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FRM-1 Study Notes

Uses of Futures

  • Hedging  –
    • Hedgers principal activities are production, distribution, processing, storing etc. Hedgers hedge to minimize the risk of loss (from fluctuation in raw material price, inventory prices, finished good prices) from these activities.
    • Hedgers take position opposite to exposure in the cash market. i.e.
    • Long underlying asset à Short futures. Example: An oil manufacturer hedges risk of price decline of oil (sales price) by selling oil futures
    • Short underlying asset à Long futures. Example: An oil consumer hedges risk of price increase of oil (raw material price) by buying oil futures
  • Carrying of commodity positions
    • Futures market can be used to defray the costs of carrying an inventory of a commodity
    • Example: Wheat is harvested during few weeks, but consumed the entire year. Hence it is carried as inventory by the seller, till it is consumed. To hedge against losses from decrease in price of wheat, the inventory holder can short futures.
  • Arbitrage
    • Simultaneous purchase and resale of the same underlying commodity or security in different markets
    • It ensures that cash and future prices are in proper allignment.
  • Position Taking  –
    • Assuming a futures position without an offsetting cash position.
    • Used for either speculation or anticipatory hedging
    • Example: anticipatory hedging – A company that needs to issue debt in future, may lock in current prevailing market interest rates.
  • Price Discovery
    • Futures markets are efficient price discovery markets. Futures price are used as price references for many commodities.
  • Speculation
    • If for a futures transaction, one player is a hedger, the other can be assumed to be a speculator. The hedger offloads the price risk through the future transaction.
    • Whereas the speculator assumes price risk, in return for prospect of dramatic gains.
    • Speculators generally do not have any use of the underlying asset.
    • Speculators are important in the futures market, because they provide liquidity.

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