Futures and Commodities - Essay Example

Futures and Commodities Number: Paper: Futures and Commodities Summary- Future and Commodities Futures and commodities form a part of derivatives that are used to hedge financial risk that are prevalent in the financial markets. It enables the parties to hedge trade specific financial risks i.e. currency, equity, commodity price risk and interest rate risk. Hence, derivatives are used for managing personal fund of an individual who is engaged in trade in the financial market. In an extreme volatile market, the future contract helps an individual to reduce risk that is associated with a certain transactions that will take place in future. However, commodities are exchanged over the counter and it is subject to price change due to fluctuations in the financial market. Consequently, the traders consider it necessary to reduce the risk of losing fund due to price fluctuations of the commodities. Future contract According to Madura, future contract refers to the agreement that exists between two parties i.e. seller and buyer so as to sell or buy a commodity at a date in future. The trade takes place in futures exchange and follows a regular settlement procedure. These contracts are traded in an organized exchange and are not transacted over the counter (Madura 202). This agreement defines a promise made between the parties to exchange a commodity at a future date at a price that is fixed at the time of contract. It allows holder of the contract to enjoy the right to buy or sell an underlying commodity at a future date. Different types of futures The different types of futures contracts are as follows: a) Stock and Index Futures: These futures are employed for trading, investment and hedging. In this case, the risk is hedged against the shares or equities index options. The prices of the stock and index futures are determined by the cost of holding the same in a long position. It is traded at risk-free interest rate. b) Interest Rate futures: This particular contract is prepared between two parties for an underlying commodity that pays interest. It is an agreement that promises the delivery of commodity at a future date by paying a particular interest that is ascertained at the time of formation of contract (Kapoor 369). c) Foreign exchange futures: It is defined as a future contract that is transferable in nature. The contract specifies the price at which a currency is sold or bought on a date in future. It helps the investors to hedge against foreign exchange risk. d) Bullion futures: Bullion futures basically refer to an agreement that exists between two parties against bullion commodities i.e. gold, silver or platinum. The assets are exchanged on a future date at a price, which is fixed on the day of contract. The price of gold is subject to fluctuations over the passage of time. Thus, bullion features enable the trader to receive a fixed amount for gold even if the price decreases (Madura 213). Commodities Commodities are the assets that are traded in the financial market. These assets bear fluctuating price, which can bring in loss to the traders and even profit in case of a bull market. The commodities are stocks and foreign currencies with significant value that are subject to changes. So, commodities are traded in the financial market with the help of hedging instruments such as, futures, forwards, options and swaps, in order to reduce the risk of losing the investment. Options Options contract refers to the agreement that is formed between a seller and a buyer. It provides the purchaser with an opportunity to exercise the right to sell or buy a specific asset or commodity on a date in future at an agreed upon price. These contracts are used while exchanging securities, real estate and commodities. The option purchasers are buyers and are known as holders. The seller in this respect is termed as the writer. The writer is responsible for fulfilling the terms and needs of the contract by way of delivering appropriate assets or commodities to the holders on a specific date fixed while preparing the contract (Madura 245). Different types of options There are two types of option contracts: call and put options. Call options give an opportunity to the holder of the contract to exercise the right (and not the obligation) to buy a commodity at a particular price for a specific period of time. The put option provides the holder of the contract with the right to sell a commodity at a particular price or strike price. The writer of put option is bound to purchase stock at strike price. Use of this derivatives by the arbitrageurs In both future and option market, arbitrageurs have earned small profits by bearing little or large amount of risk. In order to earn out of these contracts, an arbitrageur should exercise long position at a lower price and sell the same at overpriced position (Whale 236). Risk and skill level of the arbitrageurs The arbitrageurs are adequately skilled to take a right decision at the right time. They have huge experience in these kinds of trade and are able to bear the risk of losing the invested amount, if the market conditions are not favorable for making the investment. Day trading versus hedging In day trading, a trader looks for the perfect position during the whole day and trades accordingly to earn profit. Even so, during hedging, a hedge fund manager waits for a right moment during a month so as to trade and earn profit (Madura 296). Use of options and futures The options and futures are used for hedging risks that are associated with foreign exchange and commodity price. The change in price of a commodity is subject to market conditions. The uncertainties in financial market affect the price of share and other assets, which brings loss to the investor. Therefore, in order to reduce the risk of change in commodity price, hedging is required. The same concept is true for the fluctuations in foreign exchange rates. As a result, hedging is essential in the financial market. Works Cited Kapoor. Personal Finance. New York: Tata McGrawHill. 2001. Print. Madura, Jeff. Personal Finance. New Delhi: Pearson Education Inc. 2007. Print. Whale, Robert E. Derivatives: Markets, Valuation, and Risk Management. New York: John Wiley & Sons. 2006. Print. Read More