Essay On Future Contracts

FUTURE CONTRACTS
Definition:
A future contract is a standardized, exchangeable, tradable contract between two parties to trade a specified asset on a certain date in the future at a specified price.
Those who engage in future contracts can be termed as either the purchaser or the seller. The purchaser of the asset is called the long party because when the contract is settled, the individual will have much of the asset. On the other hand the seller of the asset is called the short party because after settling the contract, that person will have less of the asset that the previously owned.
ADVANTAGES OF FUTURE CONTRACTS
Hedging – This is where investors predict adverse changes in price of an asset and therefore helps them to curb the same. An example is in the case where an oil producing

There is also no interest charged on the asset.
Liquidity – The seller is assured that this asset will be converted into quick cash with ease because the contract is sealed.
Reduces Counter Party Risk – Future contracts reduces the chances of either party defaulting when a better offer is placed on the table.

PRICING OF FUTURE CONTRACTS
Pricing of future contracts can be done in a number of ways but two simple pricing models for futures contracts can be used to estimate how the price of a stock futures or index futures. These are;
The Cost of Carry Model
The Expectancy Model
The Cost of Carry Model
Futures pricing according to cost of carry model has two assumptions. One is that it assumes that markets tend to be perfectly efficient that is there is no difference in the cash and futures price therefore the possibility of arbitrage is eliminated. The other assumption is that the contract is held till maturity. This is advantageous in that prices are predetermined and happens to be a fair price.
FP = SP + (Carry Cost – Carry