Futures are legally binding agreements between sellers and buyers to buy or sell a commodity at a specific time in future and at a specified price (Lusch, Vargo, and Malter, 2006). In most instances, the futures are determined on a quality, quantity, and delivery time basis. The price determination is through a special type of auction on the exchange-trading floor. Hedgers and speculators trade in futures. Hedgers are known to avoid risk by the use of futures while speculators take advantage of the risk and attempt to make returns from it. Futures exchange institutions are institutions in place to act as an intermediary in a futuristic agreement. They ensure that none of the two parties defaults on the agreement. A margin call is made when the margin goes below a certain amount, and the account owner must replenish the amount of margin. This process is known as marking to the market. This essay shall explore futures in a holistic approach.

Margin determination

In futures, it is often necessary that traders post a certain level of margin to deal with the credit risk. In most instances, the margin is 5-15% of the total value of the contract (Reilly, and Brown, 2011). A clearinghouse acts as the main guarantor when trade on regulated futures take place. In this case, the clearinghouse as the main guarantor becomes the buyer and seller of the futures to each of the parties and, therefore, assumes any chances of loss arising from the default of either party. For hedgers who possess the commodity under contract, the margin requirements are often waived. This is also the case where we have spread traders who hold offsetting contracts that balance the position.

Types of margins

Clearing margin refers to a type of assurance that companies perform on open futures and contracts for their customers. Customer margin, on the other hand, refers to a financial guarantee often made to both buyers and sellers of futures to ensure that neither of them defaults. In this type of trade, futures mission merchants are the people responsible for looking into the customer margin accounts. Initial margin is a type of a performance-based bond that refers to the equity amount that is requisite to initiate a futures position. Margin equity ratio is also another type of margin that is often used by speculators for trading capital that is invested as margin at that moment. A maintenance margin is a term used to refer to the minimum margin that is allowed for an outstanding futures contract, enabling the customer to continue operating. Return on margin represents a gain or loss realized when compared to the expected risk by the exchange rate and is used to judge performance. Conventionally, it is important to realize that ROM can be calculated as (realized return/initial margin).

Futures pricing

Arbitrage arguments are used to set the price where the deliberative assets supply is plenty. However, arbitrage cannot be used where the commodity supply cannot be determined. Such is the case for agricultural output, Eurodollar futures and federal funds rate futures.

Arbitrage arguments

They only exist in situations where the supply of assets is constant. The expected future value is the forward price. Letting the forward price be represented by the alphabet K and the forward price of the future equal to the forward price of the forward contract. If this is not the case, the difference between the two is proportional to the covariance arising from the underlying asset and interest rates. This reaction is referred to as convexity correction. To determine the value of an assets’ forward price, we compound the present value in a specific period by the rate of a risk-free return.

F(t, T)=S(t)* (1+r)(T-t)………………………………………… 1

Where,

F (t, T)- the forward price

S (t)-present value

t- Time

T- Maturity time

r- Risk free return

When the continuous compounding method is used, we have;

F (t, T) = S (t)*e r(T-t)…………………………………… 2

The interpretation in the above equation 1 applies in equation 2.

Pricing through expectation

This is a method of pricing where the commodity in question is not steady in supply as is the case for agricultural products. On this note and situation, rational pricing is not applicable as the arbitrage mechanism is not applicable. The supply and demand, today, is determined from an expected asset in the future. Supply and demand of such futures balances on an unbiased expectation of future prices placed on the asset hence the relationship;

F (t) =Et {S (T)}

In a situation where assets have been withheld or hoarded from the market deliberately, the clearing prices at the market level will still be representative of the balance between the two equilibrium markets (Reilly, and Brown, 2011). A relationship arises between arbitrage arguments and expectation where, the relationship based on the expectation will hold increases where arbitrage does not. This is so in the instance where the expectations are taken with respect to the risk of neutral probability. With the use of this rule, it is expected that a speculator will break even.

Futures can be widely used in our daily lives especially as a good investment avenue. One may choose to be a speculator or a hedger. Where one is acquainted more with the market conditions, one can be a speculator and make money out of it. Hedgers too have a place in the markets, where, they can avoid the risk in the purchase of futures yet stand to benefit after an increase in the value of the commodity on sale. Farmers also stand to benefit heavily from such ventures. Where a farmer wishes to reduce the risk associated with a bumper harvest; often a decline in commodity prices, a farmer may enter the futures market and agree to sell his output at a certain level. This assures him/her a certain level of sales hence enabling him to invest and control costs in respect with the expected returns. Agriculture is a field that stands to benefit heavily from the positive externalities of controlled risks (Lusch, Vargo, and Malter, 2006). This enables farmers to plan for future agricultural activities with the assurance of certain fixed market rate.

In conclusion, futures are good avenues for investors especially when new in the market. They provide a place where young investors can control the level of risks and engage in business without worry. The opportunity to trade in the markets and yet minimize losses is a good starting point into speculative ventures. Profits can also be made using the common indicators. An example, when a good harvest is expected due to rains, a speculator may accept to buy a commodity at a certain cheap price because the produce is anticipated to drop at price. More probably, the purchases can be consumed at a future date or exported to world markets realizing a higher profit margin.