Business  Basics  forEngineers by  Mike Volker

Futures Contracts...and Other Hedging Instruments

A Little History

Standard futures "contracts" have been defined by various commodity and futures exchanges. There are many "commodities" which have futures contracts associated with them. For example, certain foods, fuels, precious metals, treasury bonds, currencies, and even some exotic ones like semiconductor chips. These allow people to mitigate risk related to their underlying businesses. You can protect against a change in interest rates by buying or selling bond contracts. You can protect against an adverse exchange variance 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 instruments are widely used on a global basis. Note that these are almost always denominated in US dollars.

Almost any commodity can have a futures contract defined for it. 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 rate fluctuations), and even some very special commodity items such as semiconductors. Remember the Eddie Murphy movie called "Trading Places" - it shows how huge fortunes can be made or lost by speculating in futures.

Futures contracts can be purchased and sold in the market through regular brokers (most stock brokers can handle these). Contract trading is done for a fixed fee (commission) per contract ranging somewhere between $25 and $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 in each contract and the sum of all profits and all losses by all market participants is 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 more margin 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 a few Canadian commodities exchanges, but they are not very active.

Options on Futures

Just as there are stock options to allow people to buy/sell put and call options on shares of companies, it is possible to buy/sell both put and call options on futures contracts. These were created to eliminate the huge risks associated with buying or selling futures. For example, if you buy a C$ contract ($100K Canadian dollars), you are taking the full risk on $100K. If the C$ drops, 5%, you'd lose $5,000. But, if you buy an option on a future, you have the right to buy the future - not the obligation. For this right, you pay a 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 as futures and options contracts (note an option is a contract, too) are often referred to as  financial derivatives because they are derived from some underlying assets (shares, commodities, etc). 

Hedging vs Speculating

A business person, e.g. a hog farmer or a Canadian exporter are exposed to risk. To offset this risk, they can "hedge" by buying or 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 the difference. On the other hand, you can buy or sell futures without having any business relating to the contracts you are buying and selling. For example, if you believe that interest rates will rise this year, you can sell (i.e. short) treasury bond futures contracts (remember - bonds decrease in price as interest rates go up) and, if you are right, you can make a huge return on your margin deposit. 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 very useful in ensuring that active, liquid markets exist.

A Zero-Sum Game

For any given commodity market, there are no net gainers or losers. All losses suffered by the futures holders in a given commodity are compensated by the gains 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 futures contract. Contracts are simply created by market participants. Every time a contract is bought, it means that there has to be a seller on the other side of the trade. The exchanges facilitate this market making activity. There could be 50,000 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 no limit as to how many contracts there can be - it's all market driven.

Currency Futures (an example)

In essence, you are creating a financial transaction which will have a 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 point in time, you would buy C$ on a futures contract. Or, if you want to buy Canadian dollars, you would sell C$ Futures.

For example, you may book a sale in US$. Since you won't get paid for several months perhaps, you want to make sure that when you do get paid, you will get the Canadian amount that you counted on getting.

Plan to convert a US Receivable (or Payable) of $1,000,000. (i.e. you are 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. on sales 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 impact your $69K profit. Because the C$ dollar went down, you'd actually make more profit (which is good), BUT it could just as easily go up, giving you less profit (which is bad). So, by hedging, you neither make or lose more 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 = $30,177 Net Exposure = $4K on $1.4M, i.e. 2.8% (not 40%).

This example would work equally well if you owed someone $1m. By paying in Nov instead of in October, you'd end up paying $26K more than you expected to. By using the futures contracts, you'd "lock in" your C$ 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!

Definition:

A futures contract is an agreement to buy or sell a specified amount of a product or
financial instrument at an agreed upon price on or before a given date in the
future.

Another example of hedging your price risks:

Today, September 1, the jeweler is setting the price of jewelry to be sold in
December through the catalog he is printing. His major input expense is the cost of
gold, which changes from day to day in the market. Today, the jeweler sees the
following prices:

     spot gold, $375 per ounce
     gold futures for December delivery, $380 per ounce.

At the expiration of a futures contract, the spot and futures price normally
converge, i.e., become the same. On December 1, the futures price (which in this
example equals the spot price) can be above, below or the same as the futures price
was on September 1.

For simplicity, let's take two cases--the futures price in December is $400 per
ounce, i.e., higher than it was in September ($380), or the futures price in
December is $350, lower than it was in September. In either case, the jeweler'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 $400 an ounce. In
such a case, the jeweler has gained $20 per ounce on the futures contract that
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 December 1 were
$350, the jeweler could buy spot gold for $350, but he would have had a loss of $30
per ounce in the futures market, resulting again in an effective cost of $380 for
an ounce of spot gold in December.