An Overview Of Futures, Derivatives, and Liquidity

You are not alone if you believe futures and other derivatives increase volatility in the financial markets and were mostly responsible for last decade's financial crisis. Derivatives have been blamed for the financial collapse but do they deserve the harsh judgment? 

Probably not. Instead, we need to understand them, how they are traded, their pros and cons, and how these instruments differ from each other.

Futures are contracts that derive value form an underlying asset such as a traditional stock, a bond or stock index. Futures are standardized contracts traded on a centralized exchange. They are an agreement between two parties to buy or sell something at a future date for a certain price called "the future price of the underlying asset." The party who agrees to buy is said to be long and the party agreeing to sell is short. The parties are matched for quantity and price. The parties entering a futures contract do not need to exchange a physical asset but only the difference in the future price of the asset price at maturity. 

Both parties need to pay an initial margin amount (a fraction of the total exposure) with the exchange. The contracts are marked to market; that is, the difference between the base price (the price the contact was entered at) and the settlement price (usually an average of the prices of last few trades) are deducted from or added to the account of the respective parties. The next day the settlement price is used as the base price. The parties need to post additional funds into their accounts if the new base price falls below a maintenance margin (pre-determined level). The investor can close out the position at any time before maturity but has to be responsible for any profit or loss made from the position.

Futures are an important vehicle to hedge or manage different kinds of risks. Companies engaged in foreign trade use futures to manage foreign exchange risk, interest rate risk if they have an investment to make, and lock in a interest rate in anticipation of a drop in rates, and price risk to lock in prices of commodities such as oil, crops and metals that serve as inputs.

Futures and derivatives help increase the efficiency of the underlying market because they lower unforeseen costs of purchasing an asset outright. For example, it is much cheaper and more efficient to go long in S&P 500 futures than to replicate the index by purchasing every stock. Studies have also shown that introduction of futures into markets increase the trading volumes in underlying as a whole. Consequently, futures help reduce transaction costs and increase liquidity as they are viewed as an insurance or risk management vehicle. (For more, watch: How Do Futures Contracts Work?)

Another important role futures play in financial markets is that of price discovery. Future market prices rely on a continuous flow of information and transparency. A lot of factors impact the supply and demand of an asset and thus its future and spot prices. This kind of information is absorbed and reflected in future prices quickly. Future prices for contracts nearing maturity converge to the spot price and thus the future price of such contracts serve as a proxy for the price of the underlying asset.

Future prices also give an indication of market expectations. For example: In the case of an oil exploration disaster, the supply of crude oil is likely to fall so near term prices will rise (perhaps quite a lot). Futures contracts with later maturities may remain at pre-crisis levels, however, because supply is expected to eventually normalize. Contrary to general belief, future contracts enhance liquidity and information dissemination leading to higher trading volumes and lower volatility. (Liquidity and volatility are inversely proportional.) (For more, see Interpreting Volume For The Futures Market.)

Benefits notwithstanding, futures contracts and other derivatives come with a fair share of drawbacks. Due to the nature of margin requirements, one can take on a lot of exposure, which means a small movement in the wrong direction could lead to huge losses. Plus the daily marking to market can put undue pressure on the investor. One needs to be a good judge of the direction and minimum magnitude the market would move.

Derivatives are also 'time wasting' assets in the sense that their value declines as their maturity date approaches. Critics also contend that futures and other derivatives are used by speculators to bet on the market and take on undue risk. Futures contracts also face counterparty risk, though at a much reduced level because of the central counterparty clearing house (CCP).

For example, if the market moves very far in one direction, a lot of parties could default on their obligation and the exchange would have to bear the risk. However, clearing houses are better equipped to handle this risk, and they reduce risk by marking to market everyday and this is an advantage of futures above other derivatives. (For more, see: How Companies Use Derivatives To Hedge Risk.)

Apart from futures, the world of derivatives are also represented by products that are traded over the counter (OTC) or between private parties. These may be standardized or highly tailored for sophisticated market participants. Forwards are such a derivative product that are just like futures except for the fact that they are not traded on a central exchange and are not marked to market regularly. These unregulated products primarily face credit risk because of the chances of a counter party defaulting on its obligation at the expiration of the contract.

However, these tailored products are around only 15% of a trillion dollar industry, and evidence suggests that the standardized parts of OTC markets perform perfectly well. A great example of this is the Lehman Brothers derivatives book which represented 5% of the global derivatives market. Eighty percent of the counter-parties to those trades settled within 5 weeks of their 2008 bankruptcy.

Futures are a great vehicle for hedging and managing risk; they enhance liquidity and price discovery. However, they are complicated and one should understand them before taking on any trades. The call for regulating standardized derivatives (exchange or OTC based) could have the negative side effect of drying up liquidity to fix something that is not necessarily broken.