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Participants in the futures market frequently use the terminology "basis" (B), "cost of carry" (CC) and "convergence". As regards the latter: as time in the life of a futures contract goes by, the futures price (FP) and the fair value price of the future (FVP) converge on the spot price (SP), and they are equal on the expiry date of the future, as indicated in Figure 11.
Figure 11: basis, carry cost & convergence
It will be evident from the discussion above on the CCM, which gave us
that cost of carry (CC) is the difference between the fair value price (FVP) and the spot price (SP) of the underlying asset as follows:
Basis (B), on the other hand, is the difference between the SP and the FP of the underlying asset:
The above concepts are illustrated as in Figure 11. It will be apparent that the FVP is higher than the SP when the CC is positive (i.e. when rfr > I on the underlying asset). However, when I > rfr, i.e. CC is negative, FVP < SP. When CC is negative, B is positive.
What is the significance of basis? It is that the basis is a known number when a hedge is undertaken (buy the underlying and sell the future or sell the underlying and buy the future). If the basis changes during the life of the hedge (which is likely), risk (called basis risk) emerges, and the hedge will not be a perfect one, i.e. if the basis strengthens or weakens, the outcome of the hedge will be different from that hoped for or expected.
Participants in the futures market
Figure 12: participants in the futures market
The participants in the futures market can be categorised in a number of ways. One can, for example, categorise participants according to membership of the exchange (all futures markets are formalised):
• Futures exchange members:
- clearing members (clear for self, own clients and all other members)
- non-clearing members (all other members)
- broking members (deal for own account and/or for clients)
- non-broking members (deal for own account).
• Non-members (the clients of members):
- foreign sector
- household sector (individuals)
- corporate sector
- financial intermediaries (banks, insurers, retirement funds, CISs, etc.). However, the most logical categorisation is according to functionality as follows:
These participants are found in both the categories non-members and members of the exchange, meaning that some members themselves are engaged in investing, arbitrage, hedging and speculation. All the participants in the futures market may be depicted as in Figure 12. We examine each of these categories briefly.
Investors in the futures market are those that view the futures market as an alternative to the cash market (i.e. the underlying market). For example, an investor may wish to earn the All Share Index (ALSI) and, instead of buying the shares in the proportions that make up the index, can achieve this by buying the appropriate number of ALSI futures contracts. She may do this for the sake of convenience, to avoid transactions costs (depending on the fair value price) or she may view the underlying market as lacking in liquidity.
An investor may also use long-term instruments and short futures contracts to invest short-term, or use short-term financial instruments and long futures contracts to invest long term.34 These positions are alternatives to straightforward investing for the desired investment horizon (see Table 5).
Table 5: Use of futures to manage investment horizon
Arbitrageurs endeavour to profit from price differentials (mispricing) that may exist in different markets on similar securities. For example, if the industrial index (let us assume it is called INDI) futures price is trading far in excess of its fair value price, the arbitrageur may sell the INDI future and buy the individual equities that make up the INDI.
Arbitrageurs play a significant role in the futures market by ensuring that futures prices do not stray too far from fair value prices and by adding to the liquidity of the market.
Hedgers are those participants that have exposures in cash markets and wish to reduce risk by taking the opposite positions in the futures markets. Most investors, such as retirement funds, life offices and banks hedge their portfolios from time to time in the financial futures market. The equivalents in the commodity futures markets are the producers (e.g. farmers) and consumers (e.g. millers of flour) of commodities.
The opposite parties to hedgers are usually the speculators that willingly take on risk in order to profit from their views in respect of the future movement of prices / rates. Thus, hedgers transfer risk to speculators and speculators willingly seek risk positions (accept the risk being shed).
Speculators are those participants that endeavour to gain from price movements in the futures market. Given the small outlay (i.e. the margin) in comparison with cash markets (where the full price is paid), speculators are attracted to futures markets because they are able to "gear up".
For example, if a speculator has LCC1 million with which to speculate, she is able to buy shares to the value of LCC1 million in the cash market. In the futures market she is able to get exposure (and risk) to the extent of the amount on hand times the reciprocal of the margin requirement. Thus, if the margin requirement is 8% of the value of the future/s, she is able to go long of futures by 12.5 (1 / 0.08) times LCC1 million.35
Speculators and hedgers play a significant role in the futures market in terms of enhancing the liquidity of this market. It should be apparent that hedgers endeavour to eliminate or reduce risk faced from holding inventories of financial instruments or commodities, while speculators assume the risk. Thus, speculators willingly take on the risks transferred to them by hedgers.
It will be evident that there is no clear-cut distinction between membership of the exchange, the ultimate lenders and borrowers, the financial intermediaries, and functionality. For example, an arbitrageur may be a member of the exchange. Similarly, a speculator may be a member of the exchange, and he may be a broking or a non-broking member. Broking members can generally be divided into 3 categories, i.e. those dealing for own account (i.e. arbitrageurs and/or speculators) (in which case they may be non-broking members), pure brokers and those dealing for own account and for clients. Note that it is one of the significant rules of the exchange that if a broking member takes the opposite position of a client, she is obliged to inform the client as such.
Because of the significant role played by hedgers in the futures market, the function of hedging is covered further in some detail in the following section.
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