Futures are legally binding agreements between sellers and buyers to buy or sell a commodity at a specific time in future and at a specified price (Lusch, Vargo, and Malter, 2006). The prices of Futures are largely developed from the quality and quantity of the commodity in question. Moreover, the delivery time required is an important consideration. Price process through which the prices of futures are developed is a form of a special auction carried out on the exchange-trading floor. In most instances, only hedgers and speculators are involved in the trading of futures. Hedgers are known to avoid risk by the use of futures while speculators take advantage of the risk and attempt to make returns from it. Futures exchange institutions are institutions in place to act as an intermediary in a futuristic agreement. Futures exchange institutions are put in place as an assurance that none of either parties involved in the agreement defaults on the agreement. The investors must replenish the level of margin deficit constantly whenever a margin call is made. This is done to cover the deficit to the original margin level agreed upon. This essay shall explore futures in a holistic approach.

The Margin

In futures, it is often necessary that traders post a certain level of margin to deal with the credit risk. In most instances, the margin is 5-15% of the total value of the contract (Reilly, and Brown, 2011). A clearinghouse acts as the main guarantor when trade on regulated futures take place. In this case, the clearinghouse as the main guarantor becomes the buyer and seller of the futures to each of the parties and, therefore, assumes any chances of loss arising from the default of either party. Margin requirements may be waived in the occasion that the hedger has or possess the commodity in the transaction on a contract basis. This is also the case where we have spread traders who hold offsetting contracts that balance the position.

Margins Types

Companies perform a form of assurance on open futures and contracts to their customers through a type of margin referred to as a clearing margin. Customer margin, on the other hand, refers to a financial guarantee often made to both buyers and sellers of futures to ensure that neither of them defaults. In this type of trade, futures mission merchants are the people responsible for looking into the customer margin accounts. Initial margin is a type of a performance-based bond that refers to the equity amount that is requisite to initiate a futures position. The Margin equity ratio is a margin that is used for trading capital already invested as margin in a transaction in progress. A maintenance margin is a term used to refer to the minimum margin that is allowed for an outstanding futures contract, enabling the customer to continue operating. Conventionally, it is important to realize that ROM can be calculated as (realized return/initial margin).

Pricing of Futures

Arbitrage arguments are used to set the price where the deliberative assets supply is plenty. However, arbitrage cannot be used where the commodity supply cannot be determined. Such is the case for agricultural output, Eurodollar futures and federal funds rate futures.

Arbitrage

They existence of an arbitrage is in situations where the supply of assets is constant. To determine the value of an assets’ forward price, we compound the present value in a specific period by the rate of a risk-free return.

F(t, T)=S(t)* (1+r)(T-t)………………………………………… 1

Where,

F (t, T)- the forward price

S (t)-present value

t- Time

T- Maturity time

r- Risk free return

When the continuous compounding method is used, we have;

F (t, T) = S (t)*e r(T-t)…………………………………… 2

The interpretation in the above equation 1 applies in equation 2.

Pricing through expectation

This is a method of pricing where the commodity in question is not steady in supply as is the case for agricultural products. Rational pricing is not an applicable method due to the inapplicability of the arbitrage mechanism. The supply and demand of futures in the market today, is a function of the expected assets in the future. Supply and demand of such futures balances on an unbiased expectation of future prices placed on the asset hence the relationship;

F (t) =Et {S (T)}

In a situation where assets have been withheld or hoarded from the market deliberately, the clearing prices at the market level will still be representative of the balance between the two equilibrium markets (Reilly, and Brown, 2011). A relationship arises between arbitrage arguments and expectation where, the relationship based on the expectation will hold increases where arbitrage does not.

Futures can be widely used in our daily lives especially as a good investment avenue. An individual may choose to be a speculator or a hedger depending on their willingness to leap out of a risky venture. Where one is acquainted more with the market conditions, one can be a speculator and make money out of it. Hedgers too have a place in the markets, where, they can avoid the risk in the purchase of futures yet stand to benefit after an increase in the value of the commodity on sale. Farmers also stand to benefit heavily from such ventures. Where a farmer wishes to reduce the risk associated with a bumper harvest; often a decline in commodity prices, a farmer may enter the futures market and agree to sell his output at a certain level. This assures him/her a certain level of sales hence enabling him to invest and control costs in respect with the expected returns. Agriculture is a field that stands to benefit heavily from the positive externalities of controlled risks (Lusch, Vargo, and Malter, 2006). This enables farmers to plan for future agricultural activities with the assurance of certain fixed market rate.

In conclusion, futures are good avenues for investors especially when new in the market. They provide a place where young investors can control the level of risks and engage in business without worry. The opportunity to trade in the markets and yet minimize losses is a good starting point into speculative ventures. Profits can also be made using the common indicators. An example, when a good harvest is expected due to rains, a speculator may accept to buy a commodity at a certain cheap price because the produce is anticipated to drop at price. More probably, the purchases can be consumed at a future date or exported to world markets realizing a higher profit margin.