The Role of the exchange in futures Trading
Price discovery
As sellers offer to sell and buyers offer to buy in the pit, they
provide immediate information regarding the price of the futures contract.
The price is usually given as “Bid -Ask”.
E.g.: - Price for corn might be $2.40 bid, $2.42 ask, meaning a
buyer is willing to pay $2.40 a bushel, but the seller wants $2.42 a bushel.
Risk Transfer
In a futures transaction, risk is inherent part of doing business.
The exchange provides a setting where risk can be transferred from the hedgers
to the speculators.
Liquidity
If risk is to be transferred efficiently, there must be a large
group of individuals ready to buy or sell. When a hedger wants to sell futures
contracts to protect his business position, he needs to know whether he can
effect the transaction quickly. The futures exchange brings together a large
number of speculators, thus making quick transaction possible.
Standardization
The exchange writes the specifications for each contract, setting
standards of grading, measurement methods of transfer, and times of delivery.
By standardizing the contracts in this manner, the exchange opens the futures
market to almost anyone willing to hedge risk. In the pits, then, the auction
process is facilitated because only the price must be negotiated.
Functions of futures markets
The futures market serves the needs of individuals and groups who
may be active traders or passive traders, risk averse or profit makers. The
above broadly classifies the functions of the futures markets: -
1) Price Discovery
2) Speculation
3) Hedging
1) Price discovery
“Futures prices might be
treated as a consensus forecast by the market regarding trading future price
for certain commodities”. This classifies that futures market help market
watchers to “discover” prices for the future.
The price of certain commodity depends on the following factors:-
a) The need for
information about future spot prices
Individuals and groups in society need information not only for
generating wealth but also for planning of future investment and consumption.
E.g.- A furniture manufacturer, making plywood furniture for
printing his catalogue for next years needs to estimate price in advance. This
task is different as the cost of plywood varies greatly, depending largely on
the health of the construction industry. But the problem can be solved by using
prices from the plywood futures market.
b) Accuracy
The accuracy of the futures market is not too good but it is
certainly better than the alternative.
2) Speculation
Speculation is a spill over of futures trading that can provide
comparatively less risk adverse investors with the ability to enhance their
percentage returns. Speculators are categorized by the length of time they plan
to hold a position.
The traditional classification includes: -
Scalpers
They have the shortest
holding horizons, typically closing a position within a few minutes of
initiation. They attempt to profit on short-term pressures to buy and sell by
“reading” other traders and transacting in the futures pits. Thus, scalpers
have to be exchange members. They offer a valuable market service because their
frequent trading enhances market liquidity.
Day Traders:-
They hold a futures position
for a few hours, but never longer than one trading session. Thus, they open and
close to futures position within the same trading day.
3) Hedging
While engaging in a futures contract in order to reduce risk in
the spot position, hedging is undertaken. Therefore the future trader is said
to establish a hedge.
The 3 basic types of hedge are:
a) Long hedge/ Anticipatory hedge
An investor protects against adverse price movements of an asset
that will be purchased in future, i.e. the spot asset is not currently owned,
but is scheduled to be purchased or otherwise held at a later date.
b) Short hedge
An investor already owns a spot asset and engages in a trade or sell
it’s associated futures contract.
c) Cross hedge
In actual hedging positions, the hedgers needs do not perfectly
match with the institutional futures. They may differ in
-Time span covered
-The amount of commodity
-The particular characteristics
of the particular goods
Thus, when a trader writes a futures contract on another
underlying asset, he is said to establish a cross hedge.
The regulators and regulations
The
first level of regulation is the exchange.
The
exchange does not take positions in the market. Instead, it has the
responsibility to ensure that the market is fair and orderly.
It
does this by setting and enforcing rules regarding margin deposits, trading
procedures, delivery procedures and membership qualifications.
Each exchange consists of a
clearinghouse.
The clearinghouse ensures
all trades are matched and recorded and all margins are collected and
maintained.
It also is in charge of
ensuring deliveries take place in an orderly and fair manner.