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Futures contracts (Hedging (Long hedges would typically be used by…
Futures contracts
Hedging
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In all cases, hedgers are protecting themselves against a potential negative price movement or financial loss related to an underlying asset
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Not profit focused, but they want to achieve protection against unexpected developments
Will generally open a position that is opposite to what they currently have. If they are planning to buy an asset, they will buy futures. If they have an asset to sell in the future or will have an asset in the future which they are planning to sell, they will sell futures
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Long hedges would typically be used by manufacturers perhaps planning to buy a raw material in the near future. For example
Industrial consumers - particularly those who require fuel in their own business, perhaps airline companies who have to protect themselves against oil price rises, so they will buy oil futures
Chocolate manufacturers who need cocoa for chocolate production so buy cocoa futures whereas the cocoa producer would sell cocoa futures
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A short hedge would be used by a supplier or manufacturer concerned about falling prices in the stock they were planning to sell. If the price of the underlying asset rose rather than fell, then extra profit that could have been made in the spot market will be cancelled by having to close out their futures position at a higher price
Speculation
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They do not have any interest in owning an underlying asset or physical commodity whatsoever and are not concerned about the responsibility of ownership
They are entirely profit focused and hope to gain from price movements in the underlying assets, whether up or down, and hence in the price of futures
Attracted particularly by the high degree of leverage that futures provide. As a result of this leverage the price movement will be far greater in percentage terms than buying the underlying asset directly and there is also the benefit of deferred payment
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With long futures - The profit is potentially very considerable though unquantifiable as the price can neither move up or down after the future's expiry date. Thus maximum profit must be restricted by the expiry date
With long futures -Losses can be enormous yet quantifiable as the price of the future can only fall to zero.
With short futures - the maximum profit is known and can be huge as the price of the future can only fall to zero
With short futures - the maximum loss occurs if the price of the underlying asset / future rises rather than falls (as the speculator had anticipated) losses can be enormous as the price of the future can rise considerably
Futures margins
It is possible that those trading futures could receive all of the initial margin back, depending on which way the price of the underlying asset moves and hence the price of the future itself
Initial margins
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This amount will be placed in the margin account and is allowed to fall by 10-20% of the initial margin without there being any additional margin calls
Afford the traders the opportunity to keep open futures position past a trading sessions close, whether long or short
Traders should be mindful of margin requirements for the underlying asset to which they wish to gain exposure
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Maintenance margin
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Effectively the initial margin adjusted to take into account the maximum permitted fall in relation to the initial margin so it could fall to 80% of the initial margin
If the amount falls below this maintenance margin the margin account will have to be topped up to the amount of the initial margin. This is done by a margin call
Every business day at settlement time the trader would have a number of choices if a margin call were made
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Close the position partially, closing some futures positions while keeping others open
Arbitrage
This essentially involved locking in diskless profits by simultaneously entering into transactions in two or more different markets relating to the same underlying asset
This may happen if the price of a futures contract deviates considerably from that in the spot market
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Exchange rates may also impact on arbitrage opportunities and it is likely that such opportunities will disappear as more traders become aware of them
Futures clearing house
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Members may be recognised futures brokers or not nay broker that is not a member must deal through a recognised broker
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The initial margin is taken from the buyer as a commitment to pay the agreed price on the final settlement date. It is taken from the seller as a commitment to deliver the underlying asset on the final settlement date
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It is necessary for traders to monitor their position daily and it may also be a requirement to top up a margin account if the price moves adversely
Sufficient funds must always be maintained in a margin account in order to prevent an account being closed out by the broker / futures exchange clearing house
There is no acquisition of any rights whatsoever in relation to underlying assets such as attending AGMs, receipt of dividends etc. These would only be acquired should delivery of the assets actually be taken