Throughout financial markets worldwide the use of derivatives as a risk management methods have increased substantially over the last few decades. Derivatives are considered a financial instrument that derive their value from another financial asset or variable and as such they contrast from more commonly known financial instruments such as stocks and bonds. The main goal of derivatives is to protect investors against risk by allowing them to hedge their risk in the future value of an underlying asset (Derivative, 2016). This can be accomplished through different derivative forms, including swaps, options, forwards and futures. Forwards and futures are legally binding agreements used by investors to hedge against existing market conditions. A forward contract, is considered an over the counter (OTC) contract between two parties to buy something on a future date at a specified price (Durbin, 2010). While, forward contacts are OTC, futures differ in that the contracts are traded over the exchange. Moreover, futures derive their principal function from forward contracts and are defined as “contracts providing for the delivery of a specified quantity of a particular commodity at a specified price at some agreed-upon future date” (Futures, 2016). More simply put, a party agrees to buy or sell a commodity or security at a certain future date and price, over an exchange such as the New York Stock Exchange (NYSE) or Chicago Board of Trade (CME). Overall, futures are a commonly used derivative which help organizations and investors hedge risk.
History of Futures
The concept of a futures market was established during the mid-nineteenth century and focused on the future sale of agricultura...
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...tments because they require investors to post a margin, typically 10% of the contract, to be used as collateral against contract default. The futures margin, is vital in keeping financial integrity among investors of these derivatives. In addition, commission costs on traded futures are low and investors are able to make quick money, since there is greater exposure than normal stocks. Futures are also advantageous because they allow investors to optimally hedge their investments against certain risk such as, foreign exchange risk and commodity price risk. Moreover, futures are considered to be a fairer market, since weather and exchange rate fluctuation are nearly impossible targets for insider trading (Agarwal, 2015). Even though futures make investors vulnerable to larger losses, there are many advantages which make them an appealing derivative of investors.
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