Future Contracts are legally binding accords in which one agrees to either buy or sell a certain financial commodity or instrument at a later date in time. Future contracts are standardized depending on what is being traded, the quantity, delivery time and delivery location for each specific commodity. Future contracts consist of secondary markets and can also be dealt numerous times much like a bond and opposed to a bank loan).
Future contracts are regulated commitments that detail the important features of a transaction such as: - Both the quality and quantity of what is being exchanged - The date the exchange is destined to occur - The method in which the commodity will be delivered - The buying price of whatever will be exchanged. For Example: British Pound Contracts: 62,500 (approx. $112,500), Japanese Yen contracts: 12.5m (approx $116,000), The Euro: 125,000 (approx $160,000), SF: 125,000 (approx $104,000), etc. Expiration dates may include: The third Wednesday of March, June, September, and December.
Currency future trading dates back to 1972 where they began at the Chicago Mercantile Exchange (CME), which began trading in 1898. It is currently the largest future exchange in the U.S. in four different product areas: interest rates, stock indexes, commodities and currency. How can one explain this new trend in which trading in many derivative markets blew up in the 1970s. The following are some explanations.
- Prior to 1973 there were fixed exchanges rates which meant that there was no currency risk.
- Interest rates for saving accounts (Reg Q.) checking accounts (i=0%) and some mortgages (this lead to "points") became fixed by federal law.
- Inflation was consistently low and stable, ranging between 2 and 3% from the 50s, through the 70s.
- T-bills interest rates were low and stable ranging between 1 and 2%.
- The price of oil also was low and stable.
There were several participants of currency future markets First there were Speculators who were exclusively involved with speculative bet/investment, while lacking any financial interest of what was happening with regards to the underlying commodity/currency involved.
There were also hedgers who were people with more of a business/financial interest in understanding what is happening with the underlying currency, using future trading to control minimize, or eliminate currency risk, e.g., MNCs, exporters, importers, banks, etc.
If a hedger is interested in the short term picture (long) and a speculator is interested in the long term picture(short), then one can say that the hedger is "selling" risk to the speculator or alternatively the speculator is buying "risk" from the hedger.
First lets look at Hedgers:
The details of hedging can be somewhat complicated but the principle itself is simple to understand. By either buying or selling commodities in the future market at the moment, individuals and firms can familiarize themselves with an approximate known price for something they will want deal (buy or sell) at a later point in the cash market. Buyers are thus able to offer themselves protection, also understood as hedging against-higher prices whereas sellers are now able to hedge against smaller prices. Futures can also be used by Hedgers to fix an acceptable boundary between their purchase cost and their selling price.
Whether the hedging strategy is to buy or sell, all hedgers in principle, are happy to give up the opportunity for large benefit that comes from favorable price changes in order to defend and protect themselves from large disadvantageous price changes.
