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Futures contracts (In the UK, ICE futures Europe provides exposure to a…
Futures contracts
In the UK, ICE futures Europe provides exposure to a range of derivative instruments, including futures and options. The groupings are as follows
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Agricultural and softs - corn, wheat and cocoa
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Futures terminology
Standardised contracts
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It might only be possible to purchase a minimum of two or even ten futures, depending upon the specific underlying asset on which the future is based.
Contract specifications
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Includes details such as
The underlying asset, including a detailed description
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The unit of trading
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The size of the contract and the minimum trading unit are determined by the exchange where the futures are traded
Fixed future date
The final date or the date on which the counterparties must fulfil their outstanding obligations whether the settlement is to be physical or in cash
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In the case of physically delivered futures, those contracts with open positions on the final settlement date must finish with the actual delivery or acceptance of the underlying asset
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Last trading day
Occurs a few days before the actual delivery date and afford the futures contract seller a period of time to make goods available for delivery. This is particular pertinent in the case of physically delivered goods
The price agreed today
The seller of the underlying asset wants price certainty whereas the buyer wants to know how much they have to pay
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Although the price is agreed today, money will only be exchanged simultaneously when the seller delivers the underlying asset on the fixed future date
Contractual obligations
It is not the underlying asset being traded, merely the right to buy or sell; it is obligations / contracts being traded not assets
Although both parties are acquiring obligations, they are doing this for various reasons to suit their own requirements
The buyer of a futures is acquiring an obligation to buy an underlying asset and is said to be 'long the future' whereas the seller of a future is acquiring an obligation to sell an underlying asset and is said to be 'short the future'
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Both parties must each make a payment to a futures broker. The exact amount of this payment will depend on
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Uses & Users
Hedging: To reduce or eliminate risk. This is a type of insurance. Hedgers tend not to be profit focused, they want to protect themselves from the price volatility of an underlying asset
Speculation: To make an investment in the hope of making a gain but with the risk of loss. Those who use futures for this purpose are referred to as speculators
Arbitrage: Simultaneous buying and selling of assets in different markets (the spot market and the futures market) in order to take advantages of differing prices in these markets. For instance differences in prices between the equities markets and the futures market based on the same underlying asset. Those who use futures for this purpose are referred to as arbitrageurs
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Risks & rewards
Those who buy futures are expecting a price rise in an underlying asset and hope either to profit (speculation) from rising markets or to lock in a price for an asset (hedging) to be acquired in the future
Those who sell futures hope to profit from falling markets or are trying to lock in a price for an asset they are planning to sell in the future
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Hedgers may also incur considerable losses in the event that they have a short futures position and are unable to provide the underlying asset on the final delivery date
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Traded exclusively recognised futures exchanges to either buy or sell underlying assets whether financial, physical or abstract at a price agreed today but paid on the final expiry date
Only a margin payment is paid today for delivery of that underlying asset in the future, this represents a commitment to fulfil the contract
Legally binding, standardised forward contracts between two parties (a buyer and a seller) to either buy or sell a predetermined quantity of a specified asset (commodity or financial asset) of a specific quality requiring the delivery of that specified asset on a fixed future date, the price of which will be agreed today by both the buyer and seller
Final cash settlement (agreed price less margins already paid) will be made on the final delivery date
All futures are absolutely standardised units: indeed the standard unit one future, with each being standardised in terms of the underlying asset in terms of quantity, quality and place of delivery
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Provide absolute certainty in terms of the underlying asset whether bought or sold in terms of the mount of money to be paid or received
The seller of an underlying asset knows precisely how much will be received whereas the purchaser knows exactly how much has to be paid and precisely what will be received in terms of quantity and quality in relation to an underlying asset
At the agreed expiry date, futures can either be physically delivered or cash settled. This is done by creating an equal and opposite position to that already open. If futures for a specific expiry date have been bought, futures for the same delivery date will be sold subsequently in order to close that position
Provide investors with the ability to gain exposure to a large amount of an underlying asset for an initial outlay which is only a fraction of trading the same underlying asset in the relevant spot market.
When a future has reached its expiry date, it is irrelevant how much the price of the relevant underlying asset has moved against any trader. Even if a price recovers in the spot market, the future has expired
Many multiples of an original outlay may have to be made and a trader may still end up not owning any underlying asset
Institutions and experienced indvidual futures traders who have signed a disclaimed either open long or short futures positions buying or selling one or more futures through a recognised futures broker