RESOURCE In this issue: Paper P2 Performance Management STUDY NOTES Paper P3 Performance Strategy When dealing with futures contracts involving foreign currencies or interest rates, it is easiest first to consider the situation of futures in physical commodities, since the same basic principles apply to both transaction types By David Collingridge Futures contracts can be used as a hedging technique and for speculation – two activities that are closely linked. Hedging is an attempt to transfer risk to other parties with a different appetite for it, such as speculators, or to find those who have a diametrically different view of the market. Futures markets arose as a way of dealing with the uncertainty in agricultural markets. As a farmer, say, I will not know the price I’ll obtain for the crops I am growing, because I won’t be delivering it for maybe six months. But I need to spend money now on the assumption that I’ll receive a certain price for my produce later. My fear is that the price will fall. On the other side of the market there are buyers who are aware that the price can also increase. They need to be certain about their future costs. One of the key features of agricultural markets is the uncertainty that surrounds not only the price but also the STUDY NOTES delivery date, because this usually depends on the weather. In effect, this factor precludes the use of forward contracts. This type of contract crystallises on a specific date, but crops do not mature according to deadlines. Even in the case of meat products such as carcasses, delays may arise, because the animals might not put on the expected weight by the time the contract takes effect. For a buyer, a forward contract ties the purchase to a specific date and supplier, which might not always be appropriate. The buyer might want to make the purchase later or buy earlier from a different supplier, depending on the circumstances. Forward contracts are subject to credit risk, too: I have agreed to deliver or purchase a commodity on a specific date, but can you trust me to honour that promise when the time comes? Futures markets provide a mechanism for solving both of these problems. First, they enable the two parties to “fix” the price now through the use of a gamble. Futures also give a degree of timing flexibility (at least up to their expiry or delivery date). In a futures contract no commodities actually need to change hands if the contract is “closed out”. Closing out is the process of reversing the position from that taken at the start. If we had originally entered the futures market with the intention of selling the underlying assets – carcasses, say – we can later close this position by delivering the meat to the counterparty at the agreed price. Alternatively, we can close out by re-entering the futures market and agreeing to buy what we were going to sell. These two contracts then cancel each other out. But there is no guarantee that the prices at which we contracted to sell and buy will be the same. This means that we will have made a profit or loss on the futures position. We then use this profit or loss to neutralise the loss or profit on the underlying transaction. Second, futures markets remove the problem of credit risk by insisting that both parties put up money with the STUDY NOTES exchange. This sum, known as margin, is held to cover the size of any potential losses made on the contract taken out, whether it was to buy or sell. Should losses continue to increase on the futures position (reducing the amount of margin held by the exchange), the exchange will make a call for further money, which is known as variation margin. This means that there’s never any credit risk to consider. If one of the parties were to fail to answer the call for variation margin, the exchange would close out its position. The losses would crystallise at this point but be covered by the margin already taken by the exchange. Carcass case study It is now January and the current price of carcasses is $10 per unit, but a farmer may fear that the price he can obtain will fall by the time he’s in a position to supply them. If he’ll have 5,000 carcasses to sell in May, he can enter a futures contract now to sell these at $10 per unit. There may be a buyer, such as a restaurant chain, that is afraid that the price of carcasses will rise. The buyer can enter a contract to purchase 5,000 carcasses at $10 apiece. Providing that there are matching supplies and demands at the current price, the contract can proceed. What happens in May will hinge upon the supply and demand for carcasses at that point. The market price may rise to $12, which would clearly be good for the farmer but bad for the buyer. On the other hand, if the price falls to $7, this would be bad for the farmer but good for the buyer. What happens if they’ve both entered a futures contract? To answer this, we first consider what will have happened to the future price and why. If the price of the underlying asset rises to $12, we’d assume that the price of the future is also $12. The reason for this is arbitrage – see the next section on the relationship between future prices and spot market prices. (Similarly, if the market price falls to $7, we’d expect the futures price to fall to a similar level.) STUDY NOTES Closed-out positions The farmer will have made a profit on his carcasses of 5,000 x ($12 – $10) = $10,000. This is neutralised by the loss on his futures position, as he would have sold carcass futures at $10 and now has to buy them back at $12 in order to close out his position, meaning that he makes an equalising loss of $10,000. In effect, he has fixed the price at $10. The position for the farmer is shown below. Underlying transaction (seller) Profit/loss on futures position Net receipts 5,000 x $12 = $60,000 5,000 x ($10 – $12) =-$10,000 $50,000 Expected receipts at commencement 5,000 x $10 = $50,000 Discrepancy0 Hedge efficiency (net receipts ÷ planned value) £50,000 ÷ £50,000 = 100% The buyer’s position is exactly the opposite: there will be a loss on the underlying transaction because the (spot) market price has risen, but the profit gained on the futures neutralises this loss. The relationship between future prices and spot market prices Futures are subject to three types of risk that should be considered by both buyers and sellers. Basis risk and quantity risk apply in all cases; quality risk applies only where firms engage in cross-hedging (see last section). The spot market price for an asset such as a carcass and the current futures price for the carcass will be similar. (In our carcass example they are the same for simplicity.) If this were not the case, an opportunity for arbitrage profit would exist. Speculators would take advantage of this opportunity and in the process remove the difference. STUDY NOTES In our example, if the price of the future remains at $10 at expiry and the spot market price is $12, we could agree to buy at $10 using the future contract and then sell immediately on the spot market at $12, making a profit on the deal. This opportunity is open to any buyer of the future and means that there would be more buyers than sellers of futures for carcasses. This would cause the future price to rise in line with the spot market price. In general, it is unlikely that the two will be exactly the same. There is only one occasion when they can be guaranteed to be exactly the same: the last day of the futures contract. At this point it is possible for buyers and sellers to switch readily between the two markets. This means that it would be impossible for there to be a price difference, because the two markets are the same. Before the expiry date we would have to take into account the time value of money tied up in the physical asset and therefore interest rates, as well as the cost of storing physical commodities, meaning that there will usually be a difference between the spot price and the future price. This discrepancy between the two prices is known as the basis risk. Determining basis risk If the only factor that had to be considered were the cost of storing the underlying asset, we would expect the future price to be higher than the spot market price (the spot price includes storage and opportunity costs, which therefore reduce its value compared with the equivalent future). We would expect the basis risk for a commodity to reduce steadily as the delivery date on the future contract approaches, disappearing entirely on that date. At the delivery date there is no further cost of storing the physical asset to consider. This is also true of the future and why the two prices will now be the same. This idea can be represented by the diagram on the next page. STUDY NOTES Price Basis risk Time path of futures price NowDelivery Time The diagram shows the adjustment process as smoothly continuous. This unlikely to be the case in reality. Prices in both the spot and future markets are governed by supply and demand, plus factors driving supply and demand – eg, market expectations, volumes and the prices of substitute products. These factors will disrupt the smooth path of the futures price illustrated here. Basis risk will be one of the factors that affect hedge efficiency – ie, the ability of the hedging instrument to fully cover the gain or loss that arises on the transaction at the underlying transaction date. The existence of basis risk means that it is possible that the profit or loss on the futures hedge might not fully cover the loss or profit on the underlying transaction, leading to less than 100 per cent efficiency, or that it might more than cover it, leading to more than 100 per cent efficiency. Basis risk and the timing of hedging Basis risk provides an explanation of why it is generally recommended that, when you’re hedging a transaction, you choose a contract date that is just after the transaction date. If a transaction is expected to occur in May, for instance, June contracts would generally be recommended. There is no reason why September contracts could not also be used, but these contracts would potentially result in a greater profit or loss resulting from the bigger basis risk. To keep things simple in the diagram on the next page, the basis risks for both June and September are shown as equal in the present. This is unlikely to be the case in practice. The diagram shows that, with both time paths STUDY NOTES converging on the spot price by their respective delivery dates, there will always be bigger basis risk from the longer-dated contract. This means bigger losses or profits on the futures contracts to counteract the position on the underlying transaction. The aim of hedging is to limit risk: the September contracts are less desirable than the June contracts for a transaction date in May. Time path of September futures price Basis Basis: risk: Sep risk: Jun Time path of June futures price Now June September While it usually makes sense to choose contracts that expire just after the transaction date, this is not a definitive rule. If we have a receipt from a customer due to pay in May but we fear they might not pay until July, say, June futures would expire too early. A profit or loss would crystallise on the futures in June, which might not cover the actual profit or loss on the underlying transaction in July. Indeed, it might be possible to have made losses on both the futures and the underlying transaction because of a contrary movement in the asset between June and July. In this case it might have been justifiable to have used the September contracts to hedge the “possible” May transaction. Quantity and quality risk Futures hedging is subject to quantity and, potentially, quality risk as well as basis risk. This is because contracts come with predetermined expiry dates and sizes. The transaction we wish to make may not match exactly in terms of the contract sizes. If contract sizes are, say, 1,000 units but we wish to hedge an underlying transaction of 3,300 units, we will not be able to buy 3,300 ÷ 1,000 = 3.3 contracts. Futures exchanges deal only in discrete contract STUDY NOTES David Collingridge is a senior lecturer at Kaplan Financial sizes, so we’d have to round down to three contracts and in doing so we would be under-hedged. Futures do not exist in all commodities, but in such cases there may be a future that is a close substitute that could be used instead. This is known as cross-hedging, which is subject to quality risk. Taking fossil-fuel commodities as an example, there are no futures in natural gas but there are in crude oil. Providing that the two commodities’ prices move broadly in tandem, it is possible to use crude oil futures to hedge a transaction in natural gas. Quality risk arises because of the residual risk that the two will not move exactly in line with each other. All future contracts, whether physical or financial, have similar features and operate according to the same principles. Financial futures are subject to quantity risk and basis risk in the same way that physical commodities are. The calculations for currency futures follow the same principles. They seem more confusing only because the “price” in this case is an exchange rate.
