While the future fascinates some of us, for others, it is a source of fear. Financial agents can be sub-divided into two categories. There are some who wish to seek exposure to the uncertainty and risk that the future entails. We term such agents as ‘speculators’. On the other hand, there are others who are already exposed to this uncertainty and seek ways of mitigating, if not eliminating, their exposure to such risk. We term such agents as ‘hedgers’. Irrespective of their goal, economic agents have access to financial tools that facilitate both exposure to risk as well as risk-avoidance.
Futures and forward contracts, which we term as derivative securities, help traders to both speculate on the future as well as minimise, if not eliminate, the risk to which some of them may already be exposed.
Such contracts are what we term as ‘commitment contracts’, for the assumption of a position in such contracts amounts to a binding commitment to perform on a future date. Such contracts require two counter-parties who are termed as the ‘long’ and the ‘short’, respectively.
The long in the case of such contracts has a binding commitment to take delivery of the underlying asset at the date that is specified in the contract. The short, on the other hand, is committed to give delivery of the underlying asset on the same date. In practice, both parties may be speculators, albeit with different price expectations. The long may be acting on the assumption that the price of the underlying asset will increase by the expiration date of the contract. If so, he can take delivery at the price fixed at the outset, and sell the asset at the terminal spot price, which, by assumption, is higher.
However, there is every possibility that he is wrong and the spot price of the underlying asset may decline as the contract expiration date approaches. In such cases, he will have to countenance a loss since, by its very nature, a long futures position makes it mandatory for the party to take delivery at the contract price.
The short in such a deal may be acting on the premise that the price of the underlying asset will fall. If he reads the market correctly he can acquire the asset at the terminal spot price, which, by assumption, is lower, and deliver at the initial contract price. However, he, too, may misread the