December 2022
Financial futures are part of both ACCA FM and AFM, but tested at different levels of depth. Here Sunil Bhandari explains the basic principles behind futures.
Futures are a derivative product. They trade on futures and options markets in the major financial centres – London, New York, etc..
Futures are linked to a primary product (e.g. oil) or index/value (e.g. Forex rate). The futures value moves in the same direction of the primary. This is a key point.
Futures for speculation
This maybe a surprise for some students, but futures are used for speculation. Let’s take a simple example.
I believe the price of oil will rise. So I could go on the primary market and purchase a barrel of oil for, say, $100. I store it in my garage (and check my house insurance policy!).
I wait a month, and the oil price has gone up to $120 and I dispose of the barrel. I make a profit of $20. More importantly, my wife feels the house is now safe.
However, rather than do the above, I could use the futures market – I want to speculate/bet on a price rise. As I want to bet on a rise, I would ‘buy’ at today’s futures price, let’s say $100. Then a month later I would ‘sell’ at $120 and make a profit of $20.
I have put buy and sell in quotation marks as I will talk more about these terms later.
Futures as a hedge
So now I am a business that purchases oil to use as part of the production process. The next purchase date is in a month’s time.
The price on the primary market is currently $100 per barrel. But we are concerned this price may well rise before the purchase date. So, the concern is that the oil price could rise on the primary market. This is what we call the downside risk. The change in the price that could hurt the business.
But if the price rises on the primary market, it will rise on the futures market. Hence, the hedge is to ‘buy’ on the futures market at $100.
A month later, the primary price has gone to $120. So the purchase has cost the business $20 more than expected. But the futures price has risen to $120. The profit on the derivative will cover the extra purchase cost.
What if the oil price falls rather than rises? Let’s say it goes to £75. The business will only pay that on the primary market, and it saves £25.
However, the futures price will also fall and as the hedge was ‘buy’ at £100, there will be a loss on the derivative of £25.
But, in both cases, the effective overall cost to the business is $100. That was the objective, and it has been achieved.
The terminology
Futures has its own language, and you just need to know enough of this to get the marks. It’s like going abroad on holiday, you just know enough of the local lingo to have a good time.
So here is a summary of the key terms:
• Buy – Bet on a rise.
• Sell – Bet on a fall.
• Basis – Difference between primary and futures values (unlike in my example, they are not quite the same value on all occasions).
• Basis risk – Due to imperfections in the markets, the hedge may not be perfect. Take my business example above; the primary my rise by $20 but the futures by only $18.
• Margin – Traders on this market need to deposit funds to cover any potential losses.
Futures and Islamic Finance
Futures are a form of speculation and hence not allowed under the Sharia law. The nearest Islamic Finance product are Salam Contracts.
Sunil Bhandari is an ACCA AFM and FM tutor with FME Learn Online – see www.SunilBhandari.com
