Look-Alike Contracts Meaning Limitations Criticism
Look-Alike Contracts: Meaning, Limitations, Criticism
What Are Look-Alike Contracts?
Look-alike contracts are cash-settled financial products based on the settlement price of exchange-traded futures contracts. They are traded over the counter and do not involve physical delivery.
Futures look-alike contracts are regulated by the Commodity Futures Trading Commission (CFTC).
Key Takeaways
– Look-alike contracts are cash-settled derivatives with similar specifications as physically settled futures contracts.
– Traders do not need to close out positions to avoid making or taking delivery.
– Critics argue that look-alike contracts fuel speculation and generate market inefficiencies.
Understanding Look-Alike Contracts
Look-alike contracts are essentially options based on futures contracts with specific settlement dates. For example, the ICE Brent Crude American-style Option Product is based on an ICE Brent Crude Futures Contract. The contract terms closely correspond with those of the futures contract and can be offered in American and European styles.
Look-Alike Contracts and Position Limits
Look-alike contracts become interesting when they cover contracts traded on other exchanges, allowing the exchange to capture trading activity on different commodities. This separates pure risk speculation from the underlying futures contracts and allows traders to skirt position limits meant to temper commodity speculation.
Criticisms of Look-Alike Contracts
Like other derivative products, look-alike contracts have detractors. Instead of influencing the price of the underlying asset, they allow traders to bet against each other without providing new market price signals. However, traders argue that their speculation volume and open interest provide market information on the performance of the underlying futures contract.
Former CME Group CEO, Craig Donohue, called look-alike contracts "parasitic, second-order" derivatives. While these contracts are no different from other over-the-counter products, they allow high-level market participants to make specific and risk-prepared bets.
What Are Futures Contracts?
Futures contracts are agreements to purchase commodities at predetermined prices and dates. They are used to lock in future income and reduce exposure to volatility.
What Are Index Futures?
Index futures are futures contracts based on the value of stock market indexes at specific dates. Traders use these futures to speculate on future index movements.
What Is an Inverted Futures Market?
An inverted futures market occurs when near-maturity contracts have higher prices than far-maturity contracts. This may be caused by disruptions in the supply of the underlying commodity.
The Bottom Line
Look-alike contracts are derivatives of exchange-traded futures contracts. Unlike the underlying futures, look-alike contracts are traded over the counter and do not involve physical delivery. However, they have been criticized for being speculative vehicles that do not contribute to price discovery.
