The foundations of the futures markets date back to nineteenth century Chicago when farmers first ventured into the American mid-west and the need for the food they produced became pivotal.
Industrial development meant that the population of Europe was rising rapidly, and the prairie offered a way to feed these extra mouths.
Chicago was the ideal port to handle this food: ships sailed from Europe, down the St. Lawrence River, through the Great Lakes to Chicago in the heart of the mid-west; railways and cattle drives brought grain, pork and beef to the port.
The only downside was the length of time the whole process took. American farmers might have to plant crops a year or more before they were delivered to their destination in Europe, and agricultural prices see-sawed widely with supply and demand. Shortages may have encouraged farmers to plant more crops, but who could tell what price they might be in a year’s time?
A good harvest in Europe and American the following year might mean low prices and therefore, redundant farmers. Such worries were a deterrent to expansion.
European importers also wanted some certainty in the price they would have to pay for imports; profits could disappear if raw materials prices suddenly shot up. So both producers and consumers wanted to take some of the risk out of agriculture.
A Market Solution
To try to alleviate the problem, markets were established in Chicago where people could buy or sell wheat, corn and other commodities for future dates.
These markets meant that farmers could estimate the size of their crops, go into the markets and sell an equivalent amount of produce for delivery into, say, six months time, but at a price that was fixed or agreed today. In effect they were hedging their risk. Similarly, importers could go to the markets and buy what they needed, fixing the price well before the goods were due to arrive.
A Standard production
To make the markets attractive to as many people as possible, the futures markets dealt in standard specified amounts of goods.
For example a corn deal was for a specified number of bushels of set weight. What was bought and sold on the market was a contract to deliver (or accept) a set amount of goods of a standard quality.
The other important feature about the futures market is that deals were done on a MARGIN. Anyone buying or selling only had to put up a small proportion of the total price at the time the deal was agreed upon; the rest did not have to be paid until the commodity was delivered.
This helped encourage buyers to use the market, since paying for goods months in advance has never been popular, but it brought in the speculators.
Dealing on margin offers speculators the opportunity to make huge gains, and it is not difficult to see how. For example, wheat costs $100 a tonne, but someone buying it on the futures market for delivery in sex months only has to pay up $10 initially. Over the next two months the price of wheat rises to $150 a ton, and rather than wait to take delivery of his wheat the speculator sells his futures contract to close out the deal. The speculator makes $50 profit or 500 per cent on his $10 investment, despite the fact that the price of wheat has only risen by 50 per cent.
Such speculators make a futures markets more liquid; they might well take a deal on even if there is no natural buyer or seller in the market at any given time.
These, then, are the essential elements of a futures market. A standardized commodity is bought and sold on margin for future delivery. The key participants are hedgers, usually the producers or consumers of a product or commodity who want to reduce the risks they run, and speculators who are prepared to take on the hedgers risks in the hope of making a profit.
The futures market is thus a way of transferring risk from hedgers to speculators. Bearing in mind the god economic principle that there is no such thing as a free lunch, the hedgers effectively pay the speculators to take on this risk.
The large profits which can be made trading futures on margin give rise to the common misconception that futures are inherently volatile and risky. In fact, futures prices futures prices rise and fall in line with movements in cash commodities. What gives rise to this misconception is the fact that a speculator, when purchasing futures, will only pay a small percentage in relation to the amount they would pay to buy the actual commodity.
We encounter options often in our daily lives, but without paying too much attention to it. Options occur in situations of uncertainty, and they are helpful in managing risk.
For example, most of us insure our home, our car and our health. We protect our assets by taking out policies from insurance companies who agree to bear the cost of loss or damage to them. We periodicallypay these companies a fee, or premium, which is based in part on the value of our assets and the duration of coverage. In essence, we establish contracts that transfer our risk to the companies.
Although options are often dominated by professionals, there is a closely allied market where individuals play an important part. Options are often considered alongside futures because they are both based on other quantities, for example, options give the buyer the right to buy or sell a commodity or contract s to deal in a financial instrument or a commodity at a future date – for that reason futures and options are collectively known as derivative products.
Investors are keen on options because they offer limited risk. Unlike futures where investors are equally exposed to a rise or fall in the market, options are a one-way bet, not unlike an insurance policy. This happens because options give the buyer the right but NOT the obligation to buy or sell something at a specified price, on or before an agreed date.
In many ways options are the most versatile trading instrument ever invented. Since they cost less than the stock or commodity they are priced against, they provide a high leverage approach to trading that can significantly limit the overall risk of a trade or provide additional income.
Futures & Commodities – Trading Revolution in the United Arab Emirates
The region in general and the UAE in particular has developed an unceasingly growing appetite for sophisticated investment products and financial instruments.
But this revolution did not happen instantly, it has been a work in process since the 1990’s; a time of renovation in the economy of the UAE. At that time the framework for the Emirates, and Dubai in particular, as a financial, tourism and service-based economy of the UAE were laid out.
In addition to visionary planning, unexpected causes assisted the already laid out scene in the region. Firstly the terror attacks in New York on September 11,2001, that forever altered the Arab and Western world at the same time and subsequently came the same time and subsequently came the occupation of Iraq by coalition forces; these two historical incidents provoked the repatriation of Arab capital home.
Now adding to the previous formula the surging oil prices, this equated to a tremendous bulk of liquidity in the UAE.
Changing the formula and consequently the rules of the game in the region, at a macroeconomic level it ‘hit a home run’ for the financial, banking and real estate sectors.
This translated into phenomenal growth in regional gross domestic product (GDP), purchasing power, investment appetite and capabilities. Dubai became an irresistible magnet for investment, not just for the region, but also for South Asia, East Africa and Russia.
The cyclical manifestation continued, embodied in the growth in the number of millionaires in the UAE, with increasing rates higher than the US and the UK which is not much of a surprise since the UAE ranks among the top Arab nations in terms of per capita GDP. In the UAE, the private investor’s potential product universe encompasses a wide spectrum of asset classes, risk tolerance ranges and investment methodologies.
Zooming into the investment scene, traditionally the demand was for products such as equity and fixed income. Today, with investor’s increasingly sophisticated demands, equity investments are leaning towards commodities and futures.
Commodity trading has developed from physical buying and selling into sophisticated managed futures strategies with Wall Street Commodity Trading Accounts (CTA). The demand for new ideas has given way to the huge growth of alternative investments in derivatives, hedge funds and private equity.
With the help of regulatory bodies and exchanges like the Dubai Gold and Commodities Exchange (DGCX), and the Dubai Mercantile Exchange ( DME) UAE and regional investors are given access to the wide range of multi class assets to invest in locally.
We have seen trading volumes on the Dubai Gold and Commodities Exchange (DGCX) grow last October 2014 28% from the same period in 2013, a month in which the Exchange significantly expanded its Emerging Markets portfolio with four new products. October saw the year’s second highest monthly volume with volumes touching 1,044,396 contracts.
DGCX’s currency segment grew 31% year-on-year, accounting for 93% of total volume with 978,169 contracts traded, with both the Indian Rupee Futures and mini Indian Rupee futures contracts performing well.
The DGCX strengthened its product offering with the launch of two new Index products and two mini-Indian Rupee contracts in October. The Index products included two MSCI India index contracts, the first – a price return index that takes into account the price performance of the 67 constituent stocks in local currency (Indian Rupee) and the second a total return index taking into account both the price performance and the dividend payments, calculated in US Dollar terms.
DGCX also launched two new mini currency-pair futures contracts – Indian Rupee/British Pound and Indian Rupee/Euro. Trading in the new contracts is gathering trading momentum with the participation of a wide range of players including a sophisticated institutional investor base.
With regards to gold, Dubai’s top trading partners for gold are India, Switzerland, Malaysia, Australia, South Africa, Italy, The UK, Turkey, USA and Saudi Arabia, while the geographical reach of the business extends to 101 countries.
In a nutshell, all the factors mentioned, have created a demand for new, sophisticated investment channels and instruments all manifested in a futures and commodities trading revolution in the region.
We have seen the popularity of futures trading increase in the region after the establishment of the (DGCX)
Dubai is ideally situated geographically to play an increasing important role in proving liquidity and hedging facility to traders, producers and importers in the Middle East, Asia and beyond.
The introduction of further products at the DGCX, such as agriculture commodities with contract specifications that local market participants can relate to, will be highly welcomed.
It is also important in my opinion to introduce futures to the local stock markets. This will offer investors the possibility to open short as well as long positions so as to protected investors from sharp unpredicted market swings. Position can be reversed easily of course. This should be a great hedging tool and also for the exchanges this should lead to high liquidity.
In other well established international stock markets such as that in the US, the use of futures helps makes sure that no market makers can play games with a particular stock. The futures markets are so huge it is almost impossible for anyone to manipulate them.
One thing is for sure, is that we all expect interesting years ahead in the local exchanges here in Dubai-
By Ali Hamoudi,
Follow me: @Ahamoudi