Essay: Pros and cons of future contracts

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  • Subject area(s): Finance essays
  • Reading time: 2 minutes
  • Price: Free download
  • Published on: October 16, 2015
  • File format: Text
  • Number of pages: 2
  • Pros and cons of future contracts
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Pros:
Offset the risk exposures
The main reason that companies or corporations use future contracts is to offset their risk exposures and limit themselves from any fluctuations in price. The ultimate goal of an investor using futures contracts to hedge is to perfectly offset their risk. In real life, however, this is often impossible and, therefore, individuals attempt to neutralize risk as much as possible instead. For example, if a commodity to be hedged is not available as a futures contract, an investor will buy a futures contract in something that closely follows the movements of that commodity
minimized the stock risk
Stock index futures have become a popular derivative product for hedging, for several reasons. First, they create the possibility of speculative gains using leverage where a relatively small amount of investment is required for trading a large amount of stocks.
Second, investors can sell contracts as readily as they can buy them, since there is no significant difference in the amount required for either buying or selling and no special restrictions on being short.
Third, the standard feature in stock index futures contracts allows trades to be completed sooner. With electronic trading, trading sessions allow investors to get in and out of positions, often within minutes.
Fourth, stock index futures offer low transaction costs compared to the costs of trading equities.
Fifthly, futures contracts can be effectively used for hedging the risk of underlying spot.
Futures contracts can be very useful in limiting the risk exposure that an investor has in a trade. The main advantage of participating in a futures contract is that it removes the uncertainty about the future price of an item. By locking in a price for which you are able to buy or sell a particular item, companies are able to eliminate the ambiguity having to do with expected expenses and profits.
Cons
There are several factors which market timing is concerned with the ability to forecast market movements, while stock selection relates to the ability of the fund manager to spot stocks which are miss-priced influence the hedge ratios. Futures contracts come with definite expiration dates. Even if you have established fixed prices for the assets in the contract, as the expiration date approaches those prices can become much less attractive to others. At times, this condition can cause futures contracts to expire as worthless investments. Similar to banks that offer too many loans at fixed rates, changes in the market increase the risk that some of their loans will come with well-below market rates. Futures contract expiration dates, as they get closer, come with similar risks. The disadvantage involves the sometimes fast movement of futures prices. Contract prices can tick up or down daily, sometimes within minutes.

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