WEEX Futures Trading Guide: Explaining Leverage and Risk Management
The development and expansion of financial markets and financial liberalization have led to a growing variety of financial instruments traded in these markets. While trading was once limited to traditional instruments—stocks and bonds—the necessity of managing risks led to the emergence of innovative financial instruments. Among the most widely traded and well-known of these are Forwards Contracts, which are a type of financial derivative traded in global financial markets.
What is the concept of a Forwards Contract?
Forwards contracts are among the oldest forms of futures contracts; they involve two institutions, or a financial institution and a business, contracting to complete a transaction at a specific price and quantity at a later date.
When are Forwards Contracts created and executed?
A forwards contract is created when one party agrees to buy an asset at a specific price in the future, and the second party agrees to sell that asset. Typically, the asset is physically delivered on the execution date. Significant credit risks may arise from one party's inability to fulfill the contract, especially if there are clear changes in the underlying asset's trajectory as the maturity date approaches.
Where are Forwards Contracts traded?
Forwards contracts are traded in over-the-counter (OTC) or unregulated markets. They are customized according to the client's needs regarding contract size and execution date.
Dear investor, you can join the WEEX platform and access the futures trading section from your dashboard to explore this world at your own pace.
Why are Forwards Contracts attractive to contracting parties?
Because they do not require an upfront payment from either the buyer or the seller; this incentivizes others to enter into these agreements. The initial value of any contract in the market is zero when the terms are set, and any change in market conditions increases the value of the contract for one of the parties.
What are the types of Forwards Contracts?
There are various types of forwards contracts, but the most well-known are as follows:
1. Interest Rate Forwards
This is an agreement between two parties to pay or receive amounts generated by the difference between the interest rate likely to be in effect at the end of the contract and the current rate. This type is used to hedge against interest rate fluctuations.
2. Currency Forwards
These specialize in the buying and selling of foreign currencies on local and international exchanges.
3. Stock Index Forwards
This type of contract focuses on stock prices and is used by participants who have funds invested in various investment projects.
4. Exchange Rate Forwards
These are contracts where two parties agree to buy and sell a certain quantity of a foreign currency at a future date and a specific price agreed upon when the contract is written.
From the above, dear trader, we understand that a forwards contract is an agreement to sell or buy an asset in the future at a pre-determined date and price. Accordingly, the forwards contract involves two types of prices: the strike price and the forward price.
What is meant by the strike price?
This is the price agreed upon for the future execution of the contract. It is determined between the two parties based on supply and demand, their respective views on benefiting from this price in the future, and their future expectations. This price does not change from the date the contract is concluded until the execution date.
What is meant by the forward price?
This is the price of the currency or asset underlying the forwards contract in the future. This price changes over time as market prices fluctuate.
It can be said, dear trader, that the strike price is a forecast of the forward price at the time the contract is concluded, but it is not required to be equal to it on the execution date.
What are the characteristics of Forwards Contracts?
1. These contracts are exchanged in organizations.
2. These contracts include standardized terms regarding the underlying assets traded and the time.
3. These contracts are linked to information exchange centers to ensure the smooth functioning of the market.
4. There are margin and daily settlement requirements as additional protection.
5. Flexibility; this means that both the buyer and seller negotiate the contract terms, so they have the freedom to act and create any terms they deem appropriate for any commodity.
6. They lack liquidity compared to other derivatives; if a buyer or seller wishes to exit the forward agreement, they need to find someone else to take their place who is willing to sell the contract within the specified timeframe.
7. They are traded in over-the-counter markets, and the contract size and execution date are flexible. The trading time is not fixed, and it does not require a specific margin.
8. The value of the forwards contract is realized only on the contract expiration date, and there are no payments at the beginning of the contract.
9. No money is transferred from one party to another before the contract expiration date.
What are the distinguishing features of Forwards Contracts?
1. Speculation with these contracts is difficult; their primary purpose is protection against future price volatility risks. There is an obligation for both parties to execute, and there is no secondary market for trading them.
2. They do not have a standardized form, as their terms can be agreed upon.
3. The maturity date and strike price are precisely defined in this contract, and they are final contracts once signed; they cannot be revoked or modified.
4. Execution occurs on the execution date, not before.
You might wonder how to trade futures on the WEEX platform. Dear trader, you can find the steps for trading contracts on the WEEX platform in our article on the platform titled: The Difference Between Spot Trading and Futures in WEEX: Which is Best for You?
Through this article, dear trader, you will also learn how to set leverage. One of the features of trading futures on the WEEX platform is that it allows for leverage, which enables you, dear trader, to manage large positions with small capital.
What is meant by leverage?
Leverage refers to an entity's (company's) reliance on borrowing from financial and banking institutions to meet its financial needs. Consequently, its fixed financial costs in this case are the interest paid on debt.
However, if the company issues preferred stock to meet these needs, the fixed financial costs here consist of the preferred stock dividends that the company will pay to preferred shareholders, as preferred stock enjoys guaranteed and fixed dividends.
Thus, the concept of leverage emerges as one of the methods a company resorts to in order to improve its profits, representing the extent of its reliance on loans to finance the entity's capital needs.
What is the impact of leverage?
Leverage affects the cost of both equity and debt components. An increase in the level of debt (higher leverage) leads to an increase in fixed expenses and an increased probability of being unable to pay these expenses, along with the resulting costs such as bankruptcy costs. With these costs, there is a direct relationship between leverage and the risk associated with equity and debt, which means an increase in the required returns on equity and debt.
How does leverage work?
Leverage does not produce the same obligations as taking out a credit loan. No debt or credit repayment is expected because leverage is not a loan in the literal sense of the word; rather, it is simply an obligation to close positions as long as they have not been closed by a margin call.
Note: All open positions will be closed automatically if the actual balance reaches a level insufficient to keep them open.
Conversely, if these positions are profitable, they earn much larger profits than they would without leverage, and there is usually no interest or fees associated with leverage.
What is the relationship between leverage and financial risk?
Financial risk refers to the additional risk borne by common shareholders resulting from management's reliance on long-term loans and preferred stock in the entity's asset financing structure. This is due to the fixed costs management bears, such as interest, and the potential inability to repay the principal of the loans at maturity, the interest, or both.
You might also wonder, dear trader, how to manage risk in futures contracts. To know this, we must understand what is meant by risk management.
Some distinguish between hedging and insurance: hedging is reducing loss by giving up the possibility of profit, while insurance is paying a price to avoid loss while retaining the possibility of profit. Hedging is avoiding risks as much as possible; therefore, hedging is acceptable if it is associated with real activity. Thus, the benefits of risk distribution can be achieved without falling into the negatives of gambling.
What is meant by risk management in Forwards Contracts?
Hedging with forwards contracts is considered one of the hedging tools based on counter-contracts intended to achieve profits. One of the goals of using forwards contracts is to hedge against the effects of exchange rate fluctuations for traders who have future obligations.
The effectiveness of a forwards contract in hedging against risk can be evaluated by comparing the changes that occur in the forward price with the changes that occur in the spot price. If these changes are close or equal, the hedging is ineffective.
What are the reasons for companies to move towards hedging?
1. It is a process that does not involve high costs; that is, it involves a relatively low cost that may reach zero if the forward exchange rate is equal to the spot exchange rate in the future.
2. The foreign exchange market is an efficient market, at least regarding major currencies, so arbitrage should be zero unless financial managers and traders in that market possess private information.
Why do large companies tend to acquire Forwards Contracts?
Large companies that wish to hedge, especially against foreign exchange rates, tend to acquire forwards contracts as a means used to address the volatility of foreign currency returns and to hedge their stock investments, as well as those of their foreign branches.
In order to use forwards contracts, companies with global investments, such as multinational corporations, sell the currency associated with their future accounts receivable.
How are Forwards Contracts useful for hedging?
For forwards contracts to be useful for hedging, their prices must be systematically linked to the spot prices of the commodities intended to be hedged.
Frequently Asked Questions:
What is meant by a Forwards Contract?
Forwards contracts are agreements in which one party agrees to buy a commodity immediately without both parties being financially strong. There are risks that one party may be unable to fulfill the contract, especially if the price of the commodity changes significantly after signing the agreement.
Are Forwards Contracts financial derivatives?
Yes; forwards contracts are known as a type of financial derivative. Due to the lack of specific specifications for forwards contracts in terms of contract size (i.e., the quantity of assets traded), delivery date, and the absence of a centralized market, they provide a type of flexibility when dealing with them and adapting them according to the needs of their users.
What is meant by leverage?
The ratio of total debt to total assets, or to the total value of the company.
It is also defined as the degree of an entity's reliance on fixed-income financing sources (whether loans, bonds, or preferred stock) to finance its assets; this affects the profits obtained by the owners as well as the degree of risk they are exposed to.
What advantages does leverage provide?
Leverage provides the advantage of obtaining higher returns and more tax deductions compared to investments consisting of similar capital and similar business conditions. In parallel, it carries an additional cost, which is the cost of borrowed capital.
What are the pros of leverage?
- Investment is magnified, which may lead to achieving a larger profit.
- Providing more opportunities for investors to access more expensive investment opportunities.
- It can be used strategically by companies to meet short-term financing needs, especially in acquisitions.
What are the cons of leverage?
- Magnifying losing investments, which may lead to heavy losses.
- More expensive than other types of trading.
- Paying fees, margin rates, and contract premiums regardless of loss.
- More complex.
Are there new ways to manage risk for those who use forwards contracts?
Yes; by adopting forwards contracts, new ways to manage risk can be created by fragmenting the risks accumulated in traditional financial instruments, such as price volatility risk, interest rate risk, and foreign exchange rate risk, and managing each of these types of risks separately through the hedging process.
Disclaimer
The WEEX platform and its affiliates provide digital asset trading services, including derivatives and margin trading, only where legal for eligible users. All content is general information, not financial advice - please seek independent advice before trading. Cryptocurrency trading involves high risks and may lead to a total loss. By using WEEX services, you accept all related risks and terms.
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