Question

Choat and Sons Limited is a company based in reading in the south of england. The company specializes in the production of forklifts both for domestic market and for export mainly to the USA. Due to increased demand for the company's products, it has become necessary to expand its production facilities.

Choat and Sons Limited intends to borrow £1,500,000 in three months time for a period of three months but expects interest rates to rise above the current 6% to more than 11%. Management of the company is worried about the expected future interest rises and wants to insulate the company from interest rate risk.

Required;

Explain two problems that may be encountered when using futures contracts.

Answer 1

Future Contract :

A forward contract is a non-standardized agreement between two parties to buy or sell a commodity or an asset at a future date at the price decided now. A futures contract is similar with the difference being that the assets bought or sold are standardized and the contracts are negotiated at a futures exchange which acts as an intermediary. The forward contract has the benefit that it can be customized according to the needs of the two parties and designed in the fashion they want. The futures contract has the benefit that the future exchange acts as an intermediary, which essentially means that the buyer is buying from the futures exchange and the seller is selling to the futures exchange. This eliminates the possibility of default by the other party and makes the entire system credible and transparent.

Problems That may be encountered when using future contracts:

Problems in Using Futures. When using futures contracts to hedge a corporate risk, the risk manager must have a thorough understanding of the contract's workings and potential problems. Two problems often encountered in using futures contracts are complexity and basis risk

Basis Risk

Basis risk arises when there is a divergence between the value of the risk being hedged and the value of the futures contract. The divergence can occur if the hedging instrument does not exactly match the risk. This divergence can reduce the effectiveness of the hedge.

Example

A firm plans to borrow short-term funds to finance future receivables. Specifically, the firm will borrow $2 million in two months and contract to repay the funds three months later. But the firm faces the risk that borrowing rates may rise before the loan is taken out. The corporate treasurer can hedge this risk by shorting interest rate futures. Because taking out a loan amounts to selling an interest-bearing security, selling interest rate futures contracts serves as a temporary substitute for taking out the loan now and investing the proceeds until the funds are needed. If interest rates rise, the cost of satisfying the delivery requirements for the futures contract will fall, whereas the contracted delivery price remains the same. The gain from the futures position offsets increased borrowing costs.

Suppose the company decides to use a Treasury bill futures contract that matures in two months to hedge against the uncertain future cost of borrowing the $2 million. When an IMM T-bill contract matures, the long side of the contract takes delivery of T-bills with a face value of $1 million and a maturity of 91 days. Before expiration, the futures trade on the basis of an index number. For example, suppose the current futures price is 91.68. This implies that the annualized discount on the underlying bills is 8.32 percent, that is, 100 minus 91.68. At maturity of the contract, the long side takes delivery and pays the face value times the discount implied by the futures price:

Cash Flow = $1,000,000[1 — 0.0832(90/360)] = $979,200

Whether the contract gained or lost money depends on whether the current market value of three-month T-bills with a $1 million face value is greater than or less than $979,200.

Return to our example of the firm that plans to borrow money in two months. To hedge the risk that borrowing costs will rise, it can sell two T-bill contracts. As noted, if interest rates rise, the firm's borrowing cost will also go up, but it will gain on the short futures position, as the price of the Treasury bills that it must deliver will fall. If interest rates fall, it will gain with a lower borrowing cost but lose on the short futures.

However, the firm is subject to basis risk to the extent that the borrowing rates and Treasury bill rates don't move exactly in sync.

Complexity Risk

Futures trading involves speculating on the price of a specific underlying asset going up or down in the future. A future gives the holder a standardised obligation to either buy or sell the underlying asset at a specified price at a certain date in the future. The underlying asset may, for instance, be raw materials, agricultural produce or financial products. Depending on the nature of the future, the asset either has to be settled for the price difference or by actual delivery at the settlement date. Futures are always traded on margin (see "Foreign exchange trading" above). Futures are always traded in a regulated market, either by direct trading in the stock exchanges' trading systems, or by reporting of transactions.

As futures are margin traded, allowing you to take a larger position than you would otherwise be able to based on your funds with Saxo Bank, a relatively small negative or positive market movement can have a significant effect on your investment. Futures trading therefore involves a relatively high degree of risk. This makes the potential gain quite high, even if the deposit is relatively small. If your total exposure on margin trades exceeds your deposit, you risk losing more than your deposit.

Example:

A Chicago Mercantile Exchange (CME) currency contract, for example, pays a fixed number of units of foreign currency. Others are more complex. The Chicago Board of Trade's (CBT) Treasury bond futures contract, for example, is not written on any particular Treasury bond. Rather, any Treasury issue with a maturity of at least 15 years, along with no right to call the issue before 15 years, is deliverable in round lots of $100,000 face value. There is a formula for determining the price that bonds of a particular issue will receive when delivered to satisfy a futures contract. Consider a contract that matured in June 2000. An investor with a short position who wanted to deliver T-bonds that mature on November 15, 2022, have a coupon of 7 5/8 percent, and are callable starting in 2017, would have delivered bonds with a total face value of $100,000. In return, the investor would receive a payment of the closing futures price times .9660 (the conversion factor). By electing to deliver T-bonds that mature on November 15, 2018, have a coupon of 11 7/8 percent, and are not callable, the investor would also deliver bonds with a face value of $100,000. However, the higher coupon bonds have a higher present value and thus can be used to satisfy the contract at a higher total cash flow: The payment would equal the closing futures price times a higher conversion factor of 1.3683. Of course, the 11 7/8 percent bonds have a higher value in the spot market as well. Therefore, the futures investor must carefully consider the costs and benefits of each deliverable issue before deciding which to use. In addition, the investor has some choice as to what time and date to deliver the bonds.

Given the complexity of deciding which bond is cheapest to deliver and the process of delivering it, many corporate hedgers elect to close out a short position in T-bond futures with an offsetting trade, rather than by delivering bonds.