January 5, 2007
I’ve been hearing a lot about the futures market. What is it?

The futures market is conceptually a place where an investor can arrange to buy or sell something at a specified date in the future and at a price agreed upon today. There are futures markets for commodities as well as financial instruments. There are many different types of commodities that can be traded including wheat, oil, Soya, corn, silver etc. Similarly futures contracts on financial instruments such as equities, Eurodollar deposits, and indices are available.{{more}} Futures contracts can be extremely useful. For example, if a producer of wheat is going to have a certain quantity of production to sell in three months time but thinks that the price may fall over that time, he can get into a contract to sell at the futures price agreed upon today. In this way the producer hedges the risk of the price he gets for his produce. On the other hand, the purchaser of wheat may think that the price of wheat may rise and in order to avoid paying a higher cost can also hedge this risk by arranging to purchase wheat at a specified future date and price. The financial markets also have such hedging facilities. For example, if a mutual fund manager has to pay a distribution in six months but feels over this time the prices of shares in his portfolio may fall he can hedge the prices of the shares falling by arranging to sell these in the future at prices agreed upon today. This sounds all well and good but remember nothing comes for free. The opportunity cost in a futures contract is if the price of the commodity or financial instrument goes counter to what was anticipated. If the wheat producer arranges to sell at the futures price but if the spot price at the time of settlement is higher than what was expected the producer loses the opportunity to sell at the higher price. The producer may prefer incurring this opportunity cost rather than selling at a lower price.

l I’ve heard that refinancing my mortgage can reduce my monthly payments as interest rates are low right now, but when the rates go back up won’t I be back to square one?

l The rates on most mortgages are fixed for the term and so if you refinance your mortgage today and rates subsequently go back up again the rate on your mortgage would stay constant. Therefore, by refinancing now before rates increase again you effectively lock in a fixed rate for the term of your mortgage. Now a fixed rate mortgage is a double-edged sword. If rates go back up you benefit. However, if rates fall further you would be paying higher than you have to. In fact, this would have been the reason why you had to refinance in the first place.

Overall fixed rate mortgages may not be the most efficient instrument. If rates fall, while in theory you may be able to refinance, the costs associated in the form of legal fees and stamp duty can be significant. These upfront costs may make it prohibitive to refinance even though there could be significant interest savings over time.

There may be a way to avoid this by getting into a floating rate mortgage, which increases or decreases in tandem with market conditions. If rates fall so does the interest cost on your mortgage. However, if rates increase so does your interest cost. However, if you expect rates to decline, this facility could be useful in that your interest cost is lowered without having to incur the upfront costs of refinancing. The only downside remains the fact that the rate can float up if rates in the market increase. However, even this can be hedged to an extent by the use of an interest rate ceiling. While you may have to pay a slightly higher initial rate on your mortgage for this benefit it provides protection in a rising interest rate environment. Discuss the options with your banker and shop around to get the best deal.

l My sister has been investing $100 every month for about two years. I prefer to save when I have some extra cash, some months $200 and other months nothing. She tells me her regular saving, although small, will grow faster than my casual approach. Is she right?

l Your sister may be right. It may be better, especially when inculcating a savings habit, to set aside a fixed amount per month. This imposes a discipline on yourself from which it may be difficult to stray. This routine approach would promote the commitment that is needed to keep dedicated to savings. If an ad hoc approach is adopted it is very easy to procrastinate and keep on deferring saving for the future. In such circumstances, the extra luxury good may become more important than the extra $ 100 in savings.

Apart from building the habit, your sister may be right about the rate of growth of your savings if a regular amount is set aside. The quicker you accumulate savings the faster you benefit from the time value of money and the compounding effect, two very important concepts in finance. The time value of money is intuitively obvious-the longer the time period over which you save, the greater is the dollar interest earned. The compounding effect is a related concept but specifically refers to the ability to keep on augmenting your initial principal. This arises from adding interest on to your principal periodically thus being able to earn “interest on interest” which significantly increases the growth of your savings. So work out a budget and determine the fixed amount per month that you can set aside and stick steadfastly to it.

All information contained in this article has been obtained from sources that CMMB believes to be accurate and reliable. All opinions and estimates constitute the Author’s judgment as of the date of the article; however neither its accuracy and completeness nor the opinions based thereon are guaranteed. As such, no warranty, express or implied, as to the accuracy, timeliness or completeness of this article is given or made by CMMB in any form whatsoever.

CMMB and/or its employees or directors may, where applicable, make markets and effect transactions, or have positions in securities or companies mentioned herein. Neither the information nor any opinion expressed, shall be construed to be, or constitute an offer or a solicitation to buy or sell.