Long and short of futures and forward contracts

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Sunil K Parameswaran: Dec 14 2012, 02:04 IST

While the future fascinates some of us, for others, it is a source of fear. Financial agents can be sub-divided into two categories. There are some who wish to seek exposure to the uncertainty and risk that the future entails. We term such agents as ‘speculators’. On the other hand, there are others who are already exposed to this uncertainty and seek ways of mitigating, if not eliminating, their exposure to such risk. We term such agents as ‘hedgers’. Irrespective of their goal, economic agents have access to financial tools that facilitate both exposure to risk as well as risk-avoidance.

Futures and forward contracts, which we term as derivative securities, help traders to both speculate on the future as well as minimise, if not eliminate, the risk to which some of them may already be exposed.

Such contracts are what we term as ‘commitment contracts’, for the assumption of a position in such contracts amounts to a binding commitment to perform on a future date. Such contracts require two counter-parties who are termed as the ‘long’ and the ‘short’, respectively.

The long in the case of such contracts has a binding commitment to take delivery of the underlying asset at the date that is specified in the contract. The short, on the other hand, is committed to give delivery of the underlying asset on the same date. In practice, both parties may be speculators, albeit with different price expectations. The long may be acting on the assumption that the price of the

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