How futures are traded

To better understand how futures are traded, it is helpful to know what a future is, the history behind them, and the benefits of trading them in addition to the trading process. A 'future' is an evolved financial contract to buy or sell an underlying commodity or product at a future time. Futures are exchanged through authorized clearinghouses such as the Chicago Board of Trade and must be exercised on a predetermined date called the 'final settlement date'.

The exchange of futures contracts is regulated by the Commodity Futures Trading Commission and requires the use of credit to the contract purchaser and has less risk than a similar contract called a forward. Since futures contracts and prices are derived from a product or commodity they all called derivative securities. Speculators often buy and sell these contracts with the intent of making a profit off price fluctuations before the delivery date, however they are also used to by farmers and agriculturalists to hedge farm operating costs, and product sale prices such as those associated with animal feed and grain prices.

The history of futures

Modern day futures trading evolved out of a forward trading system which was used in the mid 1800's as a way for farmers, bankers and merchants to collaborate their interests financially. A forward contract is an agreement between two or more parties to deliver a specific product on a specific date in the future. These contracts are different from futures in that they don't have to be traded using an exchange and the settlement of price is determined by delivery of the product rather than the final settlement date.

One of the largest exchanges through which this process took place was the Chicago Board of Trade, which was called The Board of Trade of the City of Chicago in the 1840's. Over the following 30 years after 1840, futures trading which occurred through the exchanges became more regulated and standardized allowing the futures exchange to become more reliable and standardized. Eventually, in the 1970's a fixed market related to, but separate from the actual underlying commodities emerged in which financial instruments such as bonds and foreign currency could also be traded using futures contracts.

The trading process

Futures are traded using 'margin' which is a financial term for a credit account with a minimum down-payment or collateral. This margin amount is usually between 5-15% but may go much higher. A speculator or trader buys a futures contract through an exchange and/or a broker who works through the exchange and does so at a fixed cost of the underlying security. If the price of the underlying commodity or financial instrument rises during the term of the futures contract, the contract holder can make a profit.

Despite this, if the price falls, a loss will be incurred. During each day the buyer of the futures contract continues to hold it, the profit or loss is recalculated. Speculators in futures trading sometimes use a trading strategy using technical indicators and other financial tools to aid them in their decision making. A step by step process of trading futures is as follows:

1. Use a reliable brokerage account that works through an exchange that trades futures.
2. Choose a commodity or financial instrument to trade in such as coffee or currency.
3. Study the different contracts, the costs and goods.
4. Develop a trading strategy
5. Purchase the Futures contract and hope steps 1-4 work.

Why Futures are Useful

Futures contracts are useful because their derivative nature affords them the ability to represent advanced securities transactions, products and financial instruments through a systematized trading environment. In other words, they greatly facilitate commercial trade. Some of the ways they do this are as follows:

• Control price risk fluctuations by locking into a fixed price
• Assist companies in generating capital in advance of sale.
• Demonstrate buyer and seller predictions of future prices.
• Assists observers with assessing economic and market conditions through price efficiency theory.
• Can be used across many markets including currency, bond, equity index and commodities markets.

Who Invests in Futures and Why

Futures are traded by farmers, agriculturalists, financial institutions and speculators. While all have a financial interest in the contract, they may have different reasons for entering into the contract. In the case of 'hedging' for risk , farm managers and crop farmers attempt to bring a more stable cost and selling environment to their operations through locking into a futures contract price they think is fair. For speculators and financial institutions however, the purpose of the contract is different. For these latter two participants, the intent is profit. These latter two generally do not intend to exchange the underlying commodities but rather the money for them and hopefully at a profit. Since the clearinghouse assumes the cost of the commodities they take responsibility for the cost of the commodities and can re-sell the contract.

Summary

Futures contracts are financial agreements to buy or sell an underlying commodity at a fixed price on a settlement date. While the actual commodity need not be exchanged, this does happen as the futures market has evolved out of an actual commodities exchange system. The currently futures market is currently very sophisticated, and takes place through traditional trading and electronic exchanges that are regulated by Commodity Futures Trading Commission (CFTC). 

Futures contracts have the potential to be costly especially if the price of the commodity drops rapidly within a short time period. However, the contract may also be profitable if exercised at a profit. Futures contracts have a history in the commodities trade of farm products but have expanded to include metals, energy resources and financial instruments such as currency and bonds.

Sources:

1. Zvi Bodie, Alex Kane and Alan J. Marcus. 'Investments' New York. 2002 McGraw-Hill Irwin. p.739-760.
2. http://www.answers.com/topic/futures-contract?cat=biz-fin
3. http://eh.net/encyclopedia/article/Santos.futures
4. http://www.riskglossary.com/link/future.htm
5. http://en.wikipedia.org/wiki/Futures_contract
6. http://www.cftc.gov/

Types of International Bonds

Some types of international bonds sound more like an athletic league listing than financial instruments with names like Kangaroo, Dragon, Bulldog and Yankee bonds. What these bonds have in common is that they are all international in the sense they can by issued by foreign countries or international corporations. For example, a Kangaroo foreign bond is denominated in Australian dollars, but is not issued by the Australian government. Rather, the issuer of the Kangaroo bond is the foreign organization, country, or corporation seeking to raise money exclusively in Australia.

Not all international bonds may be available for purchase according to Laura Bruce of Bankrate.com. However, as Bruce points out, there are other ways to invest in the foreign bond market. Moreover, in addition to bond funds, there are plenty of other international bonds to choose from, all with varying interest rates and ratings, which may also trade via accessible bond exchanges or purchasing services. Below is a listing of some of the different types of international bonds that can be purchased.

The United States Agency for International Development describes international bonds as coming in three types of markets 1. Eurobonds, 2. Foreign bonds, and 3. Global bonds.  These bonds are classified by who the issuer is, what currency the bond is denominated in and where the bond is sold. Eurobonds don't have to be issued in or by the country of currency denomination, but foreign bonds do. Global bonds are a type of international bond that can be issued both in and out of the country of denomination.

Types of Foreign Bonds:

• Matador bonds

Matador bond is a term given to bonds issued in Spain by foreign organizations. These bonds, as with any bonds, may be subject to default. According to Investopedia, Matador bonds can be issued despite low bond ratings thereby increasing the potential risk to investors.

• Maple bonds

The Maple leaf is the symbol on the national flag of Canada hence the term Maple bond identifying this type of international bond. Maple bonds are issued in Canadian dollars by international entities such as corporations. These types of international bonds provide a lower risk avenue of foreign investment provided the bonds are highly rated. According to the bank of Canada, the majority of Maple bonds issued in the mid 2000's where from U.S. and non-U.S. banks.

• Yankee bonds

Yankee bonds may sound like they are American bonds, but they're not. Yankee bonds are a type of international bond because they are issued by foreign entities and denominated in U.S. Dollars after having registered with the national regulatory authority i.e. the Securities and Exchange Commission (SEC).

• Sumarai bonds

Similar to Yankee bonds in the sense registration and approval are required by Japan's securities regulator i.e. the Japanese Financial Services Agency. Samurai bonds can be issued by entities outside of Japan. These types of international bonds are issued in Yen and can be purchased by the public to help raise Japanese investment capital.

Each type of international bond is subject to regulation by the country in which it is issued and the underwriting requirements of the bond. A list of international securities regulators can be found at Mondovisione for further investigation of international bond regulation. The terms of international bonds can vary considerably. For example, Eurobonds can be issued with fixed and variable rates in addition to asset backed and convertible bonds. Investigating the benefits, fees, commission, and terms of bonds are generally a good idea before considering purchasing these types of financial instruments.

Sources: (Date of record, October 20, 2010)

1. http://bit.ly/cAhYHe (US Agency for International Development)
2. http://bit.ly/9GvE4q (Bank of Canada)
3. http://bit.ly/ap2Whq (Bankrate.com)
4. http://bit.ly/cluqwS (Investopedia)
5. http://bit.ly/coml7q (Eurobonds.Info)

Overview: U.S. Savings Bonds

U.S. savings bonds are essentially loans to the Government from whoever is willing to make them. Due to the stability of the U.S. Government, these bonds are considered safe i.e. low risk investments. The receipt for the loan is called a Bond and carries an interest rate paid to the bond holder along with the final face value of the Bond. Depending on the type of bond interest payments vary, and maximum holding periods are between 20-30 years.

Options: If one includes Treasury Inflation Protected Securities, there are four types of U.S. savings bonds according to the U.S. 'Treasury Direct' website http://www.savingsbonds.gov. These bonds can be purchased directly from the U.S. Treasury Department of Public Debt website or through financial institutions such as commercial banks. The U.S Treasury's Bonds are illustrated as follows:

• EE/E: These bonds are fixed rate bonds are fixed rate bonds with interest rates competitive with some money market accounts and less than some Certificates of Deposit. The interest and face value of these bonds are payable upon maturity and/or redemption and the income is state and locally tax free.

• I: Also known as I-Bonds or Inflation Bonds. These bonds offer fixed rates of return competitive with some money market accounts and interest is payable upon redemption.

• HH/H: Pay bi-annual taxable interest through direct deposit at a lower interest rate but are not currently being issued by the U.S. Treasury.

• TIPS: Offer higher yields that vary in accordance with the consumer price index inflation gage. Interest and face value are paid upon redemption and interest is applied bi-annually.

Benefits: Holding savings Bonds almost guarantees the bond holder savings that yield between 1-7% if EE, 3-4% for I 1-4% and 5-7% for TIPS. These benefits can be useful retirement savings tools because all but the HH/H bonds can provide state and local tax free or tax deferred interest income at a higher rate than savings, checking and some money market accounts. Bonds can also be held, bought and sold electronically essentially eliminating the need to go to a bank for bond related activities.

Risks: An opportunity cost presents itself in the holding of bonds. For example, if a U.S. Savings Bond is paying 4.75% interest and a commercial certificate of Deposit is paying 5.5% one is losing 75 basis points in opportunity cost. Additionally, U.S. savings bonds are locked money until the non-redemption period expires, and even though they can be redeemed prior to expiration, there is an interest forfeit penalty associated with early redemption.

Costs: Bond prices vary based on the type of bond issued. I-Bonds and EE/E bonds come in denominations as small as $50 and as large as $10,000 whereas HH/H bonds' smallest face value is $500.00.

Ideas to Consider before Purchasing Bonds:

In terms of getting the most return on money loaned, TIPS offer the best interest rates of the bonds discussed above. However, depending on what one's needs are the HH/H Bonds might be a useful source of liquidity if held in a large volume. Since EE/E bonds and TIPS have tax deferred interest income both these financial instruments are possible considerations for a retirement portfolio.

The time value of money is also an important consideration because the longer one holds a Bond the greater the potential decrease or increase in savings is in relation to alternative financial investments. For example, in reverse of the opportunity cost risk mentioned above, there may also be adversity protection from harsh market conditions, recessions or any other event that might reduce the value of non-Government backed investments. As time progresses the combination of market forces, economic conditions and investment decisions amount to either an opportunity cost or gain depending on the circumstances.

Bonds are generally secure and stable investments that can anchor an otherwise volatile investment portfolio. However, if one invests entirely in HH/H or I bonds, one may forfeit higher returns available through other investment vehicles. Since some bond rates are variable the rate can become more favorable after one has purchased them. In this respect it can be wise to consider past, present and possible future prices of bonds when deciding whether or not to buy them.

Comparing bonds Vs stocks as an investment

A big difference between bonds and stocks as investments are that bonds are considered 'bear' investments and stocks are considered 'bullish'. In other words, when the stock market is being flailed and vulnerable to 10-20% swings, more cautious investors may head for the bond market in which returns may be more stable and/or fluctuate less. Some investment advisers believe it is sensible to diversify investments between the two markets via portfolio ratios such as 30:70, or 40:60. In turn, this can be an indicator of a particular firms stance on the market.

Bonds and stocks really are two different breeds of investment. Bonds, especially the Government kind, are less vulnerable to recessions and weak market conditions because their value is tied to their interest rates. The value of stocks however, is generally not coupled to interest rates per se, but rather share price via economic and market conditions. While a change in the Federal reserve funds rate may influence stock prices, these changes in valuation are correlation only and not an absolute relationship as with bonds.

Risks and rewards

There are risks and rewards associated with both bonds and stocks because of principles such as opportunity cost and market timing. Time value of money is also a factor in the pricing of investments because present values of an investment are determined in part by the future flow of income and/or capital gains via stock dividends, bond interest payments, as well as changing industry and/or market conditions.

As these things change, the foreseeable value of investments can rise or decline because of better investments such as higher yielding bonds, a giant new contract for a newly financially streamlined company, or an IPO in a high demand industry. Risks and rewards associated with stocks and bonds are listed below:

• Financial Stability: In the case of bonds, an investor can generally have more peace of mind because even if interest rates do rise causing the price of bonds to lower, the percentage fluctuation in price is likely to not be as great as can occur in the valuation of stocks.

• Earnings Potential: The earnings potential is most often higher in the stock market because stock prices are essentially unlimited in how much they can rise. For example, a stock price can rise as much as 50% over the course of a few months under certain circumstances whereas the chances of this type of percentage rise affecting a bond is significantly lower.

• Opportunity Cost: If one has bought a substantial position in Bonds, such as 80% of one's investment portfolio and a dramatic improvement in economic conditions emerge, the return on stocks could prove fantastic in comparison to bonds making the opportunity cost higher of holding the bonds higher.

• Leveraging: When one has investments in Bonds one may be able to take out loans against those Bonds and in effect leverage a new position into another financial instrument. In other words, a financial institution or private lender may view paper or Government bonds held outside of an exchange as good collateral for a loan which can be used to make further investments. With stocks, such leveraging may not be as likely due to their potential volatility and nature of exchange.

• Timing: Since the primary risks involving bonds is that interest rates on bonds may rise after bonds have been purchased and vice versa, how an investor uses time in each market becomes a potential risk or reward. That is to say, if an investor does not time investments well by entering too early, or exiting too late, that investor faces timing related risks and rewards. 

In the former case, if one buys bonds with an interest rate of 3.5% fixed returns and the rate changes to 4% the value of the 3.5% bond becomes lower, the investor has in essence been affected by timing risk. The same holds true for stocks. For example, if an investor takes a position in a company that is very financially strong, if the timing is wrong, the investor may still lose. This is especially true in companies that benefit from seasonal and cyclical trends.

Deciding what to invest in:

Making the decision to invest in stocks and bonds does not have to be daunting. It is for all intents and purposes impossible to predict all financial conditions, price movements and economic conditions. While forecasting, technical analysis and fundamental analysis of financial information can assist with predicting investment outcomes, eventually an investor either decides to invest, not invest or think some more.

When choosing stocks and/or bonds one may consider the above information in determining how much of each investment would be prudent given current financial trends and data. Conditions in the stock market can affect conditions in the bond market and vice versa. Bonds often serve as a hedge against stocks, and stocks assist in capitalizing on market conditions. By investing in both, one can potentially benefit from the best of both financial markets.