Comparative Analysis of Forwards and Futures Contracts

Comparative Analysis of in the lead and Futures ContractsA Mauritian PerspectiveAbstractThis research comp bes the all over-the-counter(a) differentials commercialize with the permute- passeld derivatives grocery store. Forwards contracts subscribe to been put ond as a representative for unlisted markets and Futures for organised transpositions and the apostrophizes and benefits of each iodine have been analysed. This research has been done existence with regard to the GBOT setting up in Mauritius.Forwards argon frequently utilize contracts relative to another(prenominal)s, in Mauritius. Hence, it is assumed that if the users have to shift to the GBOT, they leave alone use futures contracts as a substitute for preliminarys since twain have similar characteristics except that futures are more sophisticated than forwards. A survey has been done on the top one hundred and twenty companies in Mauritius stunned of which, nevertheless 70 have responded. The questionn aire aimed at determining the current derivatives position in Mauritius and a glance at the perception of the monetary officers with respect to GBOT.Even though they believe that GBOT will benefit the country, they are unwilling to lay the market plot of ground roughly of the respondents are unaware of GBOT and uncertain about the futures market and trade mechanism. Unexpectedly, it was found that nigh firms use futures for risk management.The results have been used to close whether it is possible for Mauritius to introduce an exchange and what measures apprise be bourgeonn to ensure that GBOT is successful. With respect to this research, it seems that the Mauritian market is not ready yet, to conceive this new development in its financial system but there are near measures that can be adopted to combat the inhibitors and there are much lessons to be wise(p) from the record of derivatives mismanagement.List of AbbreviationsAML Air Mauritius Company LimitedCDS Ce ntral Depository and stoppage Company LimitedCBOT Chicago Board of TradeCME Chicago mercenary ExchangeCFTC Commodity Futures Trading CommissionEFP Exchange of Futures for PhysicalFSC Financial Services CommissionFX Foreign ExchangeGBOT Global Board Of TradeHSBC Hongkong and nobble Banking Corporation LimitedMTM Mark-To-MarketOTC Over-The-CounterSEM Stock Exchange of MauritiusSTC State Trading CorporationS0 Spot wrong todayST Spot value at maturityUSA United States of America1.1 IntroductionThe presence of derivatives market has undoubtedly improved national productivity growth and standards of living. Alan Greenspan (Chairman of the US Federal each(prenominal)ow for System, 2005)Derivatives have shooted prominence in the past few decades and are today a vital element in finance. Although they are the latest addition to the financial world, they have been witnessing a high rate of success. They have unde rgone constant innovation and active trade, notwithstanding the fact that they have take to a more interlacing form of hedging. Electronic trade and settlement facility has revolutionised the global financial and good markets by attracting foreign investors and increasing liquidity.1.2 Background Theory1.2.1 hedgingHedging is a form of insurance that uses derivatives to absorb financial risk by locking in a price for a particular respectable. Its essence pertains to the uncertainties associated in prices of goods. Since prices of goods cannot be predicted with certainty, people speculate.Gol (1980) states that when everyone expects a price rise, all opinions seem to converge over a price rise, such(prenominal) that, if speculators enter the futures market, they would too be subverters quite than sellers and their buying activity whitethorn further aggravate the price rise.Speculation helps in effective risk management but some quantifys backfires for instance, many airlines speculated a rise in fuel prices and hedgerowd their exposure with derivatives. Unfortunately, the financial crisis 2007-2008 caused fuel prices to decrease considerably in the spot market, but the airlines had the obligation to honour their derivative contracts at relatively higher prices.1.2.2 Derivatives marketDerivatives are financial instruments that derive their value from one or more underlying assets such as stocks, bonds, currencies, busy rates, commodities and market indices for example, an oil futures contract derives its value from the price of oil- oil being the underlying asset.Derivatives are used extensively in financial and non-financial institutions. Forward contracts are the basic derivatives that stemmed from the goods market, and have thereupon paved the way for other derivatives. Some goods traded through derivatives are base metals, precious metals, agricultural products, energy products, foreign currencies, amuse rate, and stock indices among others.Other accommodates contracts based on carbon, trade good indices, credit, fertilizer, housing, inflation, and weather.Source Futures Industry Magazine 2009For this research, commodities, assets, and goods are used interchangeably, irrespective of whether they are used in the financial, commodities or foreign exchange markets.1.2.3 Types of derivativesThere are dickens distinct groups of derivative instruments forward-based products and option-based products. Forward-based products are termed linear derivatives as they offer a linear payoff and include futures, forwards, and swaps.Conversely, option-based products are non-linear derivatives since they offer a non-linear payoff and include puts, calls, caps, floors, and collars. Other derivatives, such as options on futures, swaptions, and forward caps, combine the features of both forward and option contracts.Derivatives trade in over-the-counter (OTC) markets or in organised exchanges. OTC trading occurs among a few dealers via phone or electronic messages. OTC contracts are vulgar balances made through private negotiations and accomplished outside a trading platform. However, some OTC derivatives are cleared via exchanges (e.g. in the Chicago Mercantile Exchange). Swaps, forwards, and customised options are OTC contracts.Exchange-traded derivatives are standardised in terms of quantity and quality (the amount and quality of the good is persistent) and negotiation is not possible. Organised exchanges employ both generate outcry system and electronic order barracking systems and share similar purposes to securities exchanges. They design the contract terms and operate a clearinghouse, which acts as a guarantor, settles all contracts, and regulates trading. Large securities firms and commercial banks act as derivatives dealers. Futures and standardised options are traded on exchanges.1.2.4 PlayersThe three broad categories of traders in the derivatives market are hedgers, speculators, and arbitrageurs. Hedge rs use derivatives to reduce the risks that they vista from adverse movements in prices of goods while speculators take a position to realise gains with a relatively small initial outlay. Arbitrageurs enter the market to realise gains without risking their get capital. Conclusively, hedgers transfer their risk to speculators and arbitrageurs and thus, boost liquidity on the market.1.3 Objective of StudyA well-regulated organised derivatives market encourages a sustainable financial development and increases nest egg and investment in the long-run, thereby promoting economic growth. However, the concern is how and when to discern the time for its implementation in small economies.This dissertation aims at analysing the benefits and drawbacks of using forwards and futures contracts. Forwards contracts can be used by minority users, without major procedures and regulation. Contrarily, futures require significant concern and assistance of the government to support and ensure a good op erating system. The research is carried out with regard to the commodities market being set up in Mauritius.Forwards laid the groundwork for futures, hence, both are treat simultaneously throughout this study. Futures (exchange-traded) are enhanced forms of forwards (OTC) but differing somewhat in the way they are traded. The costs and benefits of the two instruments are analysed and compared. This will hint whether it is viable for Mauritius to introduce a derivatives exchange and suggests the measures that can be adopted to ensure that its objectives are attained.Swaps and options are excluded from the study because they operate differently and due to record constraint. Forwards and futures are relatively simpler and typically alike, thus, rendering comparison easier.1.4 Overview of Remaining ChaptersChapter 2 deals with the literature review while Chapter 3 is an overview of the derivatives market in Mauritius. Chapter 4 covers the research methodology section. Chapter 5 prese nts the analysis and findings of the research, followed by Chapter 6, which concludes this study and includes some recommendations.chapter two literature review2.1 Importance of Derivatives MarketSeveral factors such as size, leverage, asset-liability duration, and taxes amongst others, affect the hedging decision of a firm. The Miller and Modigliani theory posits that hedging is fruitless in absolute financial markets. In reality though, markets are defective and hedging alters a firms value by influencing its investment decisions.Bessembinder (1991) distinguishes that hedging corporate risk with forward contracts increases firms value by reducing incentives to under-invest. He also advocates that grownup institutions are more likely to use derivatives due to informational economies of scale. Likewise, Haushalter (2000) finds a positive correlation between hedging decision and total assets and characterises it as the economies of scale in information and transaction costs of hed ging. Hedging also enables a firm to negotiate with its customers, creditors, and managers, which improves contract terms.A research on African countries suggests that volatile international capital flows have the tendency to destabilise shallow markets and precipitate a crisis if there is a change in investors appetite and urges adoption of stronger domestic policies and local anesthetic derivatives markets for financial risk management purposes (Adelegan, 2009).Hedging is a zero-sum game one does not gain from trade unless another establishments a loss. The gain to the buyer will be exactly equal to the loss to the seller of the forward contract, whilst the gain to the seller will be exactly equal to the loss to the buyer. Hieronymus (1971) defines hedging as taking a position in a futures market that is equal in size and opposite to a predetermined position in the capital market. Hence, a loss in one market is offset by a gain in the other market. This principle works since no tes prices and futures prices of a commodity are expected to converge as the contract reaches expiry.Anderson and Danthine ( 1981) define a pure hedge term equal to the risk-minimising futures position corresponding to a predetermined cash position. A hedger, thus, uses the possibilities offered by futures markets to minimise his risk.2.2 Forwards MarketA forward contract is a bilateral binding agreement to buy or sell a specific quantity and quality of an asset, at a pre-determined price and pre-determined future time. Normally, contracts specifying settlement in excess of 30 long time after the trade date are forward contracts.Forwards are the first and simplest derivatives that sprouted in the sixteenth century in the agricultural markets, wherein they were used primarily to resist adverse price movements. Dong and Liu (2005) advocate that the equilibrium forward reduces commodity price risk the buyer and seller will transact at the price specified in the contract, whatever the price of the underlying asset in the spot market at maturity.A forward agreement is somewhat like a legal contract, customised with respect to the needfully of the particular buyers and sellers, obligating delivery of the underlying asset under the conditions specified in the contract. The buyers and sellers negotiate over the contract terms. Anderson and Danthine (1981) claim that, in the forwards market, speculators are assumed to be risk-neutral, bidding competitively to exercise arbitrage opportunities.2.2.1 Benefits of Forward Contracts2.2.1.1 Risk ManagementTypically, a forward contract alleviates financial risks, thereby protecting traders. There is no initial investment in the forwards market since cash changes hand only on settlement of the contract at maturity. This causes less excitability in cash transactions, rendering cash flows easy to manage.2.2.1.2 Settlement FacilityCases wherein the seller defaults for some reason, contracts may be mutually settled in cash. Duff ie (1989) finds that in practice, only a small fraction of forward positions are actually delivered while most are closed out before delivery by a cash settlement. Sometimes, initial traders are able to transfer their contracts to someone willing to take their obligation. Per se, it offers a certain degree of flexibility.2.2.1.3 Trade Linkages and other benefitsForwards allows negotiation on the contracting terms, which benefits traders, builds up trust, and streng whences trade links between parties. Wolak (2007) analyses an electricity company and concludes that forward contracts reduce the cost of production as well as its volatility, and increase pro?t. Likewise, Dong and Liu (2005) show that forward contracts in non-storable goods benefit both producers and suppliers.2.2.2 Costs of Forward Contracts2.2.2.1 Counterparty Default RiskForward contracts mitigate financial risks but give rise to counterparty risk (risk of default), which is one of the prominent risks in OTC derivati ves. Counterparty risk can cause huge losses.2.2.2.2 Transaction CostsIn order to ensure guaranteed deals, parties with good credit ratings should be identified, which is a very costly task. Nevertheless, these firms do have a possibility to default for reasons such as insolvency or bankruptcy. An ideal illustration is the collapse of the Lehman Brothers investment bank that has created the biggest turmoil in the worlds history following which, more concern has shifted to the OTC market.2.2.2.3 Legal proceduresOnce the terms and conditions of the contract are accepted, they must be adhered to otherwise legal procedures may entail. Forwards market is an unorganised form of trade with no ability to deal with conflicts other than seeking legal recourse that may be in addition costly. Influential and wealthy parties only may recourse to such practices. Besides, it causes damage to the dealers reputation.2.2.2.4 Liquidity and Transparency issuesThere is no possibility of closing out or reversing a forward contract. Thus, forwards lack flexibility and liquidity and forward delivery is not guaranteed in the absence of a regulator. Additionally, since the contract involves only two entities, there is reduced transparency and possibility of mispricing the goods since not all the forces are at work.2.2.2.5 Market Power and Bargaining PowerMarket power and talk terms power affect the capacity for negotiation along with the forward equilibrium price. As such, small investors with lesser power may suffer. Dong and Liu (2005) show that the forward equilibrium moves in favour of the participant with high market power, such that he gains from the contract. However, when negotiation costs are very high, both producers and buyers face a loss regardless of market power and use forward contracts for risk management rather than for gains.2.2.2.6 Informational InefficiencyA study by Mahenc and Meunier ( 1983) stipulates that there is no comme il faut information dissemination i n the forward market but under conditions of imperfect information, forward trading indirectly creates efficiency in the spot market.The destiny to deal with the pithycomings of forward contracts led to the emergence of the futures market.2.3 Futures MarketA futures contract is an agreement between two parties to buy or sell a fixed amount of an asset at a pre-decided price and date. In this respect, futures share the same characteristics as forwards for instance, they help buyers and sellers with long term planning by locking in a price. However, futures are more sophisticated than forwards.Financial futures were traded on shares of the Dutch East India Company in the seventeenth century, but in advance(p) futures markets originated in Japanese rice futures, which were traded in Osaka in the eighteenth century. Futures emerged with the grading system, which purported to ensure that at maturity, the quality of goods delivered was as specified in the contract, which eventually led to standardisation of futures contracts.Futures are standardised contracts in respect of quantity, quality, delivery date, and location. They trade on organised exchanges, which are responsible for setting the quantity, quality of the underlying asset in the contract. Moreover, the exchange sets the terms and conditions of the contract, which are non-negotiable by the traders. All investors are treated equally small investors are also able to hedge without difficulty.2.3.1 twist of the Futures MarketFutures exchanges share the same purpose as securities exchanges. They usually have an integrated clearinghouse for clearing and settlement facility. Brokers, who are also members of the exchange, are responsible to match the buy and sell orders without buyers meeting sellers and vice-versa. Only members are allowed to trade on the platform, thus, a non-member wishing to deal in futures, should trade through a broker.The exchange connects buyers and sellers worldwide, communicates and keeps parties joint and ensures compliance with the terms and conditions of the contracts. Exchanges use pass on outcry in pits or electronic order matching systems or some use both, such as The Chicago Mercantile Exchange. Some authors argue that the open outcry system is more liquid and transparent than the automated system.Traders need to unsex a margin with the exchange prior to trade. The demand for margin (a percentage of the value of the contract) is referred as collateral or as a good faith deposit (Gay, Hunter, and Kolb 1986). All traders are required to have a minimum stated sum of money in their accounts. Contracts are settled on a periodic basis the mark-to-market system (MTM) which affects the contract price. If price of contract increases on a particular day, the holder makes a profit, which he can withdraw from his account, whereas if price decreases, he makes a loss and the amount is deducted from his account. As such, he is required to deposit a margin, referred as a call margin, to replenish his account to the threshold level, cognise as the variation margining system.Futures contract protect the value of inventories and partly finances the cost of storage since the future price of a commodity is dependent upon its cost of carry (Future price = cash price +cost of carry). This helps to improve marketing policies, financial planning, and long-term forecasting of prices. If ST is expected to be higher than current S0, then the current futures price will be set at a high level relative to the current S0. Likewise, if ST is expected to be lower at maturity, current futures price is set low.2.3.2 Benefits of Futures ContractsFundamentally, futures market confers two main purposes price discovery and price risk management. The market provides protection against default, manipulation, and abuse.2.3.2.1 Risk Management and Settlement GuaranteeMoser (1998) reckons that futures contracts counteract default risk and protect traders through a set of rules. Firstly, standardisation protects traders as it ensures that the quality of the goods delivered is as specified in the contract. Moreover, the exchange can order its members to produce their financial accounts for inspection if their solvency is doubted. In 1873, the CBOT decided to expel any member who refused to abide by this rule (Andreas 1894). The margining and MTM system also contribute to curtail counterparty default risk as traders are called to supplement their account for the losses incurred on their contracts within 24hours failure to do so causes their positions to be liquidated. There is a settlement guarantee in case of default while a tight regulation ensures that manipulation and abuse is virtually absent.2.3.2.2 worth DiscoveryFutures market is transparent pricing of commodities are fair and manipulations very difficult. Electronic trading on the exchange platform pools together all forces impact the price of a commodity, leading to price discovery mechanis m, which improves efficiency and lowers costs. Technology renders the exchange highly competitive since the market reacts very fast prices and transactions are monitored constantly while information is captured continuously and incorporated in the intrinsic value of a good. Telser and Higinbotham (1977) concur that, futures market pools trade from diverse area into a central market, thereby increasing the heterogeneity of potential transactions. They proclaim that futures are liquid as transaction occurs readily at mutually acceptable prices and that homogenization and clarity of the terms and conditions boost liquidity.2.3.2.3 LiquidityOne need not possess the underlying asset to sell futures while one may not be in need of a commodity to buy futures. Speculators and arbitrageurs enter the futures market without possessing or the intention of buying the commodity. Thus, the transfer of risks to different players in the market increases liquidity and maintains the equilibrium in de mand and supply. Telser and Higinbotham (1977) statistically dispute that as the number of traders in the market increases, the market clearing prices become normal. Futures can be squared-off (reverse a position) without negotiation, thus making delivery non-mandatory.Positions can also be rolled-over. If period for hedge is later than the expiry date of the current futures contract, the hedger can rollover the hedge position by closing the existing position in a futures contract and simultaneously taking a new position in another futures contract with a latter expiry date.2.3.2.4 Transactional and Informational EfficiencyFutures market increases the informational efficiency of cash market and promotes import and export competitiveness. Cox (1976) empirically demonstrates that futures trading increases traders information about forces affecting supply and demand. His analysis rejects the claim that futures trading impose costs on producers, consumers, and others who handle the co rporal commodity. Additionally, evidences from more fully intercommunicate traders suggest that futures trade increases efficiency in spot markets.2.3.2.5 Increase Export CompetitivenessWhen entering forward contracts, exporters do not, usually, possess the entire stocks for export. Futures market enables them to hedge their projected purchase, until they have to buy in the physical market for exporting. Taking a position in the futures market will help to offset the gain/loss in the physical market that is, at maturity the net loss/gain in futures market offsets the gain/loss in the physical market. Thus, exporters can accept contracts with longer duration and increase their competitiveness.2.3.2.6 Offsetting gains and losses in the physical marketFutures market also allows a hedger to take a position in the futures market opposite to the position he takes in an over-the-counter market. Such a transaction is termed exchange of futures for physical (EFP). The OTC and futures positi ons should be for the same underlying assets or at least similar in terms of value and quantity. This results in the flexibility of customising the physical market with respect to the needs of traders, parallel to the OTC market and at the same time enjoying settlement guarantee in an exchange.Usually, margin requirements for EFP transactions are lower. EFP may seem appealing but is inefficient in fair pricing. Exchange Officials apprehend that EFPs would harm the futures market by reducing volume and liquidity and inhibit fair price discovery.2.3.2.7 Diversification of portfoliosFutures on commodities serve to diversify portfolios, since they are less volatile than financial securities. Bodie and Rosansky (1980) report an average excess return of 9.5% per annum for an equally weighted portfolio of commodity futures between 1950 and 1976. Their analysis reveals that equities are riskier than commodity futures. Furthermore, total return of the equally weighted commodity futures was negatively correlated with the return on long-term bonds, suggesting that commodity futures are effective in diversifying equity and bond portfolios. The benefits of diversification from commodity futures tend to be voluminousr for longer holding. A similar analysis carried out by Gorton and Rouwenhorst (2005) confirms that commodity futures returns have been effective in providing diversification of both stock and bond portfolios.Weiser (2003), on the other hand, contends that commodity futures returns vary with the stage of the barter cycle. He finds that commodity futures usually perform well in the early stages of a recession while stock returns are generally disappointing and in later stages of recessions, commodity returns fall while equities perform well.2.3.3 Costs of Futures Contracts2.3.3.1 ComplexityDespite appealing benefits, futures contracts inherit some costs and the prime one is the complexity of handling them. Futures were generated to deal with the limitations o f forwards but, in so doing, they brought a more complex form of hedging. Proper knowledge of the market is crucial otherwise, hedgers may face unwanted losses.2.3.3.2 Basis RiskBasis risk (the difference between spot and futures price) is inbuilt in futures market. Hedge positions are usually not perfect due to this difference. Working (1962) emphasises that the existence of basis risk prevents the elimination of all risks. Brorsen (1995) finds that changes in basis can cause forwards to be cheapest in some periods and futures to be cheapest in others.Therefore, the benefits of hedging can be enjoyed when the market is well understood.Advanced futures concepts about hedge positions, hedge ratios, and types of hedges should also be mastered as they benefit hedgers differently in different markets.2.3.3.3 Mark-to-Market System (MTM)-cash drain outThe transaction costs involved, such as, initial margin and variation margin in the MTM system freezes up working capital that could have y ielded interest. Furthermore, the margin call should be paid before next opening of the market- a very short delay. These daily settlements make transactions volatile and cash flows cumbersome to maintain. Margin costs and brokerage commission discourage some investors, especially small traders, to enter the market. Williams (1986, 1987) shows that risk-neutral firms will hedge if transaction costs are lower in the futures market than in the cash market. Moreover, instances of dual trading exist, whereby brokers trade on behalf of their clients to sort out a commission, without improving the customers position.2.3.3.4 Large Number of Participants neededFutures contracts fail for lack of interest by market participants, that is, a low trading volume. Telser and Higinbotham (1977) statistically demonstrate that the benefit of an organised market is an increasing function of the number of potential participants and hence, an increasing function of the turnover of the potential partici pants in that market. They conclude that an organised futures market survive only if it is perfectly competitive, which is achieved when there are many participants. If the open interest (number of contracts outstanding) in the futures market declines, the volume of trade falls relative to the open interest. The commission and the margin are raised consequently. They even assert that there is a cost to the emergence and survival of an organised exchange.2.3.3.5 Standardisation issuesStandardised nature of contracts may cause over-hedging or under-hedging. For example, a contract specifies 1000 to be sold while a hedger may need only 800. Therefore, he over-hedges by 200. Conversely, say a hedger needs 1100, he under-hedges by 100.2.3.3.6 Uninformed Investors Increase VolatilityUninformed investors may increase price volatility in the futures market. If the market is inefficient in information, futures prices become biased predictors of future spot prices and causes cash prices and future prices to diverge rather than converge.Usually, futures contracts with longer maturity are closer to spot prices since time is required to assimilate unanticipated shocks. However, Kaminsky and Manmohan (1990) suggest that it is impractical to make any generalisations about the short-term and long-term horizons in commodity futures market. They find that for longer periods several markets are not fully efficient. In addition, Chernenko et al. (2004) study a wide range of futures and forward rates from financial markets and conclude that forward and futures prices are not generally pure measures of market expectations per se, they may not be an efficient forecast of the future prices of assets.2.3.3.7 Losses Faced By InvestorsOther studies indicate that large scale, professional speculators can profitably forecast commodity prices, but small traders cannot. Stewart (1949) considers futures-trading accounts for small-scale speculators and discovers that they face huge losses. M oreover, Houthakker (1957) and Rockwell (1967) find that large speculators earned profits and small speculators incurred losses for a particular set of data. Similarly, Working (1931) estimated that speculators in wheat futures, incurred losses.Empirical research shows that, for cattle and wheat producers, futures markets have lower transaction costs than forward contracts, while for small firms like farmers, the contracting costs might be higher because of opportunity cost of time in learning about futures, setting up a brokerage account, and managing margin calls. It would be unnecessary for small groups of traders, well acquainted with each other to transact among themselves than use futures.2.3 Derivatives MishapsThe history of derivatives has witnessed some spectacular losses in the derivatives markets, which includes losses made by both financial (e.g. Amaranth hedge fund, Barings Bank) and non-financial institutions (e.g. Orange country, Shell, Metallgesellschaft).The Metallg esellschaft (MG) is a German oil company, which used futures to hedge its exposure in its early 1990s. MG hedged its position with long positions in short-dated futures contracts that were rolled forward. However, the price of oil fell and then came the margin requirements, which caused short-term cash flow pressures.Members of MG claimed that these were short-term cash outflows and in the long-run, there would be a cash inflow. However, this led to a serious issue as huge cash was drained out of the system. Consequently, MG executives closed out all their hedged positions. Therefore, one lesson to be learned is to be alert at all ti