This chapter sets the stage for risk management and the study of derivative instruments in futures, options, and swaps markets. It covers the institutional aspects of forward and futures markets, the valuation of forward and futures contracts, hedging, the minimum variance hedge ratio, cross-hedging, and speculation in futures markets. This chapter emphasizes the flexibility in the use of futures contracts, their use in hedging of long and short positions, and their role in speculation.
Futures markets are important components of capital markets. Futures instruments play a key role in risk management, speculation, and arbitrage. They transfer risk from hedgers to those who are willing to bear the risk; they may contribute to reduce risk for counterparties in a forward or futures contract. They are attractive to traders because of the very low cost to use them and their efficiency in risk management. In fact, it costs nothing to establish a forward contract and only a small margin is required to establish a futures contract. This contrasts, for instance, with an option contract, which requires a premium for its establishment. Considerable innovation has taken place in developing and spreading futures markets and instruments. Futures contracts arose from primitive forward contracts on agriculture commodities to standard exchange-traded products that cover a large spectrum of products such as stock index futures, currency futures, and bond futures. Options ...