We conclude this series of posts with a brief look at the role that futures markets and exchanges play in global financial systems and in society. Virtually all participants in the financial markets have heard of futures markets, but many do not understand the role that futures markets play. Some participants do not understand how futures markets function in global financial systems and often look at futures with suspicion, if not disdain.
In earlier posts, we discussed the purposes of derivative markets. We found that derivative markets provide price discovery and risk management, make the markets for the underlying assets more efficient, and permit trading at low transaction costs. These characteristics are also associated with futures markets. In fact, price discovery is often cited by others as the primary advantage of futures markets. Yet, all derivative markets provide these benefits. What characteristics do futures markets have that are not provided by comparable markets as forward markets?
First recall that a major distinction between futures and forwards is that futures are standardized instruments. By having an agreed-upon set of homogeneous contracts, futures markets can provide an orderly, liquid market in which traders can open and close positions without having to worry about holding these positions to expiration. Although not all futures contracts have a high degree of liquidity, an open position can nonetheless be closed on the exchange where the contract was initiated. More importantly, however, futures contracts are guaranteed against credit losses. If a counterparty defaults, the clearinghouse pays and, as we have emphasized, no clearinghouse has ever defaulted. In this manner, a party can engage in a transaction to lock in a future price or rate without having to worry about the credit quality of the counterparty. Forward contracts are subject to default risk, but of course they offer the advantage of customization, the tailoring of a contract’s terms to meet the needs of the parties involved.
With an open, standardized, and regulated market for futures contracts, their prices can be disseminated to other investors and the general public. Futures prices are closely watched by a vast number of market participants, many trying to discern an indication of the direction of future spot prices and some simply trying to determine what price they could lock in for future purchase or sale of the underlying asset. Although forward prices provide similar information, forward contracts are private transactions and their prices are not publicly reported. Futures markets thus provide transparency to the financial markets. They reveal the prices at which parties contract for future transactions.
Therefore, futures prices contribute an important element to the body of information on which investors make decisions. In addition, they provide opportunities to transact for future purchase or sale of an underlying asset without having to worry about the credit quality of the counterparty.