest and exchange rates. A further problem is that, because contracts are standardised, it is difficult to find a perfect hedge with respect to the principal to be hedged and its maturity. Considering cost, while there are no premiums to be paid with futures contracts, the initial margin must still be found. Variation margin may also be required as interest or exchange rates move adversely. Finally, basis risk may exist if changes in exchange and interest rates are not perfectly correlated with changes in the futures contract prices, which in turn affects the hedge efficiency of the futures contracts.