What is the liquidity risk of a futures contract?
Liquidity Risk
At its core, liquidity is the collective expression of traders' opinions on the market. Like any other market, these opinions are represented in a futures market either as existing positions held by traders, known as open interest, or as buy or sell orders communicated to the rest of the market but yet to be executed.
Market Risk: The most obvious risk with futures trading is that prices can be highly volatile, and changes are can be swift, adverse, and devastating. 11 This is because the market risk is magnified by leverage, when there's already enough to worry about when supply and demand shift.
Liquidity risk applies to investors who plan to close out a derivative trade prior to maturity. Overall, liquidity risk refers to the ability of a company to pay off debts without big losses to its business. To measure liquidity risk, investors compare short-term liabilities and the company's liquid assets.
Liquidity: Forward contracts have lower liquidity than futures contracts. This is because forward contracts are not traded on exchanges, while futures contracts are traded on exchanges. Exchange-traded contracts are more liquid because there are more buyers and sellers in the market.
First, for each contract, we find the difference in settlement prices between day t and the previous trading day. Next, we calculate a weighted average of the absolute value of the price change for each contract, using each contract's relative trading volume on day t as the weight.
Futures are standardized and traded on regulated exchanges, making them highly transparent and liquid. Futures trading involves leverage and margin requirements, which can amplify both profits and losses.
Futures depict a more standardized agreement where the trades are made on the stock exchange markets. They are never delivered; hence they are settled on a marked-to-market on a daily basis. Since they come with fixed maturity periods, they bear less default risk because they guarantee payment on the agreed-upon date.
For futures traders, the biggest risks of futures trading come from the adverse movement of prices. Volatility risk is often not appreciated as one of the key risks of futures trading. When you trade futures, you normally set a stop loss.
There is less oversight for forward contracts as privately negotiated, while futures are regulated by the Commodity Futures Trading Commission (CFTC). Forwards have more counterparty risk than futures.
How do you determine liquidity risk?
- The current ratio or working capital. This compares current assets, including inventory, and liabilities.
- The acid test, or quick ratio. This measures only current assets, such as cash equivalents, against liabilities.
- The cash ratio or net working capital.
The three main types are central bank liquidity, market liquidity and funding liquidity.
Liquidity Risk Calculation Example
Starting with the current ratio, the formula consists of dividing the “Total Current Assets” by the “Total Current Liabilities”.
It basically describes how quickly something can be converted to cash. There are two different types of liquidity risk. The first is funding liquidity or cash flow risk, while the second is market liquidity risk, also referred to as asset/product risk.
An example of liquidity risk would be when a company has assets in excess of its debts but cannot easily convert those assets to cash and cannot pay its debts because it does not have sufficient current assets. Another example would be when an asset is illiquid and must be sold at a price below the market price.
Here are some important differences between them. A forward contract is signed between party A and party B face to face (or over the counter), whereas in a futures contract there is an intermediary between the two parties. This intermediary is often called a clearance house, which is a part of a stock exchange.
Illiquid options are option contracts with a very low level of liquidity, that is, they cannot be easily and quickly sold or exchanged for cash. Illiquid options fall into the high-risk category: they have wider bid-ask spreads and may be more challenging for investors to sell at a fair price in the market.
Generally, a good Liquidity Ratio should be above 1.0. This indicates the company has enough current assets to cover its short-term liabilities.
Current, quick, and cash ratios are most commonly used to measure liquidity.
While forward contracts reflect both counterparty credit risk and market risk, futures contracts aim to eliminate counterparty risk to the extent possible, leaving only market risk. Assets that are most commonly referenced in futures contracts include equities, treasuries, index units, currencies, and commodities.
Why are futures more liquid than forwards?
Answer and Explanation: Futures are more liquid because they trade in an exchange market while forwards are over the counter contracts. The forward contracts are flexible since they are customized between two parties.
Crude oil (CL) provides decent volume, but it also requires the most margin and is the most volatile.
Failure: An Insufficient Commercial Need
Some new contracts historically have failed because there was an insufficient need for commercial hedging. This occurred when economic risks were not sufficiently material or contracts already provided sufficient risk reduction.
Futures contracts require a margin payment in advance by both parties. That ensures that both buyer and seller are make a financial commitment towards the contract, which brings down the risk of default. A Forward contract requires no such initial margin, and credit risk remains high as a result.
Rollover. Rollover is when a trader moves his position from the front month contract to a another contract further in the future. Traders will determine when they need to move to the new contract by watching volume of both the expiring contract and next month contract.
