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Futures exchanges: Insurance providers to the nation

Kshama Fernandes

The story of the emergence and growth of the futures and options markets over the last 30 years has been astounding to say the least. With the introduction of foreign exchange futures, what started as an experiment at the Chicago Mercantile Exchange's International Money Market, grew to be one of the largest markets in the world - the foreign exchange futures market.

Today, financial futures exchanges can be found in virtually every major country in the world. In recent years, many developing countries too have launched these markets. Yet in spite of their explosive growth, the importance of the role of futures and options is often not understood and appreciated.

To understand the role of these markets in an economy, one would first need to look at the reason behind the success of these markets. Almost in all countries that they have been launched, financial futures have been a great success. (Yes, yes, I've heard of those terrible derivatives disasters but we'll come to that shortly.) So we ask the question, what are the reasons behind this phenomenal growth?

The reasons are the same as those for the growth of any industry in an economy. The industry that offers a product that people want succeeds. The next question is what is this product that people want all over the world that the financial futures industry seems to provide? Once again, the answer is insurance. The world wants insurance against price risk and that is what the futures industry provides so effectively and efficiently.

To cite a few tested cases, take the case of the index futures markets which provide insurance against price risk due to market fluctuations, currency futures which provide insurance against price risk due to exchange rate fluctuations and treasury bill futures markets which provide insurance against price risk due to interest rate fluctuations.

How does this insurance work? Let's begin with the case of a treasury bond dealer in the US who has just bought $ 100 million worth of US Treasury securities at a treasury bond auction. His plan: to break it up into smaller pieces and sell it to his customers. So long as interest rates are steady, he could make a living by selling his inventory of treasury securities. However, a small rise in interest rates could result in a drop in the value of the securities he holds and wipe him out of the market.

Under such circumstances, how can he insure against being wiped out by rising interest rates? Sell interest rate futures. If the interest rate goes up, he loses due to a fall in the value of his inventory. However, if adequately hedged, he will have made an offsetting gain on the futures contract he entered into. Then, as he goes about his business of selling his treasury securities in retail, he begins to unwind his position by buying back the required amount of futures contracts. The futures he sold and later bought back will do the job of insuring against price risk. The same technique of "insuring" can be used by any agent in the economy who maintains a stock of financial assets, be it a treasury bond dealer or a securities underwriter.

Financial futures are particularly appealing because they not only provide price risk insurance, but do so in a way that is cheap, liquid and reliable. The transactions costs associated with dealing in the futures markets are about one-twelfth those associated with cash markets. The volume and turnover in these markets is by far more than that seen in cash markets. Futures markets have been structured in such a manner that the clearing corporation and stringent margining followed in these markets guarantees the performance of the parties to each transaction.

The next questions that have been often raised in economies attempting to launch these markets are: Won't futures trading destabilize the stock market? Won't allowing futures trading expose the economy to evils of large-scale speculation? About whether futures trading will destabilise the stock market, numerous in-depth studies over the last 30 years show that stock index futures trading has not increased the market volatility of the US stock markets nor of the other markets where they have been launched.

As far as speculation is concerned, let us figure out who a speculator is. A speculator is a person who wishes to take a position on the market based on his/her view of the market. In other words a speculator does not hold the underlying commodity. What he/she does hold is an opinion about the market. And it is based on this opinion that he/she is betting that the market will either go up or go down. Technically, in futures markets it means that if you do not qualify as a hedger, then you are a speculator. Take the example of an Indian exporter who does not cover his dollar receipts. What he is basically doing is speculating on a fall in rupee.

Now let's look at the special role that speculators play in the futures markets. Futures markets are a zero-sum game. It means that for every short, there must be a long. For every hedger, there has to be someone on the other side of the transaction. Often, the other side to the transaction happens to be another hedger. Take the case of an exporter who worries that the rupee may appreciate, and so decides to hedge his risk by selling currency futures (assuming he has access to the currency futures market). He's a short hedger. The party who enters into the opposite end of the contract could very well be an importer who is worried that the rupee may depreciate and hence decides to long currency futures. He's a long hedger.

Most markets involve both short hedgers and long hedgers, but it may often happen that one of the two dominate the market, ie at times, the long hedgers could outnumber the short hedgers and vice versa. This basically means that there are more number of people who want to insure against a price rise than there are people who want to insure against a price fall. This is where the role of the speculator comes into play. By taking an opposite position, either long or short, what the speculators are basically doing is selling insurance. So while it is true that futures markets do provide an excellent avenue for speculation, so long as the regulatory and control mechanisms are in place, speculators play an important economic role - that of insurance sellers.

The author is a faculty member at the Department of Management Studies, Goa University. She handles capital markets and derivatives.

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