Commodities in the financial world include stocks, bonds, and currency. You may not think of currencies, stock indexes, and interest rates as commodities, but they are. Money is as much the raw material of domestic and international trade as wheat is the raw material of bread.
Just as farmers, mining companies, and jewelry manufacturers can be dramatically affected by changes in the price of corn, copper, and gold, so changes in currency values, the direction of the stock market, or interest rates can have an enormous impact on investors.
How do Financial Futures work?
Foreign currency, stock indexes, and interest rates serve as fundamental assets for financial futures. Like other commodities, financial futures contracts trade on specific exchanges, often among the most actively traded products.
Because they provide all financial institutions with cost-effective transaction services, financial futures have become essential to the financial sector. Depository institutions use them to adjust the risk exposure of their asset/liability mix, by market-making securities dealers to balance the risk of their inventory, and by portfolio managers to hedge their income-producing assets.
Index futures can be used to make predictions about index movements in the future. Portfolio managers use index futures to protect their equity positions against decreasing share prices.
Currency futures are one of the types of financial futures. This futures contract allows you to buy or sell a currency at a predetermined rate in terms of foreign currency (such as the euro against the dollar, for example) at a future date. Speculators and those seeking to hedge risks both use this. Stock futures are another category of futures. Trading stock futures has several advantages. Leverage is the biggest.
Financial futures contracts expire every three months, in March, June, September, and December. This helps to explain the so-called triple witching day, which takes place on the third Friday of these months and sees greater buying and selling due to the increased volatility that day brings about.
What are the functions of Financial Futures?
To hedge against this possibility, the company may sell pound futures. Then, if the value drops, the company can use the futures transaction’s profit to offset the losses on the invoice payment.
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There are hedgers in the financial futures market as in other futures markets. Pension and mutual fund managers, securities firms, and international companies, to name a few, rely on financial commodities to run their businesses or meet their obligations to clients. So they use financial futures to protect themselves against unexpected losses or reduce purchase costs. For example, a US company that sells its product in England and is paid in British pounds must convert the pounds to dollars before recording the payment on its books. If the product’s price is fixed and the pound’s value falls against the dollar, the US company is, in effect, paid less for its product since the pounds will convert into fewer dollars.
As in other futures markets, speculators keep the markets active by constant trading. Speculators buy or sell futures contracts depending on which way they think the market is going. World politics, trading patterns, and the economy are unpredictable factors in these markets. Rumor, too, plays a significant role.
Once every quarter — in the third week of March, June, September, and December — stock options, stock index options, stock index futures, and single stock futures all expire at the same time. The phenomenon, which can trigger intense Friday trading to resolve all open positions before the deadline, is known as quadruple witching day.
Financial speculators are no more interested in taking delivery of $100,000 in Treasury bonds than grain speculators are in 5,000 bushels of wheat. What they’re interested in is making money. So, at what seems to be a good time, they liquidate a contract they own and take their profits. Or they may act to cut their losses.
How do Security Futures work?
You can buy or sell contracts on single-stock futures (SSF) and narrow security indexes. Like other futures contracts, these highly leveraged products may provide substantial profits but expose you to the risk of major losses if your expectation is wrong.
A single stock contract generally represents 100 shares, which you must deliver at expiration if you’re short the contract or purchase if you’re long unless you neutralize this obligation with an offsetting trade. However, offsetting may be expensive or difficult to execute as expiration nears.
So though they may seem similar, you don’t want to confuse stock futures with stock options. A major difference is that while the most you can lose as an options buyer is the premium you paid, with a single stock future, your losses are potentially limitless.
What is the role of over-the-counter?
Institutional investors, such as corporations, financial institutions, and public agencies, use over-the-counter (OTC) contracts to manage financial risk by hedging their long-term commitments to buy, sell, or lend — especially when the deal involves multiple currencies. They work directly with dealer banks to handle the transactions, which specialized traders typically negotiate.
Because of their complexity and the extent to which they may be leveraged, OTC derivatives can pose potentially large risks. The deals usually don’t require collateral and no exchange or clearinghouse guaranteeing that the parties will make good on their commitments. And because these derivatives are tailored to specific requirements, they’re often highly illiquid.
What Are Financial Futures? Types, Examples by Inna Rosputnia
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