Stocks, bonds, and currencies are the commodities of the financial world.
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 enormous impact on investors.
Like other commodities, financial futures contracts trade on specific exchanges, where they are often among the most actively traded products.
Expecting the unexpected
There are hedgers in the financial futures market as there are 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 to reduce the cost of purchases. 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 price of the product is fixed and the value of the pound falls against the dollar, the US company is, in effect, paid less for its product, since the pounds will convert into fewer dollars.
To hedge against this possibility, the company may sell pound futures. If the value drops, the company can use the profit from the futures transaction to offset the losses on the invoice payment.
Keeping markets liquid
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 the unpredictable factors in these markets. Rumor, too, plays a major role.
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.
What’s there to deliver?
The key difference between financial futures and other futures contracts is that most of the financial products are intangible, with no physical or accountable existence. This means there is nothing to deliver if the contract is not offset. In the rare circumstance when that occurs, the contracts are settled in cash.
Instead of dollars per gallon of heating oil or cents per bushel of corn, the value of an index contract is calculated by multiplying a fixed dollar amount by the current value of the index.
For example, a contract on the E-mini Standard & Poor’s MidCap 400 is determined by multiplying $100 times the index, and on the Dow Jones Industrial Average (DJIA) by multiplying $10 times the index. So if the S&P MidCap 400 was $1,360 at expiration, a futures contract on the index would be worth $136,000. Similarly, if the DJIA was at 17,300, a contract on it would be worth $173,000.
An interest rate futures contract is also cash settled. Its value is figured as a dollar amount times points of 100% to correspond to the way that bonds are priced. For example, to find the value of a five-year Treasury note, you multiply $100,000 times the closing price. If the note closed at 1.45, the value would be $145,000.
You can buy or sell contracts on single stocks futures (SSF) and narrow security indexes. Like other futures contracts, these highly leveraged products may provide strong 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.
You don’t want to confuse stock futures with stock options, though they may seem similar. 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.
Institutional investors, such as corporations, financial institutions, and public agencies, use over-the-counter (OTC) contracts as tools 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 are typically negotiated by specialized traders.
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 there’s no exchange or clearinghouse to guarantee 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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