A futures contract is an agreement whereby two persons (natural or legal) agree to sell and buy, respectively, an asset, called the underlying asset, at a price and at a future date according to the conditions set in advance by both parties.
Example: Mr. X, who needs to make dollar payments within 3 months, agrees to buy $ 1,000 from Mr. Y, who will receive that amount for an already agreed transaction. Both parties agree that the transaction will be carried out at an exchange rate of 0.75 euros per dollar. Within 3 months, regardless of what the euro / dollar market quotation is, Mr. X will be obliged to buy the $ 1,000 at the fixed rate, and Mr. Y will be obliged to carry out such sale.
When concluding the transaction, Mr. X (buyer of the futures contract) expects that, within 3 months, the exchange rate will be above 0.75, while Mr. Y (seller of the futures contract) maintains the opposite expectation. If Mr. X was right, the price would be, for example, at 0.80, so if they went to the market, they would have had to pay a total of 800 euros (0.80 x € 1,000) to get the $ 1,000. Therefore, they would have saved € 50 (800-750). This profit equals the loss suffered by Mr. Y, who could not have sold their dollars at 0.80, but at 0.75.
On the other hand, if the correct expectation were that of Mr. Y, the price within 3 months would have been, for example, at 0.70. In this way, they would have sold the $ 1,000 for € 750, getting a profit of € 50, which would be equal to the loss incurred by Mr. X.
If the quotation equals the contract price, neither party would have a profit or loss.
Futures contracts can be of two types:
- Standardized, in which the nominal amount, subject matter and expiration of the contract are already determined. These contracts have the following characteristics:
- They are traded on organized markets, so they can be bought or sold at any time, without having to wait for expiration.
- The counterparty risk is assumed by the Clearing House, which, in order to guarantee full compliance with the contract, forces investors to provide certain margins to the market and, in the event that the margins provided are not sufficient to face possible losses, the Clearing House sets a level from which the investor will be required to provide new margins. In addition, there is a daily mark to market.
- Traded on an unregulated market (OTC), in which the buyer and seller negotiate the terms of the contract.
- When trading in an unregulated market, both parties take the counterparty risk, which refers to the fact that the opposite party does not comply with the obligations included in the futures contract.
- The liquidity risk of futures contracts traded in OTC markets is quite high, since they are traded to meet the specific needs of the parties.
The purposes that can be pursued when trading futures are the following:
- Speculation: Anticipate the market based on the prospects that the investor has about it. Thus, if you consider that the market will have an upward trend (increase in the price of the underlying asset), it will be suitable to buy futures, since this will allow you to acquire the underlying asset in the future at a price lower than the listing price, while with a bearish perspective (fall in the price of the underlying asset), the investor will be interested in selling futures, since this will allow them to sell the asset at a price higher than that its listing price.
The advantage of futures trading instead of directly purchasing assets is that the full price does not have to be paid at the time the contract is concluded, with the ensuing leverage effect.
- Hedging: Sometimes, futures trading is not due to a speculative purpose, but rather to the investor’s interest in protecting their portfolio from possible decreases in value. Such hedging consists of taking, through financial derivatives, a forward position contrary to the existing one. In this way, the investor can ensure that the changes in the price of the assets in the portfolio have a neutral effect on the result, since if, for example, the investor holds shares whose price falls but at the same time has sold a futures contract on the same shares, the result of the transaction will be neutral.
- Arbitrage: Its purpose is to take advantage of the inefficiencies of the market in those cases in which the price of the asset (spot) is not equal to its forward price. Thus, what an arbitrageur does is operate simultaneously through opposing positions in the spot (traditional market) and forward (derivatives market) markets. Therefore, they will act in one market as a seller and in the other market as a buyer.
