This essay aims at explaining futures and forward contracts, describing their origins and purpose of usage as well as regulatory requirements. Moreover, it discusses advantages and disadvantages.
Futures and forward contracts are financial instruments. More specifically, they are derivatives. Derivatives are financial contracts that derive their value from an underlying asset (Hirsa & Neftci, 2014). The literature distinguishes between physical commodities, such as corn or precious metals, and financial instruments, for example bonds, stocks or currencies, as underlying assets (Gottesman, 2016). Futures and forwards are agreements to buy or sell the underlying at a precise time in the future for a specified price, strike price. Their difference is that futures are traded on an exchange, whereas forwards are traded in the over-the-counter (OTC) market, meaning off-exchange trading directly between two parties (Hull, 2016). Consequently, futures are standardized, whereas forwards can be privately negotiated.
Table of Contents
1. Introduction
2. Main characteristics of futures and forward contracts
2.1 Example
3. History of origins and purpose of usage
4. Benefits
5. Comment on potential dangers and failures
6. Regulation of futures and forward contracts
7. Conclusion
Objectives and Research Themes
This report examines the fundamental nature of futures and forward contracts, tracing their historical evolution and practical utility. It aims to clarify the structural differences between these instruments, assess their primary advantages and associated risks, and analyze the regulatory frameworks that govern their use in financial markets.
- Key distinctions between exchange-traded futures and over-the-counter (OTC) forwards.
- Historical developments of derivatives markets, from ancient times to modern standardized exchanges.
- Strategic benefits of utilizing derivatives for hedging, speculation, and arbitrage.
- Critical analysis of systemic risks, ethical concerns, and market volatility impacts.
- Overview of national and international regulatory oversight in the financial sector.
Excerpt from the Book
2. Main characteristics of futures and forward contracts
Futures and forward contracts are financial instruments. More specifically, they are derivatives. Derivatives are financial contracts that derive their value from an underlying asset (Hirsa & Neftci, 2014). The literature distinguishes between physical commodities, such as corn or precious metals, and financial instruments, for example bonds, stocks or currencies, as underlying assets (Gottesman, 2016). Futures and forwards are agreements to buy or sell the underlying at a precise time in the future for a specified price, strike price. Their difference is that futures are traded on an exchange, whereas forwards are traded in the over-the-counter (OTC) market, meaning off-exchange trading directly between two parties (Hull, 2016). Consequently, futures are standardized, whereas forwards can be privately negotiated.
Figure 1 shows that OTC derivatives amounted to more than 500,000 billion USD, compared to 67,245 billion USD of exchange-traded derivatives. 5% of the total amount was allocated to futures (Jarrow & Chatterjea, 2018).
Summary of Chapters
1. Introduction: Outlines the scope of the report, focusing on the characteristics, history, regulation, and pros and cons of futures and forwards.
2. Main characteristics of futures and forward contracts: Defines derivatives and explains the fundamental differences between exchange-traded futures and OTC-negotiated forwards, supported by market data.
2.1 Example: Illustrates the practical application of futures using an oil industry scenario and explains the mechanics of profit and loss calculations.
3. History of origins and purpose of usage: Provides a historical overview starting from ancient civilizations to the establishment of the Dojima Rice Exchange and the modern Chicago Board of Trade.
4. Benefits: Highlights the roles of derivatives in price discovery, market liquidity, leverage, and risk management.
5. Comment on potential dangers and failures: Discusses the risks of excessive speculation, market distortion, and ethical issues related to leverage and commodity pricing.
6. Regulation of futures and forward contracts: Examines how different jurisdictions, specifically the U.S. and U.K., oversee these markets to mitigate fraud and maintain stability.
7. Conclusion: Summarizes that while these instruments offer valuable hedging capabilities, strict regulatory oversight remains necessary to prevent societal harm.
Keywords
Derivatives, Futures, Forward Contracts, Hedging, Speculation, Price Discovery, Market Liquidity, Leverage, Over-the-Counter, Commodity Trading, Financial Regulation, Risk Management, Clearinghouse, OTC, Strike Price.
Frequently Asked Questions
What is the primary focus of this work?
The work focuses on defining futures and forward contracts as essential financial derivatives, analyzing their historical context, and examining their benefits and systemic risks.
Which specific financial instruments are analyzed?
The report examines futures contracts and forward contracts as the two main types of derivatives under discussion.
What is the main objective of the report?
The goal is to provide a comprehensive overview of how these instruments function, why they are used, and the regulatory challenges associated with their trading.
Which methodology is applied?
The author employs a descriptive and analytical approach, drawing on established financial literature and case studies to explain complex derivative mechanisms.
What is covered in the main section of the report?
The main section details the technical characteristics, historical evolution, benefits like hedging and liquidity, and the dangers posed by improper use of these instruments.
Which keywords best describe this research?
Key terms include derivatives, hedging, speculation, price discovery, over-the-counter trading, and financial regulation.
How do futures differ from forwards?
Futures are standardized and traded on regulated exchanges, whereas forwards are privately negotiated between two parties in the over-the-counter (OTC) market.
Why is the example of the oil industry significant?
The oil industry example demonstrates how firms utilize futures to hedge against price volatility and improve the predictability of their future cash flows.
What is the ethical implication mentioned regarding speculation?
The report highlights that speculative activity in commodity markets can lead to food insecurity and distorted prices, which raises significant questions about ethical conduct in finance.
How has the regulation of these instruments changed?
Since the 2008 financial crisis, there has been an increased focus on regulating OTC derivatives, although organized exchanges remain the primary target of regulatory bodies like the CFTC.
- Citar trabajo
- Vivien Barth (Autor), 2019, Futures and forward contracts. Main characteristics, regulatory requirements, Múnich, GRIN Verlag, https://www.grin.com/document/513250
