Fundamentals of Futures - Market Dynamics RSS Feed

Hedgers: Minimizing Risk

CME Group — Tue, 23 Sep 2008 06:24:00 EST

Hedging is a primary function of the futures market. Hedging is the buying and selling of futures contracts to offset a particular risk.

1.Hedgers typically own a cash commodity (known as having a long position)
2.A perfect hedge eliminates all risk; perfect hedges are very rare
3.Hedgers can be anyone: farmers, pension fund managers, global companies, manufacturers

Speculators: Profit Seekers

CME Group — Tue, 23 Sep 2008 06:20:00 EST

Speculators trade in the futures market to profit from price fluctuations, and in doing so provide several vital economic functions by facilitating the trading of basic commodities and financial instruments:

1.Assuming risk in the hope of making a profit, not creating risk
2.Participating in the market provide liquidity and capital
3.Providing a mechanism for price discovery

Hedge Funds: A Special Class of Speculator

CME Group — Tue, 23 Sep 2008 06:00:00 EST

Hedge funds are a special class of speculator due to their high leverage, sophisticated computerized trading strategies and tremendous trading volume. Some things to know about hedge funds is that they:

1.Are private investment funds open to limited qualified individuals
2.Comprise between 30 - 50 percent of all trading activities in all financial markets
3.Do not act as “hedges”, rather use leverage to increase returns
4.Are not currently regulated

The Forward Market

CME Group — Tue, 23 Sep 2008 05:50:00 EST

The forward market provides a way for parties to pay “upfront” a fixed price for a product to be delivered at an agreed upon date in the future. This market is still common today, such as when you buy a house that is being built; but there are some limitations to this market such as:

1.Forward contracts lock in prices with a future delivery
2.Forward contracts can be specific and customized agreements
3.Forward contracts contain an element of default in the future

The Spot Market (OTC)

CME Group — Tue, 23 Sep 2008 05:45:00 EST

The Spot market, also called the over-the-counter (OTC) market, is an alternative to exchanges. There are some key differences between OTC and exchange traded derivatives:

1.OTC trades are typically larger and privately negotiated with specialized terms
2.OTC market is many times the size of exchange-traded derivatives
3.Exchanges offer better liquidity and transparency
4.Exchanges reduce risk of counter-party failure to pay

The Swap Market

CME Group — Tue, 23 Sep 2008 05:40:00 EST

The Swap market is relatively new, with the first swap contracts negotiated in the early 1980’s. Since then, swaps have grown to become a very important part of the OTC market, typically used for interest rates and currencies. A few features of swaps are:

1.They function by companies exchanging one cash flow for another (typically a variable cash flow for a fixed cash flow)
2.They are negotiated and transacted by major banks as OTC trades
3.The plain vanilla swap is the most common swap

The Futures Markets

CME Group — Tue, 23 Sep 2008 05:35:00 EST

The futures market has been around for centuries, providing a way for producers and buyers to minimize their risk. Non-Standardized forward contracts evolved into today’s futures contract, providing a safe, regulated environment for traders.

1.Futures contracts are legally binding, standardized agreement to buy or sell a standardized commodity
2.Traders set price for a specific quantity and quality of commodity on a specific future date
3.Counter-party risk is minimized by a clearing house
4.Contracts are regulated

History of Futures

CME Group — Tue, 23 Sep 2008 05:30:00 EST

Futures have been around for centuries, originating during our agrarian times as an effective method to manage supply and price variances.

1.Futures started as standardized forward contracts for agricultural commodities
2.Financial futures started in 1970s in the foreign exchange market
3.Interest rate futures started in 1976
4.Stock index futures started in 1980s

The Federal Reserve System

CME Group — Tue, 23 Sep 2008 05:25:00 EST

The Federal Reserve System, also known as the Federal Reserve or simply “The Fed”, is the central banking system of the United States. Through its control of the federal funds rate, the Federal Reserve is able to foster financial and monetary conditions consistent with its monetary policy objectives:

Maximum employment
Stable prices
Moderate long-term interest rates
Promotion of sustainable economic growth

The Bank for International Settlements (BIS)

CME Group — Tue, 23 Sep 2008 05:20:00 EST

The Bank for International Settlements (BIS) is an international organization of 55 central banks with the goal of establishing monetary and financial stability and liquidity:

1.Regulates capital adequacy
2.Maintains reserve requirements
3.Does not unilaterally “set” rates