 | Business Basics forEngineers by Mike Volker |
Futures Contracts...and Other Hedging Instruments
Contact: Mike Volker, Tel:(604)644-1926Email: mike@volker.org
"You can't predict the future. But, you can hedge against adverseoccurances." (self)
A Little History
In times gone by, buyers and sellers of goods would be concerned aboutfuture supply and demand - hence pricing - of their bread and butter products.For example, the hog farmer and the sausage producer both make their livelihoodat the expense of hogs. The sausage producer depends on a reliable supply- and price - of hogs. Similarly, the hog farmer would like to be ableto be assured of a steady demand, and price, for his livestock. Becauseproduction depends on many uncertain factors - weather, diseases, etc.both the farmer and the producer were at some risk. To mitigate this risk,these parties entered into one-on-one agreements with each other in whichthey contracted to buy and sell the hogs at pre-agreed to prices - therebyeliminating certain uncertainties. This was a popular practice and eventuallyevolved into the concept of regulated, pre-defined "futures" or"commodity"contracts trading. This was no different, except that now the entire worldcould trade in any given commodity and be given a variety of commodities,time periods (expiration dates), etc. What used to be a one-on-one dealwas now a global futures exchange - like the Chicago Board of Trade, forexample.Standard futures "contracts" have been defined by various commodityand futures exchanges. There are many "commodities" which have futurescontracts associated with them. For example, certain foods, fuels, preciousmetals, treasury bonds, currencies, and even some exotic ones like semiconductorchips. These allow people to mitigate risk related to their underlyingbusinesses. You can protect against a change in interest rates by buyingor selling bond contracts. You can protect against an adverse exchangevariance affecting your bottom line by buying or selling a currency contract.
Check your newspaper's page on Futures - note that there's a whole page.And look at the volumes! This is no small business. These derivative instrumentsare widely used on a global basis. Note that these are almost always denominatedin US dollars.
Almost any commodity can have a futures contract defined forit. Typical commodities include food products (staples such as cocoa, sugar,corn, soybeans, orange juice, coffee), precious metals (gold, silver, platinum,etc), currencies (Swiss francs, Deutschmarks, Yen, etc), stock indexes (e.g.SP500), financial products (e.g. treasury bonds - to hedge against interest ratefluctuations), and even some very special commodity items such assemiconductors. Remember the Eddie Murphy movie called "TradingPlaces" - it shows how huge fortunes can be made or lost by speculating infutures.
Futures contracts can be purchased and sold in the market through regularbrokers (most stock brokers can handle these). Contract trading is donefor a fixed fee (commission) per contract ranging somewhere between $25and $100 per contract (in and out). Contracts are created by the market.At the end of each day there is an equal number of sellers and buyers ineach contract and the sum of all profits and all losses by all market participantsis zero, i.e. a zero-sum game. To buy or sell a contract, a margin deposit(usually as low as $500 or $1000) per contract is required, although moremargin deposit may be needed if a contract moves against you (i.e. goes"out of the money").
Note that the pricing for almost all futures is in US dollars. There are afew Canadian commodities exchanges, but they are not very active.
Optionson Futures
Just as there are stock options to allow people to buy/sell putand call options on shares of companies, it is possible to buy/sell both put andcall options on futures contracts. These were created to eliminate the hugerisks associated with buying or selling futures. For example, if you buy a C$contract ($100K Canadian dollars), you are taking the full risk on $100K. If theC$ drops, 5%, you'd lose $5,000. But, if you buy an option on a future, you havethe right to buy the future - not the obligation. For this right, you paya time premium, but the most you can lose is the amount you pay for the option(think of it as a second-order derivative!).
Financial products such asfutures and options contracts (note an option is a contract, too) are oftenreferred to as financial derivatives because they arederived from some underlying assets (shares, commodities, etc).
Hedgingvs Speculating
A business person, e.g. a hog farmer or a Canadian exporterare exposed to risk. To offset this risk, they can "hedge" by buyingor selling a futures contract. Whatever they make or lose in the spot (actual,current market), they can lose or make up in the financial market to offset thedifference. On the other hand, you can buy or sell futures without having anybusiness relating to the contracts you are buying and selling. For example, ifyou believe that interest rates will rise this year, you can sell (i.e. short)treasury bond futures contracts (remember - bonds decrease in price as interestrates go up) and, if you are right, you can make a huge return on your margindeposit. People who do not hedge, but play in the market for profit, are speculators.The ratio of hedgers to speculator is approximately 3:1. Speculators are veryuseful in ensuring that active, liquid markets exist.
A Zero-Sum Game
Forany given commodity market, there are no net gainers or losers. All lossessuffered by the futures holders in a given commodity are compensated by thegains made by other futures holders in that market. Unlike the stock market,where everyone can make money, there is never a net gain or loss in a futurescontract. Contracts are simply created by market participants. Every time acontract is bought, it means that there has to be a seller on the other side ofthe trade. The exchanges facilitate this market making activity. There could be50,000 open contracts (referred to as open interest) or there could be 50- it all depends on the interest by those in that market. Hence, there's nolimit as to how many contracts there can be - it's all market driven.
Currency Futures (an example)
There is no need to take a financial risk because of an exposure to a currencyexchange rate that may fluctuate adversely. It is possible to use a financialinstrument, referred to as a "derivative", to hedge against such a risk.In essence, you are creating a financial transaction which will havea result this is opposite to an actual outcome that you want to avoid.i.e. if you are worried about selling Canadian dollars at some future pointin time, you would buy C$ on a futures contract. Or, if you want to buyCanadian dollars, you would sell C$ Futures.
For example, you may book a sale in US$. Since you won't get paid forseveral months perhaps, you want to make sure that when you do get paid,you will get the Canadian amount that you counted on getting.
Here is a summary of an example using CANADIAN DOLLAR contracts:
| SPOT PRICE US$ | DEC FUTURES PRICE US$ | |
| Oct 1 | 0.7236 | 0.7270 |
| Nov 12 | 0.7098 | 0.7117 |
Plan to convert a US Receivable (or Payable) of $1,000,000. (i.e. youare expecting to receive $1m in cash)
Oct 1 Spot value: C$1,381,978 (= $1m/.7236) (spot =current market price)
Nov 12 Spot value: C$1,408,847 (= $1m/.7098), an increase of C$26,869(+2.7%)
Assuming a typical Net Profit on Sales (say 5%) = C$69,098. (i.e. onsales of US$1m, this is what your anticipated profit would be).
Without a hedge, profit exposure = 40%! (range is 3.03% to 6.9%). i.e.the currency exchange variance ($26K above) would significantly impactyour $69K profit. Because the C$ dollar went down, you'd actually makemore profit (which is good), BUT it could just as easily go up, givingyou less profit (which is bad). So, by hedging, you neither make or losemore than what you planned on in the first place (which is good).
Therefore, in this example, you would BUY 14 C$ Futures Contracts(i.e. 14 X C$100K to cover C$1.4m).
Spot Gain= $26,869 Futures Loss= 14 x 100K x (.727-.7117) /.7098 = $30,177Net Exposure = $4K on $1.4M, i.e. 2.8% (not 40%).
This example would work equally well if you owed someone $1m. By payingin Nov instead of in October, you'd end up paying $26K more than you expectedto. By using the futures contracts, you'd "lock in" your C$ cost.
If you are on the receiving end of the $1m, you might be tempted to"speculate" and if you did, you'd make money (based on the above example).But then, you're a speculator and you won't always be lucky!
The Futures Industry Association has a websitewhich may be helpful.
Definition:
A futures contract is an agreement to buy or sell a specified amountof a product or
financial instrument at an agreed upon price on or before a given datein the
future.
Another example of hedging your price risks:
Today, September 1, the jeweler is setting the price of jewelry to besold in
December through the catalog he is printing. His major input expenseis the cost of
gold, which changes from day to day in the market. Today, the jewelersees the
following prices:
spot gold, $375 per ounce
gold futures for December delivery, $380 perounce.
At the expiration of a futures contract, the spot and futures pricenormally
converge, i.e., become the same. On December 1, the futures price (whichin this
example equals the spot price) can be above, below or the same as thefutures price
was on September 1.
For simplicity, let's take two cases--the futures price in Decemberis $400 per
ounce, i.e., higher than it was in September ($380), or the futuresprice in
December is $350, lower than it was in September. In either case, thejeweler's
effective cost of gold is $380 per ounce; i.e., the futures price he"locked in"
during September.
To see how this works, assume on December 1 the price of gold is $400an ounce. In
such a case, the jeweler has gained $20 per ounce on the futures contractthat
he can use to decrease the effective cost of the spot gold he is purchasing--from
$400 to $380. On the other hand, if the futures price of gold on December1 were
$350, the jeweler could buy spot gold for $350, but he would have hada loss of $30
per ounce in the futures market, resulting again in an effective costof $380 for
an ounce of spot gold in December.
Copyright 1998, 1999, 2002 Michael C. Volker
Last Update: 020718
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