The Futures Market

This article will seek to introduce the reader to the futures market and the role of the South African Futures Exchange (SAFEX).

What are Futures markets?

Futures provide an innovative array of investment tools that can help a portfolio perform in the hands of an astute investor. Speculators can also use these tools to seek the huge gains that this highly geared market provides. High potential gains usually bear high risks. Just as the leverage of the market can enormously magnify the profits, so it also magnifies the losses.

Deep in the mists of financial market antiquity, long before the coming of the futures markets, there existed an elite group of people know as forward traders. It was their job to make a price in a currency or commodity for delivery on a future date.

Naturally, they could factor such certainties like the spot price of the commodity and the cost of money for the period into the equation but they still had to reckon with market vagaries which might blow their prices out of the water.

As all deal were one-on-one, there was also the strong possibility that the counterparty might suffer from dealers' amnesia if the price went against him. All this made it quite natural for the forward trader to go the way of the dinosaur and for clients to move towards the futures markets to hedge their forward risk.

The existence of an exchange standing between all parties makes the futures transaction far preferable to the counter-party risk problems entailed in the forward market.

Then there is the size of the contract. Forward deals have to be agreed by both parties when it comes to specifying amounts - in futures you can buy as many or as few of the standardised contracts in a variety of commodities and financial instruments. In forwards the chances of a counter-party wanting to sell precisely the amount that you want to buy are slim.

Parties to forward contracts normally intend to make or take delivery of the underlying asset. In futures this rarely happens, but this does not mean it cannot happen. If you really want a lorry load of live hogs delivered to your front yard then just don't close out your commodity futures contract for cash settlement!

However, this "non-deliverable" aspect makes futures a superior product to forwards. The fact that a cash settlement can attract a speculator into a market that would not normally interest him simply because of the whiff of profit, means that the client who, a now has an army of investors who think they know more about oil than he does and are willing to put their money into the futures market to prove it, thereby providing the hedger with an efficient pricing mechanism.

In SA, the most familiar forward contract to the corporate sector is probably the currency forward. Through a bank - as only licensed bank are allowed to deal in foreign exchange - an importer or exporter is able to lock in to an exchange rate to minimise any losses from a fall in the rand.

There are no exchange traded currency futures in SA as yet because SA's exchange control regulations forbid it.

Both forwards and futures have their place in financial markets, and aside from currencies, they are used for dealing in commodities and fixed-interest securities. In addition, futures are traded on notional assets.

In essence, a futures contract resembles a forward contract, but is standardised and this makes it accessible to a wider market. Though both futures and forwards are by banks, financial institutions and brokers, there is no public participation in forwards, which is a tool of the professional markets.

Both futures and forwards are deals done now for the settlement at some future date.

A future differs from a forward in that the future is a standardised contract for a particular date, quantity and quality, traded on a formal exchange.

A forward is a one-on-one transaction.

Credit (or counter-party) risk is removed in that the futures participants look to the exchange, rather than to one another, to guarantee performance.

This, together with the standardisation of the contract, allows the users to adjust their view of the market and unwind positions without having to find the original counter-parties.

The timing of the cash flows points up major differences between the two: even though the forward contract may have a value, the gain or loss in not realised until the forward contract is closed. Until then, the profits or losses are on paper only. Losses on futures must be paid into the exchange immediately, while profits are paid by the exchange into the account of the futures holder as they accrue.

The History of Futures

Futures markets have existed for several centuries in one form or another. The earliest recorded was in Japan - in rice.

Next came agricultural commodity futures in the US during the mid-Nineteenth Century. Through this, both farmers and users of agricultural products could protect themselves, the former against a price fall and the latter against a price rise, by transferring that risk to a group of speculators who hoped to make a financial gain.

The first financial future was devised by the Chicago Mercantile Exchange, which opened the International Monetary Market in 1972, and introduced a standardised contract in currency futures. An interest rate futures contract followed in 1975.

Interest in financial futures spread and markets were opened in Australia (1979), London (1982) and other world centres in the mid-Eighties, including SA. There are now more than 50 exchanges world-wide.

The South African Experience

The development of the futures market in South Africa has reversed the usual pattern. In this country, no futures have been developed on commodities (except gold), because the marketing of produce is done through single-channel Boards and prices are not necessarily determined by market forces.

Serious investors wishing to trade in commodity futures look offshore to futures markets through foreign or local brokers.

Trading in financial futures, however, began when Rand Merchant Bank began trading contracts based on the Johannesburg Stock Exchange (JSE) Actuaries, All-Share, All-Gold and Industrial indices in April 1987. It introduced a long bond future in 1988.

In May 1988 the JSE and a group of banks and discount houses came together to define and design a formal futures exchange. In September of that year, the JSE and 21 banks subscribed to the prospectus and became founder members of the South African Futures Exchange (SAFEX) and shareholders in Safex Clearing Company, which was established to clear futures.

The Safex rules were approved by the Registrar of Financial Markets in August 1990, and the Exchange was licensed in terms of the Financial Markets Control Act of 1989 to trade in futures and in options on futures.

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