A Note On Currency And Index Futures

SETTLEMENT PROCEDURES

The three common ways in which a futures contract can be settled are by physically exchanging the assets, cash settlement, and offsetting or closing out position.

Physical delivery

This manner of settlement involves physical delivery of the underlying asset. In case of commodity futures, if a trader holds the underlying asset, say wheat, the delivery is to be made at a specified place and time. However, this way of settlement can be a bit cumbersome, in case the trader does not actually hold the underlying assets, since it would be difficult for him to buy assets of the exact specifications in terms of quality.

APPLICATIONS OF FUTURES

Futures markets were initially developed to hedge risk. Holding an asset involves some risks^[6] . Hedging is a way of insuring an asset against those risks. An example would help to understand how futures market can be used for hedging.

Example:

A wheat trader anticipates that he will need to buy additional wheat from his supplier in six months. During the period, however, he fears the price of wheat may increase. That could result in losses for him because he has already advertised his price for the six-month period. To lock in the price level at which wheat is presently being quoted for delivery in six months, he buys a futures contract at a price of, say, $30 per bushel. If, six months later, the cash market price of wheat has risen to $37, he will have to pay his supplier that amount to purchase wheat. However, the extra $7 per bushel cost will be offset by a $7 per bushel profit when the futures contract bought at $30 is sold for $37. In effect, hedging through futures provided insurance to the trader against an increase in the price of wheat. However, if the price of wheat had declined, he would have incurred a loss on his futures position but this would have been offset by the lower cost of acquiring wheat in the cash market.

^[6] Risks involved are interest rate risk, exchange risk and market risk.