A Word About Risk

With any investment comes risk, and investing in the futures market is no exception.

That’s just the nature of the investing world, and since futures are derivatives, like options, they can derive their value from other, underlying financial instruments such as equities, bonds, or currencies – each with their own inherent risks.

You should keep in mind that risk comes in different forms: For example, as an investor, you’ll typically face scenarios, where you buy something that loses value, or something you sell rises in value.

Such risks may be due to an adverse move in the market itself – it may have been that you decided to enter the market at a poor time, which, in finance, is generally referred to as Market Risk.

Alternatively, you may have purchased a stock that performed badly when the broader market soared, which is typically a signal of Company Specific Risk.

You could probably find a case each day of the week, where the market rises, but some stocks fall.

Generally, investors invest in stocks because they believe that the value of companies tends to increase over time, and as good economic policy creates an increasingly improving labor market.

You could say that the futures markets differ in the respect that buyers and sellers tend to have more balanced views, due to competing bullish and bearish information on most commodities.

However, the futures markets, by their very nature, perform another very important role when it comes to mitigating risk, as the futures exchange, where standardized futures contracts are traded, bears the role of central counterparty to all transactions.

Futures trading, like any other typical financial transaction, generally involves two parties – a willing buyer and a willing seller.

The role of a marketplace is to bring counterparties together and engage in price discovery. This process between a bank and its customer is often referred to as Over-the-Counter, or OTC, trading.

However, the relationship among buyers and sellers in the marketplace raises the question of counterparty risk, since neither party can guarantee that the other will not fail on the trade.

The purpose of an exchange facility, or transaction model, is to remove counterparty risk by creating and transferring risk to the single exchange entity, backed by the diverse financial standing of its members.

Sure, there are buyers and sellers to all transactions, but the exchange undertakes to back all futures contracts regardless of the financial health of anyone trading on it. This alleviates settlement risk, meaning participants in the market don’t need to check the quality or capitalization of the person or company they’re trading with; this is all done by the exchange.

To further help safeguard the futures markets, the Commodity Futures Trading Commission, or CFTC, was established by Congress in the mid-1970s to serve as a federal regulator. In this capacity, the CFTC acts to ensure the integrity of futures market pricing, with aims to prevent abusive trading practices, fraud, as well as the regulation of brokers that participate in futures trading activities.

Now that we’ve touched on and explored different types of risks in the financial markets, we’ll next turn our attention to futures prices – with a focus on the difference between spot and forward prices.