Explain the mechanics of futures contract trading and how
futures contracts are used to hedge financial risks
What Is a Futures Contract?
A futures contract is a legal agreement to buy or sell a particular commodity asset, or security at
a predetermined price at a specified time in the future. Futures contracts are standardized for quality
and quantity to facilitate trading on a futures exchange.
The buyer of a futures contract is taking on the obligation to buy and receive the underlying asset
when the futures contract expires. The seller of the futures contract is taking on the obligation to
provide and deliver the underlying asset at the expiration date.
Trading in Futures has been realized as an important strategy for price risk aversion in commodities. The
purpose of futures trading is mainly price risk minimization, price discovery and price dissemination. The
commodity futures markets provide a means to transfer price risk between from the persons with a
position in physical commodity or hedgers to speculators and arbitragers. Futures exchanges are
successful based on the principle that hedgers may forego some profit potential in exchange for risk
minimization while speculators may take such risk with a view to gain from probable potential profits.
Futures contracts are typically have certain features such as the ability to extinguish positions through
offset rather than actual delivery of the commodity. In addition, standardization of contract terms
makes futures contracts more convenient for hedging. Traditionally, futures contracts have been traded
in an open outcry environment where traders and brokers shout bids and offers in a trading pit or ring.
With advent of technology, trading in commodities as well as financial product futures has been
migrating to electronic trading platforms through a computerized trading system
FINANCIAL RISK
Financial risk is the possibility of losing money on an investment or business venture This type of risk
typically arises due to instabilities, losses in the financial market or movements in stock prices,
currencies, interest rates, etc
There are different strategies of futures hedging. A simple strategy can include buying a stock
portfolio and selling a stock index futures derivatives. More complex strategies can include
additional futures hedging with options and other derivatives.
Hedging currency risk
Currency futures are futures contracts for currencies that specify the price of exchanging one
currency for another at a future date.The rate for currency futures contracts is derived from
spot rates of the currency pair. Currency futures are used to hedge the risk of receiving
payments in a foreign currency.
example
Assume hypothetical company XYZ, which is based in the United States, is heavily exposed to
foreign exchange risk and wishes to hedge against its projected receipt of 125 million euros in
September. Prior to September, the company could sell futures contracts on the euros they will
be receiving. Euro FX futures have a contract unit of 125,000 euros. They sell euro
futures because they are a U.S. company, and don't need the euros. Therefore, since they
know they will receive euros, they can sell them now and lock in a rate at which those euros
can be exchanged for U.S. dollars.
Company XYZ sells 1,000 futures contracts on the euro to hedge its projected receipt.
Consequently, if the euro depreciates against the U.S. dollar, the company's projected receipt
is protected. They locked in their rate, so they get to sell their euros at the rate they locked
in. However, the company forfeits any benefits that would occur if the euro appreciates. They
are still forced to sell their euros at the price of the futures contract, which means giving up the
gain (relative to the price in August) they would have had if they had not sold the contracts.
Equity futures contract
An equity futures contract is a financial arrangement between two counterparties to buy or sell
equity at a specified date, amount, and price. The contracts settled daily using margins and
mark-to-market.They are regulated on derivative exchanges and used for speculative and
hedging purposes .Equity futures contracts are a zero-sum game; the profits of one party are
the losses of the other.
Practical Example
Two parties enter an equity futures contract to exchange 1,000 shares six months from today.
They also agree on a delivery price of $500,000, an initial margin of 10%, and a maintenance
margin of 5% of the notional value.
At the start of the agreement, both parties put up (500,000 x 10%) = $50,000 as the initial
margin. Now, suppose that the shares fall $30,000 in value. The new delivery price is adjusted
to (500,000 – 30,000) = $470,000.
Because the buyer gets to buy the shares for a cheaper delivery price in the future, the
difference is accounted for in the margin today. $30,000 is taken from the buyer’s margin:
(50,000 – 30,000) = 20,000.
The buyer’s margin account now falls below the maintenance margin of 5% (500,000 x 5% =
$25,000). Therefore, the buyer receives a margin call to replenish their account up to the initial
margin. The $30,000 taken from the buyer’s margin is placed into the seller’s margin.
Commodity Futures Contract
Imagine an oil producer plans to produce one million barrels of oil over the next year. It will be
ready for delivery in 12 months. Assume the current price is $75 per barrel. The producer could
produce the oil, and then sell it at the current market prices one year from today.
Given the volatility of oil prices, the market price at that time could be very different than the
current price. If the oil producer thinks oil will be higher in one year, they may opt not to lock in
a price now. But, if they think $75 is a good price, they could lock in a guaranteed sale price by
entering into a futures contract.