Alternative futures

From CEOpedia | Management online

Alternative futures is an exchange transaction that represents a contractual commitment of two parties, one of which undertakes to deliver and the other to accept a specified underlying instrument at a specified future date, in quantity and quality and at a price specified at the time of concluding the agreement [1]. A forward contract shall be standardised in terms of quantity, quality, place and terms of delivery and payment. Index futures on stock indices are classified as equity derivatives and are used to actively manage the risk of changes in prices of stock exchange companies and to take up synthetic positions in securities coming from foreign markets [2]. A forward contract is an off-balance-sheet transaction that obliges the buyer to pay the price agreed at the time of its maturity for the underlying instrument to which the contract relates. On the other hand, there is always the seller of a futures contract, who is absolutely obligated to deliver the underlying instrument in a contractually agreed quantity or denomination at the future maturity of the contract in exchange for a price agreed upon during the conclusion of the transaction [3] . Futures contracts based on specific shares operate according to a similar mechanism with the difference, however, that it is possible to settle them by means of a physical delivery of securities, which in the case of index derivatives is very difficult. Due to their specific nature, futures contracts are typically stock exchange products and it is impossible to talk about them without taking into account the characteristics of the specific market on which they are traded [4].

Characteristics ofalternative futures

The alternative futures market includes transactions up to a year, with the highest liquidity for the shortest terms. The standard petrol contract size is 500,000 barrels [5]. In the delivery month, the party occupying a short position is obliged to inform the buyer of the contract about the delivery date in accordance with the schedule set in the transshipment terminal. The futures market includes standardized futures contracts with much smaller denominations, within 1000 barrels (42,000 gallons), with monthly maturities up to one year. Contracts may have maturity dates of up to 12 months and are settled by physical delivery in locations marked by the exchange [6]. The New York Stock Exchange also offers a very convenient service, which includes swap transactions for specific locations of petrol transhipment, thanks to which manufacturers and customers from the United States can choose the most convenient place of delivery for themselves [7]. As a standard, the place of delivery is the transshipment port in New York, and the subject of delivery is gasoline meeting the technical specification and free from customs obligations. Additionally, in order to improve the settlement of transactions, the exchange offers EFP (Exchange for Physicals) and EFS (Exchange for Swap), in the first case two parties having opposite positions in futures contracts can agree on the delivery of an instrument different from the stock exchange specification. In the latter case, the futures contact is settled with the opposite position in the long-term swap, in one of the exchange dates [8].

Example

The American investment fund has a large equity portfolio consisting of shares of leading Japanese companies from the Tokyo Stock Exchange [9]. Asset managers are afraid of temporary falls, which may significantly reduce the current valuation of the fund's units. At the same time, they do not want to risk strengthening the dollar against the yen, so they sell futures contracts based on the Nikkei 225 index, which are quoted on the CME in U.S. dollars. In order to hedge US$50 million of assets held in major Japanese companies, the fund should sell 1000 futures contracts (NK) at an index value of Nikkei 225 of 10,000. If the Nikkei 225 fell by 5% during the term of the contract, the fund would lose out on the valuation of its shares, but this loss would be largely compensated for by a futures gain of $2,500,000 (5%*10000*5*1000) [10]. Of course, there would be some mismatch due to the difference in portfolio structure and market index composition, possible dollar/yen exchange rate changes and base risk between forward and spot. A more accurate hedging strategy can be applied using futures contracts on individual shares or quanto options, but the transaction costs are much higher. The cost of financing the initial margin should also be considered as the cost of hedging, which in this example for 1000 contracts is US$6,250,000 (1000*6250) [11].

Valuation

The value of futures contracts, both index-linked and equity contracts, is determined directly on the exchange futures market as a result of transactions between trading participants [12]. This price, depending on the mood of the investors, oscillates around its theoretical value. The theoretical value takes into account the purchase price of the underlying instrument on the spot market at the time of concluding the forward transaction and the costs of financing the position until the expiry of a given series of contracts [13].

Advantages

Can be replaced [14]:

  • Possibility to hedge market risk
  • Possibility of speculation
  • High market liquidity, low transaction costs
  • Possibility to trade on electronic trading platforms virtually 24 hours a day
  • The credit risk of the other party to the transaction secured by the clearing house

Disadvantages

Can be replaced [15]:

  • The need to make a security deposit
  • Mismatch between hedging transactions and existing exposure to the risk of changes in prices of securities
  • Limited maturity of contracts, which makes it necessary to roll over hedging positions

Other approaches related to Alternative futures

  • Futures trading is an alternative strategy that allows individuals to speculate on the future price of an asset, commodity, or currency. It involves taking a long or short position on the asset in question and agreeing to buy or sell it at a predetermined price on a specified date in the future.
  • Options trading is another alternative strategy that involves the purchase or sale of rights to buy or sell an asset at a predetermined price on a specified date in the future. Unlike futures, options are not obligated to be exercised and can be bought or sold before the specified date.
  • Spread trading is a strategy that involves taking both a long and short position on two different assets, with the goal of profiting from the price difference between the two assets.
  • Arbitrage trading is a strategy involving taking advantage of price discrepancies between two different markets, by simultaneously buying and selling an asset in order to make a profit.

In conclusion, alternative futures offer investors a range of strategies to speculate on the price of an asset in the future. These strategies include futures trading, options trading, spread trading, and arbitrage trading, each of which present different levels of risk and reward.

Footnotes

  1. B. Liang, 2004,  p. 4
  2. B. Liang, 2004,  p. 4-5
  3. B. Liang, 2004,  p. 4-5
  4. B. Liang, 2004,  p. 4-5
  5. S.Y.S. Che, J. K.W. Fung, 2011, pp. 12-15
  6. S.Y.S. Che, J. K.W. Fung, 2011, pp. 12-15
  7. K. McKinnon,2010, pp. 259-260
  8. K. McKinnon,2010, pp. 259-260
  9. A. Hodgson, J. Okunev 2006, pp. 211-224
  10. A. Hodgson, J. Okunev 2006, pp. 211-224
  11. A. Hodgson, J. Okunev 2006, pp. 211-224
  12. M.J. McAleer et all.,2001, pp.270
  13. L. Martin, et all., 2014, pp. 225
  14. C. Angheloiu, et all., 2017, pp.4-6
  15. C. Angheloiu, et all., 2017, pp.4-6


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References

Author: Justyna Wieczorek