Concepts and Characteristics, Types of Financial Future Contracts- Stock Future, Index Future, Currency Future, Interest Rate Future and Commodity Future
Financial future contracts are contracts on fixed income securities, equity indexes and currencies. The investor can effectively improve the risk-return feature of his portfolio with the help of these financial future contracts. These include significant financial futures which are enormously used by the investors in the futures market.
Types of Financial Future Contracts
- Stock Index Futures
- Foreign Currency Futures
- Hedging with Stock Index Futures
- Interest Rate Futures
- Short Hedges
- Long Hedges
Stock Index Futures
Stock index future is first type of financial future contacts that indicate the promise to sell or buy the standardize units of certain index price at a particular future date. At expiration of the contract, there is no actual delivery mechanism. All matters are settled in the shape of cash. The requirements of the contract cannot be fulfilled by delivering 500 different stock certificates in the sufficient quantities by the hedgers or speculators. At delivery time, the value of index is known and it is convenient to debit or credit the account with the accrued losses or gains.
A speculator has forecasting about the progress in the overall stock market and therefore he makes a decision to purchase one S$P stock index future contract. Let’s assume that in early march the S$P 500 index is at 1415.70 and speculator purchases future contract of June S$P 500 at the agreed price of 1417.70. The futures contract is set at a dollar value 250 times the agreed price, so the buyer of the contract promises to pay at delivery date 1417.50x$50 or $354,425. After several weeks, the stock market progressed and the future contract now trades at 1420. It is decided by the investor to terminate the position and get his profit (1420-1417.70) x $250 or $575. It is important to clear that only net loss or gain changes hands. Stock index futures may offer large gains or losses and many people are attracted by the offering leverage of these contracts.
Foreign Currency Futures
One of the important ways of financial future contracts “Foreign Currency Futures”. At International Monetary Market of the Chicago Mercantile Exchange, foreign currency futures contracts are traded. In the country of issuance, they all are call for delivery of foreign currency to a bank of the clearing house’s selecting.
When foreign security is bought by the US investor, there are actually two relevant purchases. One of them is the actual purchase of the security. But before the purchasing of that security, US dollars must be exchanged by the investor for the necessary foreign currency. In fact foreign currency is purchased by the investor whose rice can change daily. Foreign exchange risk is developed for the investor from the changing relationships among currencies of interest. Small change in exchange rate can make large dollar difference.
The financial futures market rapidly grew with the use of catalyst of foreign currency futures. These future contracts are regarded as hedging vehicle for conveniently dealing with the foreign exchange risk by many large companies, which is the reason for the success of these contracts. Both hedgers & speculators are interested in the foreign currency futures.
Hedging with Stock Index Futures
Financial future contracts are hedged by the common stock investors for the similar reasons that fixed income investors utilize them. Substantial stock portfolio is held by the individual or institutional investors that includes the risk of the entire market. This systematic risk is partially or totally transferred through a future contract to those willing to take it. New and relatively inexpensive opportunities for investors are opened by the stock index futures for management of market risk through hedging. Financial futures can be used by the investors on stock market indexes to hedge against on entire market decline. The investors can sell sufficient number of contracts against a stock portfolio for the purpose of hedging against the market risk or systematic risk. The portfolio of the investor is protected from the market fluctuations through stock index futures contracts.
Interest Rate Futures
Investors are exposed to severe price movements because bond prices are highly volatile. The risk of volatile interest rates faced by the bondholders is transferred through financial futures. Investors and portfolio managers try to protect themselves against unfavorable movements in the interest rates, which is the main reason for growth in financial futures. The possible impact of the interest rates on the value of the securities should be considered by the investor while protecting his securities.
There are several interest rates future contracts that are considered by the investors in recent days and which are trading on many exchanges. Contracts on Treasury bill and one-month LIBOR rate as well as euro dollars are traded on the Chicago Mercantile Exchange. Longer maturity instruments are traded on the Chicago Board of Trade (CBT) like Treasury bonds and Treasury notes.
For most investors short hedge is the natural kind of contract as too much common stock is held by investors. Stock index futures are sold for hedging purpose by investors who hold stock portfolios. This indicates that these investors assume a short position.
The selling of forward maturity contract is used to implement the short hedge. The aim of this hedge is to counterbalance any losses on stock portfolios with profits on the futures-position. One or more index futures contracts would be sold by the investors in order to implement this defensive strategy. Conceptually, the value of these contracts would be same as the value of the stock portfolio. The decline in the market results into the loss on the cash position. As a result of this, there is also decline in the prices of stock index futures which provide an opportunity to make profit for the sellers of the futures.
When price increase the long hedger normally desires to reduce the risk of having to pay more for an equity position. Following are the main users of the long hedge
Companies that have regular cash flows use long hedge to better the timing of their positions.
Companies exchanging large positions which desire to hedge during the time it take to finish the process.