In this lesson, you’re expected to learn about:
Futures contracts are very similar to forward contracts, except that future contracts are highly standardized in a number of ways:
· Futures contracts must be for a similar commodity of a standardized type and quality.
· Each futures contract must be for a standardized quantity.
· Futures contracts must be in a single currency determined by the location of trade.
· Futures contracts must have a standardized delivery date.
Basically, futures contracts of a single type must all be completely identical. This allows futures to be freely bought, sold and traded. The buyer of a futures contract is obliged by the terms of the contract until it’s resold.
As a result, unlike forward contracts, futures are highly liquid; i.e. they’re sold in high volume and high frequency on markets (much like shares).
Although futures are less customizable than forwards, they’re still very common as a form of risk management. After all, futures are extremely easy to buy and sell for companies that produce or purchase goods that are available for future contracts for market trade.
The initial contract sale by the producers, called the primary market, is quite easy to make and then the contract is likely to change hands many times before the delivery date. It can be traded on the secondary market between investors.
Futures are far more viable as a method of revenue generation than forwards, but buying and selling futures strictly to generate revenue can be very dangerous. Like shares, people purchase futures with the expectation that the price is going to change dramatically, and then resell the contract to the seller or the buyer.
The aim is to sell these contracts before the delivery date for more than you paid for them or for less value than the delivery if you decide that you want the goods underlying the contract.
Valuation methods of a futures contract are the same as those of a forward contract.
However, the increased liquidity in futures allows for additional strategies involving them that more closely resemble share investing strategies, instead of simply hedging (attempting to minimize) the risk of the exchange of the assets underlying the futures contract.
Companies can apply swaps to a number of different things of value, usually currency or specific types of cash flows. Swaps allow companies to benefit from transactions that otherwise wouldn’t be available to them in a timely or cost-effective manner.
They are typically done through a swap broker; a company that deals in swaps and makes money off the bid-ask spread (the difference between the bid price and ask price) on these exchanges.
Swaps are used to manage risk to ensure favorable cash flows, either through timing or through the types of assets being exchanged.
Let’s use an example to understand how this works.
Suppose that Company A owns $1,000,000 in fixed rate bonds earning 5% annually, which is $50,000 in cash flows each year. The company thinks that interest rates are going to rise to 10%, which will yield $100,000 in annual cash flows ($50,000 more per year than their current bond holdings). But exchanging all $1,000,000 for bonds that yield the higher rate is too costly.
– Company A goes to a swap broker and exchanges, not the bonds themselves, but the company’s right to the future cash flows.
– Company A and the swap broker continue to exchange these cash flows over the life of the swap.
In this example, swaps help Company A to mange its risk by making available to it the possibility of altering its investment portfolio without the costly, difficult and sometimes impossible process of rearranging asset ownership. As a result, Company A makes an additional $50,000 per year in bond returns.
When pursuing opportunities to generate revenue through swaps, the process is no different than in Company A’s scenario in the example above, but the motivation behind the swap is to take advantage of differentials in the spot rate and anticipated future values related to the swap.
When using derivatives to generate income, there is always potential for loss. The term ‘speculate’ can mean to engage in the buying or selling of a commodity with an element of risk on the chance of profit but it can also mean to guess.
The value of a swap isn’t difficult to measure. You start with the value of what you’re receiving plus any added value that results from changes in rates or returns, and then you subtract the value of what you’re giving away plus any increases in value associated with interest earned or changes in rates.