A future is an agreement to sell a standard quantity of an underlying asset at a future date. We have already discussed this in general terms under derivatives, and we have seen how futures contracts apply to real assets such as commodities. In contrast to options, where there is no obligation to buy the underlying asset, futures contracts normally require the buyer to take delivery of the asset. As a rule, private investors are likely to be more interested in financial futures rather than those where the underlying assets are real. However, it must be stressed that financial futures are suitable only for experienced and knowledgeable investors.
A futures contract is in effect a pledge to make a certain transaction at a future date. Futures are transferable and can be traded through a futures exchange such as Euronext (LIFFE). The contracts contain standardized terms and are regulated by an appropriate body and guaranteed by a clearing house. Because of the obligation to close the contract, futures require the parties to make a margin payment (part of the contract price) that is normally settled daily.
The underlying assets are currencies, bonds, market indices, and interest rates. The risks for the parties in a futures contract are unlimited, and traders normally hedge their trades to reduce their exposure to unexpected changes in the price of the underlying asset.
To illustrate the risks of dealing in futures, in 1995, a major UK bank, Barings, was effectively bankrupted by un-hedged trades involving Nikkei Dow futures carried out by Nick Leeson operating in Singapore. (buy the book Rogue Trader by Nick Leeson here). There have been a number of other high-profile financial disasters involving futures. Typically, a large trading company will use futures contracts to buy currency forward to pay for future supplies of goods or raw materials in overseas markets. Similarly, banks and mortgage companies will use futures to hedge against adverse changes in interest rates. However, if these futures trades turn out to be profitable in their own right, there is a temptation to use futures as speculative instruments rather than hedges, and the risks are very substantial.
For example, Metallgesellschaft AG, a German company originally involved in metal manufacturing, lost $1.5 billion through trading futures contracts in oil.
|9 October, 2008 © 2008 K.R.Wade and Co Ltd|