Forward, Future, and Options Agreements
(part B)
by
Charles Lamson
Financial Futures
Prices of financial securities, stocks, and foreign currencies have become unstable during the past 40 years. Consequently, financial futures markets, which trade financial futures, appeared and are now used by most major financial institutions and other large corporations to manage risk.
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Financial futures are contracts in which two parties agree to trade standardized quantities of financial instruments on standardized future dates, according to the terms (including the price) that are determined today. Financial futures can be used to reduce to reduce the risk associated with future price changes of financial instruments.
The futures price is set by bidding and offering in an auction-like setting on the floor of the exchange. Each financial instrument that is traded usually has its own pit (trading area on the floor) where authorized brokers gather to buy and sell for their customers. Bid and asked prices (to buy or sell) are called out until the brokers become aware of the prices in the market. The most favorable transactions (from the point of view of both of both the buyers and sellers) are consummated. Once an agreement is struck in the pit, the transaction becomes depersonalized and the agents of the buyer and seller never meet again for that transaction. Instead, a clearinghouse, operated by the exchange, takes on the responsibility of enforcing the contract. Both the buyer and the seller rely on the clearinghouse to execute the transaction. Specifically, the seller looks to the clearinghouse to deliver, and the buyer looks to the clearinghouse to pay the amount due on the delivery date. In this way, the default risk associated with a forward transaction is greatly reduced because the clearing house of the exchange assumes the obligation.
The futures contract is a standardized agreement to make a trade at a later date. In exchange for the small brokerage fee, the clearinghouse of the organized exchange guarantees that the terms will be met. To facilitate this guarantee, the exchange requires buyers and sellers of futures to put up a performance bond, called a margin requirement, set by the exchange. Brokers are required to collect margin requirements from their customers before they make any futures purchases or sales. Note that the performance bond or margin is required of both the seller and the buyer and that the brokerage fee plus the margin requirements are relatively small compared to the dollar value of the futures agreement.
In summary, financial futures markets have experienced spectacular growth in the past 40 years because the financial world has become a much more volatile place and financial futures can be used to reduce risks associated with this volatility. Because interest rate swings are larger, the prices of government securities (or the value of any fixed-rate instrument) oscillate more rapidly and over a broader range. Stock prices now fluctuate over, and flexible exchange rates have increased the movement of currency prices, while foreign trade in goods, services, and securities has escalated sharply. Futures markets may be used to hedge all of these risks.
Recap
Financial futures are standardized contracts in which two parties agree to trade financial futures at a future date according to terms, including the price, that are determined today. Financial futures are different from forward agreements because the quantities and delivery dates are standardized, and thus, the brokerage fees are relatively small. Financial futures markets exist for government securities, stock market indexes, Eurodollars, and foreign currencies. Both the buyer and the seller have obligations and rights. Financial futures can be used to hedge the risk of future changes in prices or to speculate. Organized exchanges trade the standardized contracts.
*SOURCE: THE FINANCIAL SYSTEM AND THE ECONOMY, 3RD ED., 2003, MAUREEN BURTON & RAY LOMBRA, PGS. 439-445*
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