Futures, Derivatives, Liquidity: An Introduction

Futures, Derivatives, Liquidity: An Introduction

Many traders and other market participants think that the futures and derivatives increase volatility in the LBLV Broker financial markets. But how do they really work? In this article, we’ll take a closer look at futures, derivatives, and liquidity. Read on!

Futures Contracts

Futures are contracts that derive value from an underlying asset like traditional stocks, a bond, or even a stock index. Futures are standardized contracts traded on centralized exchange. Such contracts are an agreement between two parties to buy or sell something at a future date for a certain price called “the future price of the underlying asset.”

The party who agrees to buy is considered to be going long and the party agreeing to sell is considered to be going short. The parties are matched for quantity and price and they are entering a futures contract without the need to exchange a physical asset but only the difference in the futures price  of the asset price at maturity.

Both parties are required to pay an initial margin amount (a fraction of the total exposure) with the exchange.  The contracts are marked to market, which is the difference between the base price and the settlement price are deducted from or added to the account of the respective parties.

The next day the settlement price is used as the based price. The parties need to post additional funds into their LBLV Broker Review accounts if the new base price slips below  a maintenance margin. The investor can close out the position any time prior to the maturity but he has to be responsible for any profit or loss made from the position.

Futures and Price Discovery

Another important role that futures play in the financial market has something to do with price discovery. Future market prices depend on a continuous flow of information and transparency. A lot of factors affect the supply and demand of an asset and thus its future and spot prices.

This kind of information is absorbed and reflected in future prices quickly. Future prices for contracts closing in to maturity converge to the spot price and thus the future price of such contracts serve as a proxy for the price of the underlying asset.

Futures prices also give a hint on market expectations. Futures contracts with later maturities may stay at the pre-crisis levels, on the other hand, because the supply is expected to eventually normalize. Contrary to popular belief, futures contracts improve liquidity and information dissemination to higher trading volumes and lower volatility.

Other Derivatives

Aside from futures, the world of derivatives is also represented by products that are traded over the counter or between private parties. These may be standardized or highly tailored for sophisticated market participants.

Forwards are derivative products that are just like futures except for the fact that they are not traded on a central exchange and are not marked to market regularly. These unregulated products primarily face credit risk because of the chances of a counter party defaulting on its obligation at the expiration of the contract.

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