Kenanga Deutsche Futures : Futures 101 (Series 1)

Series 1

Introduction: What are futures?

  • A futures contract is a type of derivative instrument. It is a financial contract, where two parties agree to transact a set of financial instruments or physical commodities for future delivery at a particular price.
  • The value of a futures contract is derived from the value of an underlying asset. For example, the value of Crude Palm Oil Futures (FCPO) is derived from the value of crude palm oil itself.  
  • Buyers and sellers primarily enter into futures contracts to hedge risk or speculate on the price movements. This is why futures are used by producers, consumers and speculators.
  • Futures contracts are traded on regulated exchanges with specific quantity, quality and time duration.

How does it work?

  • The futures market is a centralized marketplace for buyers and sellers from around the world to meet and enter into futures contracts. Pricing used to be based on an open outcry system but now pricing is based on bids and offers matched electronically. The futures contract will state the price that will be paid and the date of delivery. The settlement could either be physically delivered or cash settled.
  • So, what exactly is a futures contract, you ask? For example, let's say that you decide to subscribe to cable TV. As the buyer, you enter into an agreement with the cable company to receive a specific number of cable channels at a certain price every month for the next year. This contract made with the cable company is similar to a futures contract, in that you have agreed to receive a product at a future date, with the price and terms for delivery already set today. You have secured your price from now till next year - even if the price of cable rises during that time. By entering into this agreement with the cable company, you have reduced your risk of higher prices.
  • That's exactly how the futures market works. Since a futures contract is an agreement between two parties: there are two positions one could take. One is a short position - the party who agrees to deliver a commodity. The other is a long position - the party who agrees to receive a commodity.
  • In every futures contract, everything is specified: the quantity and quality of the commodity, the specific price per unit, and the date and method of delivery. The "price" of a futures contract is represented by the agreed-upon price of the underlying commodity or financial instrument that will be delivered in the future.
  • The profits and losses of a futures contract depend on the daily movements of the market for that contract and are calculated on a daily basis i.e. mark-to-market.
  • As the accounts of the parties in futures contracts are adjusted every day, most transactions in the futures market are settled in cash, and the actual physical commodity is bought or sold in the cash market.
  • Prices in the cash and futures market tend to move parallel to one another, and when a futures contract expires, the prices converge into one price. So on the date either party decides to close out their futures position, the contract will be settled.
  • Futures market is a good source for vital market information and sentiment indicators as it is highly active and central to the global marketplace.
  • Price Discovery - Due to its highly competitive nature, the futures market has become an important economic tool to determine prices based on today's and tomorrow’s estimated amount of supply and demand.

Futures market prices depend on a continuous flow of information from around the world and thus require a high amount of transparency. Factors such as weather, war, debt default, refugee displacement, land reclamation and deforestation can all have a major effect on supply and demand and, as a result, the present and future price of a commodity. This kind of information and the way people absorb it constantly changes the price of a commodity. This process is known as price discovery.

  • Risk Reduction - Futures markets are also a place for people to reduce risk when making purchases. Risks are reduced because the price is pre-set, therefore letting participants know how much they will need to buy or sell. This helps reduce the ultimate cost to the retail buyer because with less risk there is less of a chance that manufacturers will increase prices to make up for profit losses in the cash market.

Counterparty risk is also reduced due to novation which is the substitution of the clearing house for the opposite contracting party in a futures contract. The clearing house becomes the buyer to every seller and the seller to every buyer. This facility allows complete flexibility to enter or leave the market at will.

Regulatory Bodies

  • In Malaysia, the futures market is regulated by Securities Commission of Malaysia (SC) and subjected to Bursa Malaysia Business Rules both futures exchange rules and clearing house rules.
  • A broker must be registered with Bursa Malaysia Derivatives Berhad and/or Bursa Malaysia Derivatives Clearing Berhad. All futures brokers’ representatives must also be licensed by SC to conduct futures business. It is imperative for investors wanting to enter the futures market to understand these regulations and make sure that the brokers, traders or companies acting on their behalf are licensed by the SC.