A Note On Currency And Index Futures
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APPLICATIONS OF FUTURES Contd..Speculation
Speculators have no interest in locking in a price to hedge risk. They buy
and sell futures contracts in order to make profits from price volatility.
They bet on their anticipation of the price movement, that is, either
upwards or downwards. An example will explain how the futures market is used
for the purpose of speculation. Example:
In March 2003, an investor ‘A'expects the price of corn to rise over the
next three months. The price in March is $17 per bushel. Instead of
physically purchasing the corn (35,000 bushels) and taking the risk of
storing it for three months and incurring the impact cost (storage,
transportation and protection from pests), A can enter into a three months
futures contract.
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He will enter into a contract to purchase the corn
after three months at a price fixed today, say, $20 per bushel. Three
months hence, the price has reached the level of $24 per bushel. A can
now make a profit of $4 per bushel by selling an identical futures
contract to reverse his initial position.
Profit if A had bought corn in March from the spot market
Purchase price = $17 + $2 (Storage cost) + $1 (protection from pests) +
$1 (transportation cost) = $21 per bushel
Selling price = $24 per bushel
Profit = 35,000 X ($24 – $21) = $105,000
Profit from a futures contract
= 35,000 X ($24 – $20) = $140,000 |
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Arbitraging
Arbitrageurs profit by taking the advantage of a variance between prices in
two different markets. They primarily look for opportunities to achieve
riskless profits by entering into different transactions in two or more
markets simultaneously.
Example:
Consider a GE stock traded on the NYSE and on Toronto Stock exchange with
the stock price being $138 in New York and Can $210 in Toronto. The exchange
rate is Can $1.55 per US$. An arbitrageur would simultaneously buy 100
shares in Toronto stock exchange and sell in NYSE and thus make a risk-free
profit of
100 X [(1.55*138 - 210)] = Can $390
However, this arbitrage opportunity will not last for long because an
increase in demand for the GE stock in Toronto will push up the prices.
Similarly, the prices will fall at NYSE when shares are offloaded by
arbitrageurs over there, thus reducing arbitraging opportunities.
TYPES OF FUTURES
TRADING USING CURRENCY FUTURES
TRADING USING INDEX FUTURES
CONCLUSION
EXHIBIT I DIFFERENCE BETWEEN FUTURES AND FORWARDS CONTRACTS
EXHIBIT II A NOTE ON ANALYZING FUTURES PRICES
ADDITIONAL READINGS AND REFERENCES
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