Exploring Changes in Future Price Changes - Essay Example

………………………………………………………………………….xxxxxx …………………………………………………………………….xxxxxx …………………………………………………………………………xxxxx ………………………………………………………………………..xxxxx @2012 Exploring Changes In Future Price Changes Introduction In this report, the discussion revolves around future contracts, types of futures, history of futures, their use and the factors that influence price changes. The report will evaluate wall street journal relating to oil futures contracts. Understanding every element that play a role in influencing the price changes is of great importance for any economist. Economists and players in the money market need to be prepared for future contracts that are likely to influence the price changes in any way. This report aims at solving issues and problems related to future price changes and how best they can be used to best suit the needs of the market. Future contracts A future is contract between two parties to buy or sell a financial asset or instrument at a fixed future date and at a predetermined price as argued by Chandra, (2008). Futures are traded in the exchange which acts as an intermediary between the two parties. The terms of future contracts are standardized as they indicate what is to trade, when to trade and where to trade. There are three types of protections built-in to ease credit risk in the futures. One, the daily settlement which is is usually settled in cash basis is a major protection that plays a significant role in easing credit risk. Two, margin which the balance is kept in the accounts to cover several days’ worth of potential market to market transfers. It is necessary for every trader to understand this aspect of margin in reference to credit risk. Finally, the clearing house which guarantees transactions by insures daily settlement on market gains and losses. Forward contacts are not investments as a result it costs nothing to enter into the legally binding agreement. There are three ways of settling or closing out a contract. First, enter in an offsetting transaction. Two, make or taking physical delivery of the underlying commodity. Finally, cash settlement is another aspect that should be elaborated to traders entering into any form of future contracts. Over the counter forward contracts are flexible but they have their own disadvantages. They are unregulated as no formal body regulates the players in the market and they are only designated for specific needs. History of future contracts The first standardized future to be listed in the exchange was the Chicago Board of Trade (CBOT) in the year 1848 in the United States. Other major exchanges in U.S include New York Mercantile Exchange (1872), Chicago Mercantile Exchange (1874) and Kansas City Board of Trade (1882). In Europe futures contracts in the Exchange include London international financial futures Exchange (LIFFE) and Amsterdam, Paris, Belgium exchanges merged with LIFFE to create Euronext LIFFE. This also merged with the Lisbon Stock Exchange. Types of future contracts There are two types of futures, those that provide cash settlement and those that provide physical delivery for commodity. Commodity futures such as coffee require physical delivery on the agreed day. Stock index future contract is an example of a cash settlement contract. They are settled on cash on the basis of index number at the closing day. Treasury bond futures are settled through physical delivery of treasury bonds. Upon maturity, they have to convert into deliverable bond. A holder of short must deliver 100 treasury bonds must mature for at least 15 years. Treasury bill futures. Treasury bills matures after 3 months and that’s when the holder delivers its face value Currency futures. Most of the currencies are traded at banks on a cash basis. Usefulness of future contracts Future contracts have three uses. They are useful in hedging risk, speculating price changes and arbitrage. Every trader must search or try to understand the uses of future contracts before making a commitment to trade. a) Hedging According to Brigham (2009) a hedger is a person who is willing to purchase a commodity and is ready to reduce risks associated with it. There are so many uncertainties in hedging thus by locking in the price; the hedger is able to eliminate the ambiguity associated with price fluctuations. In real practice, it is impossible to fully neutralize risk. For example, if the financial asset to be hedged as a future contract is unavailable, a rational investor will alternatively buy a future contract in a different asset that closely follows the movement of that asset. Hedging can be either is long or short. Hedging long is suitable if a company knows that in future it will be purchasing a particular item. For example, let’s assume company Y knows that in six months it will buy 30,000 ounces of silver so as to fulfill an order. Suppose the spot price for silver is $13 per ounce and in the six months the price of ounce will be $12. By buying the future contract, the company will lock in the price of $12 per ounce. As a result, risk is reduced as the company will be able to close its futures position and buy 30,000 ounces of silver at $12 per ounce in six months. On the other hand, hedging short is suitable If a company knows that it will be selling a certain item. For example, let’s say Company Y must fulfill a contract in six months that requires it to sell 30,000 ounces of silver and the spot price for silver is $13 per ounce and the futures price is $12 per ounce. Company y would hedge short on futures contracts on silver and close out the futures position in six months. As a result, the company has reduced its risk by ensuring that it will receive $12 for each ounce of silver it sells. Hedging also helps in maintaining a competitive edge for companies apart from eliminating risk. The following are the disadvantages of hedging: Deep understanding of complex relationships is required in hedging If not priced well hedging might not work Finally, hedging profits have a tax impact since the unrealized gains or losses from the daily cash inflows are taxable. b) Speculation A speculator unlike a hedger is willing to accept risk that the hedger is willing to eliminate. The speculator plays an important role in the future prices because without him the markets would otherwise go liquid. When they anticipate that prices will go up, they buy the commodity. When they anticipate prices to decline, they buy. The speculator can be long or short (Brigham 2009). The buyer of the financial asset is said to be long as he expects the prices of the financial asset to go up. On the other hand, the seller is said to be short as he expects the prices of the financial asset to go down. In this case, a speculator benefits more when he is long than when he is short. The advantages of speculation include: Better liquidity Lower costs of transaction Can sell short in futures which might be impossible in the spot market Employs greater deal of leverage The disadvantages of using future for speculative purposes include: Huge losses can be incurred as a result of having lots of leverage Lots of free cash can be experienced from the margin calls c) Arbitrage Arbitrage refers to the opportunity to making risk free profit without making any net investment. In financial theory, there is no principle regarding arbitrage. Market imperfections sometimes allow for arbitrage. Contango market and the normal backwardation market The shape of the future curve plays a vital role to commodity speculators and hedgers. This is because both speculators and hedgers care about whether commodity future markets are Contango or normal backwardation markets. Contango and normal backwardation refer to price patterns. Factors that influence future prices The prices are influenced by factors such as the spot price, maturity and interest rate futures. a) Spot price Spot price refers to the current price and it is set by the market participants based on demand and supply. Contago occurs when future prices are above the expected future spot price. This implies that as new information brings them into line with the spot price, prices are falling over time. Normal backwardation is when future prices are increasing. This means that when the future price is below the expected spot price the market will be normal backwardation. b) Maturity Maturity for future contracts might be long or short. Future markets are normal when future prices are higher at longer maturities and contango when future prices are lower at distant maturities. c) Interest rates Interest rate affects the demand or supply of futures. Demand and supply is used in determining the spot price by the market participants. Therefore, interest rates determine the curve shape for demand and supply. The spot price is the price where the demand of a commodity equates its supply. Parameters that impact on future prices In considering these parameters, we take look at an article by Kimberly Amadeo “How Oil Prices Affect Gas Prices”. According to Amadeo, Oil prices are affected by demand and supply of oil. OPEC regulates oil supply in the global economy and to some degree, it controls the oil prices. The goal of OPEC is to keep the price per barrel at $70; this reduces the supply of oil in the market. If the price per barrel was low then supply would increase. U.S has oil reserves and supplies it when necessary. This impacts the oil prices. United States (U.S) is the largest consumer of oil in the world by 20%. Therefore, the high demand of oil in the U.S can lead to high oil prices in the global markets. The other factor that contributes to high oil prices is the future contracts traded on the commodities exchange. These prices fluctuate daily depending on investor’s speculation. The traders in the commodity exchange bid on the oil price based on what they think the future price will be. The speculated prices are based on the projected supply or demand of oil. Therefore, if the investors think that demand will increase because of the growing economy, then prices will go up. This can result can result to high prices even when there is plenty supply of oil at hand. Another recent article by Jen Alic “Oil Prices Dive 5% on Speculation and Mystery” also concerns oil prices. According to Alic, oil futures in New York closed at $95.29 per barrel on Tuesday and down by $1.33 on price that closed down Monday. On Wednesday, the prices further reduced to $92.26 per barrel the lowest price ever in that month. He points out that more supply of oil has contributed to the drop in prices. Saudis pumped more oil causing increased crude supplies in the U.S market and as a result the fall in price. Saudi Arabia had already announced its intentions to pumping more oil by exceeding the global demand by 1.6 Million barrels in a day and this lead to investors to speculate fall in oil prices. Another factor that led to the drop of oil price was an announcement by FedEx Corp on its intentions to cut its growth forecasts in 2012 on slimming profits. Conclusion The market from time to time experiences fluctuations and as a result most corporations prefer using futures to offset risks exposures. Therefore, the ultimate goal of a rational investor should be to minimize risk. Derivatives such as futures as we have seen from the discussion are recommendable and should be evaluated wisely before a contract is made. The economic condition of the country play an important role as it forms the basis for expectation of future price changes. Therefore, it is recommendable important to consider the growth aspect of the economy before making an investment in futures. This is because it is not a guarantee that a given price prediction will always work ion favor of traders. Traders making a commitment to future contracts must ensure that they understand every component related to their contract and how they influence price changes. References Alic, Jen, 2012. Oil Prices Dive 5% on Speculation and Mystery. http://oilprice.com/Energy/Oil Prices/Oil-Prices-Dive-5-on-Speculation-and-Mystery.html, accessed on November 29, 2012 Amadeo, Kimberly, 2012, How Oil Prices Affect Gas Prices, http://useconomy.about.com/od/supply/p/oil_gas_prices.htm, accessed on November 29, 2012 Brigham, Eugene F. & Joel F. Houston, 2009, Fundamentals of Financial Management, Cengage learning Chandra, Prasanna 2008, Financial Management, Tata McGraw-Hill Education Jorion, Philippe & GARP (global Association of risk professionals), 2009, Financial risk manager Handbook, John Wiley & Sons Read More