Trading Issues and Basics of Forward and Future Contracts: DB2
Derivatives provide investors with the opportunity to create wealth in the future. Besides being very secure investments, these financial instruments provide investing firms with a good mechanism of hedging multiple currency transactions. Many companies are now embracing derivatives as one way of securing their future financial stability and strengthening the company’s hedging policy on currencies.
Difference between contango and backwardation markets
A contango market is one where prices of futures are set higher than the expected future prices. Therefore, the prices of futures in this kind of market decline gradually until they reach the expected price level just before the date of delivery. On the other hand, a backwardation market is one where the approaching of expiry dates of the futures contract makes the prices of the futures contract to trade at much higher prices than before. This is usually attributed to the fact that the convenience yield is higher than possible. The backwardation market is also referred to as the normal backwardation market because of the consistent movement of prices of futures in relation to the market conditions. Therefore, backwardation markets are the total opposite of contango markets.
When a contango market’s curve is plotted, it usually resembles a normal curve while a backwardation’s market curve resembles an inverted curve. This occurs when a futures curve is plotted with maturity dates on x-axis and future prices on y-axis. Usually, futures markets are inverted when prices of the future are low compared to long term maturities and normal when the prices of the future are high for long term maturities. The contango and backwardation markets have distinct price patterns over the period of the future contract.
Therefore, the main difference between the two futures markets is that, in contango markets, future prices are higher than the spot prices that are expected. Since the prices have to reduce to the level of the spot price of the future, the prices fall gradually due to new information in the market until it reaches the spot price. Normal backwardation markets have their future prices way below the spot prices of the futures contract. These prices increase as time progresses towards the end of the futures contract.
Basis
A basis is the difference between spot prices of commodities that are deliverable and the relative valuation of the futures contract for contracts with the shortest possible duration to maturity. The basis may not always be accurate because there are gaps between relative prices and spot prices until the nearest contract expires. Furthermore, deviations resulting from time differences between dates of expiry of a futures contract and the spot item, delivery location, product quality and actual attributes. Generally, investors use basis to determine the profitability that can be obtained from cash delivery. It is also used to find opportunities to arbitrage in the futures markets. Investors use basis grades to maintain uniformity in the market because products like oil differ in quality. The basis grade is the least acceptable standard that deliverable commodities must attain to be an actual of futures contracts. It is at times called a contract or par grade. There are different kinds of basis used in the futures market such as cost basis and differential basis.
Ethical issues when using derivative instruments
There are many ethical issues in the derivatives market. Failure to observe these ethical concerns might lead to devastating effects such as losses by investing companies and mistrust.
Honoring contracts
The futures contracts are the main investments in the derivatives market. The outcomes of the investment are dependent on the contract. Therefore, for the derivatives market to thrive, investors must honor their contracts and pay up the required payments in good time. This will build trust in within the market and promote efficiency in the market.
Prejudice
This is a major concern in the derivatives market because many people assume that derivatives are insecure investments where wealth can easily be stolen away from investors. The fact that there are usually defaulters in the derivatives market is because some investors are prejudiced to believe that they can get away with dishonoring their contracts, especially if they do not favor them.
Transparency
Transparency in the manner business is conducted is important in any organization or market. Derivatives market faces ethical concerns about transparency. In some cases, investors are not given full information on how the markets works, the prevailing conditions on the market and in some cases the investors sign futures contracts that have unclear conditions. Operations on the derivatives market must be done transparently to encourage investor confidence and promote efficiency within the market.
Conclusion
Investing in the derivatives can help investors to hedge currency risks. Contango markets are futures markets whose futures prices are above the spot prices and reduce as the maturity date draws close. Backwardation markets are where futures prices are set below spot prices and increase to reach the spot price at the maturity date. A basis is a standard used by investors in the futures markets to determine a commodity’s profitability and enhance uniformity for commodities that vary in quality or type. Ethical concerns in the derivatives market such as transparency, honoring of contracts and prejudice must be observed to ensure the market functions efficiently.
References
Chorafas, D. (2008). Introduction to Derivative Financial Instruments: Bonds, Swaps, Options, and Hedging (illustrated ed.). New York: McGraw-Hill Professional.
Eales, B. A., & Choudhry, M. (20o3). Derivative Instruments: A Guide to Theory and Practice (illustrated ed.). New York: Butterworth-Heinemann.
Goss, B. (2007). Debt, Risk and Liquidity in Futures Markets (illustrated ed.). London: Routledge.
Sadrinna, C. (2010). Hedging Energy Risks with Derivative Instruments in Oil Trading. New York: GRIN Verlag.
