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Market liquidity

It is generally accepted that "liquidity" refers to the ease of entry and exit from a market. Futures markets are generally very liquid for two main reasons:

• They are "derived" from underlying markets which are generally liquid

• Futures contracts are standardised and restricted in terms of expiry dates (i.e. there are not many contracts; thus activity is not dispersed amongst many contracts).

It will be understood that if participants in the cash market expect adverse and/or volatile price changes in this market, they may withhold from investing until the risk exposure is reduced to acceptable levels. Futures contracts provide the means of reducing exposure, thus allowing the participant to enter the cash market now. The existence of the futures market also encourages speculators and arbitrageurs to enter the cash market. In general, the existence of an active futures market enhances liquidity in the cash market.

Market efficiency

Market efficiency has to do with prices fully reflecting all available information. This is the case if all information is available to all participants at no cost, if there are no transaction costs and all participants are in agreement with regard to the implications for price formation of current and future information.

Closely related to market efficiency is market liquidity. A market cannot be efficient if there is limited competition (market participation). Wide market participation (i.e. intense competition) ensures that all available information is reflected in the price. If prices reflect true economic values and the information pertaining to them, capital in the market would be allocated correctly.

It will be evident that if a futures market is efficient, then it contributes to the efficient functioning of the related markets (the closest relative is, of course, the underlying market). For example, an efficient futures market reduces the cost of hedging and promotes the use of the underlying markets. This has benefits down the line such as increased production and demand, increased inventory holdings, the encouragement of specialisation (and resultant economies of scale), etc.

Allocation of resources

Closely related to market liquidity and efficiency is the allocation of resources (in fact, these should not be separated). Certain students of the economics of futures markets (particularly commodity futures markets) have indicated that the presence of a futures market for specific exhaustible resources increases the allocative efficiency of that market. The argument is that when futures trading exists the market is broad and contains more information. Prices are likely to be more efficient and resources are allocated more efficiently.

Capital formation

The effect of futures markets on capital formation is a contentious issue. The critics maintain that the existence of futures markets redirects risk capital away from the underlying markets, thus impeding capital formation. On the other hand, proponents agree that, by enabling producers to hedge, futures markets enhance capital formation - through putting producers in a better situation in terms of planning future production.

Output

Demand and supply fluctuations in an underlying market result in risk for producers. Uncertainty with regard to future prices and demand could result in lower output (and capital formation). The existence of an efficient futures market creates the opportunity for producers to relate output to demand (by utilising appropriate hedging techniques). The futures market thus reduces and distributes the risk associated with production and prices in the future - in this way contributing to increased output.

Competition

Certain commentators suggest that futures markets contribute to greater and more effective competition in the underlying markets and thus to prices which are lower than they otherwise would be. This favourable characteristic is believed to be transmitted to other related markets.

New product development

It is also maintained that the development of new products and services have been encouraged by the introduction of futures markets. Firms are more likely to create new products if they are able to reduce the risks and transaction costs involved (through hedging).

Public welfare

It is contended that the existence of efficient futures markets, through the effects on the underlying markets in terms of price discovery, resource allocation, liquidity, competition, new product development and on the output of firms, contributes to general public welfare.

Summary

Futures are contracts between two parties via a futures exchange (which accepts the double counterparty risk, and risk manages cautiously, inter alia by a margining system) to buy or sell an asset at an agreed price on a specified date in the future other than the spot settlement date of the underlying instrument. Settlement may be with the asset or in cash. The price of the futures contract is the spot rate / price of the underlying instrument plus the carry cost (the rate of interest less any income) for the relevant period.

The participants in the market are the broker-dealers, investors (that at times use futures as substitutes for the underlying), hedgers, arbitrageurs and speculators. Futures turnover in many futures markets is vast, flowing over into the underlying markets, both of which bring about efficient price discovery. The futures market has many economic benefits including the raising of economic welfare.

Bibliography

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