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The Proper Hedging Strategy: Considerable Advantages for Hedgers and Speculator - Research Paper Example

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It is the purpose of this paper to discuss the role of the futures markets and futures contracts, their usefulness as well as their limitations for those who are in search of strategies to control risks. Later, we will choose one of the three indicated types of futures contracts…
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The Proper Hedging Strategy: Considerable Advantages for Hedgers and Speculator
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Download file to see previous pages A futures contract is a binding legal contract that calls for the future delivery of an asset (Hearth 614). It specifies the asset to be delivered, the delivery location, the amount or value to be delivered, the delivery date, and the price. There are two parties or positions involved. The long position agrees to accept delivery per terms specified in the contract, and the short position agrees to deliver the asset on the same terms. Not all futures contracts terminate with delivery, as one party may close out by taking the opposite position before delivery date. Speculators, who provide most of the market liquidity, normally reverse their positions, unlike hedgers. A futures contract is similar in many respects to the forward contract; however, in the case of the futures contract, gains and losses are realized on a day-to-day basis. In other words, they are marked to market at the end of each trading day, reflecting the price fluctuations to which the futures contract is subject. No such convention applies to forwards where gains and losses are only realized on the settlement date. Another difference is the fact that to open a futures trading account, one has to deposit with the broker a performance bond called an initial margin, intended to insure against the risk of substantial losses and default on the part of the futures trader. Such deposit can vary depending on the price volatility of the underlying asset or security and can range from 2 to 10 per cent. A third difference is that futures contracts have standardized provisions regarding contract size and maturity date so that they can be traded interchangeably in the organized exchanges such as the Chicago Mercantile Exchange or the Chicago Board of Trade. ...Download file to see next pages Read More
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