Question

Define forward and futures contracts and explain how they may be used in hedging and speculation.

Explain, using numerical examples, the settlement mechanisms of forward and futures contracts and discuss how these are likely to affect the probability of, and loss from default.

Answer 1

Hedging refers to taking off-setting position in two separate but related financial instruments such that the impact of the risk factor is mitigated or eliminated. A very simple example is: Say a company completes a delivery today but payment will be received in a foreign currency a month later but based on exchange rate today. A company should immediately hedge this position by entering into a transaction where payment by it has to be made in the same foreign currency a month later but based on exchange rate today. If this happens, the company receives payments in the foreign currency a month later and pays out the same amount in the second transaction thus without incurring any gains / losses due to exchange rate fluctuation.

Hedging can be natural or (intellectual) man made.

A natural hedge is by taking offsetting positions in two securities. For example: Buying shares of India Cements and shorting (selling) shares of another cement company say J K cement. A natural hedge is a method of reducing risk by investing in two different items whose performance tends to cancel each other. A natural hedge does not involve the use of sophisticated financial tools such as derivatives or futures contracts. It’s a natural hedge. Gain in one will offset the loss in other. Insurance is a natural hedge.

An artificial hedge is by taking the offsetting position in derivative market by making use of options, futures, forwards or even swaps.

Hedging can be used to manage risks arising due to fluctuations in prices, interest rate, or foreign exchange rates. Commonly used instruments are future contracts, options (Call and Put option on the stock of two different companies operating in same sector), sale and purchase of rights to goods and services for delivery at different dates.

• Uses: Derivatives are used for the following:
  • Hedge or mitigate risk in the underlying, by entering into a derivative contract whose value moves in the opposite direction to their underlying position and cancels part or all of it out. This is the primary purpose of a derivative.
  • Obtain exposure to the underlying where it is not possible to trade in the underlying (example weather derivatives)
  • Provide leverage (or gearing), such that a small movement in the underlying value can cause a large difference in the value of the derivative
  • Take an exposure in an underlying while keeping the cost low (Buying a call option provides you the same benefit in case price rises but at a lower investment)
  • Speculate and make a profit if the value of the underlying asset moves the way they expect
  • Switch asset allocations between different asset classes without disturbing the underlying assets, as part of transition management

Thus though there are many other benefits of derivatives, they are mainly entered by the buyer to avoid any unfavorable changes in the value of the underlying asset for the contract period while the seller holds the inverse view and expects to benefit from this position. So derivatives are primarily used for hedging and risk management.

Forward Contracts Not exchange traded, customized products, traded over the counter and hence called OTC products. A customized agreement between two parties to buy or sell a particular asset (tangible/intangible) at a future date for an agreed price without any initial payment. Both parties are obliged to honour the agreement. So it’s an obligation for both the parties. Buyer is said to be “Long a forward contract” while seller is said to be “Short a forward contract”. These contracts are most commonly used for foreign exchange or commodity transactions. The counterparty in Forward contracts are most often a bank, a dealer or a foreign exchange trader. Sometimes, they also serve as market makers and facilitate private contract between two parties. A long position holder benefits if the price of underlying asset increases during the period of the contract and loses if the prices of underlying asset decreases. As the payoffs are symmetrical in forward contracts, Short position holder’s gains and losses are inverse to long position holder. As the Forward contracts are not traded on an exchange, default risk from the counterparty exists. Future Contracts Future contracts are similar to forward contracts in nature but are standardized and trade on organized exchanges. Hence they are also called exchange traded products. Some of the exchanges where future contracts are traded are New York Mercantile Exchange, Chicago Board of Trade and International Money Market Wing of the Chicago exchange. Exchange decides on the notional amount, maturity dates and daily settlements during the contract tenure. Future contracts are usually settled before maturity by net cash payments. Difference between Futures and Forwards: Sl. No. Parameter Future Contracts Forward Contracts 1. Nature Exchange traded OTC 2. Nature Standardized hence lesser flexibility Customized hence more flexible 3. Liquidity Since exchange traded, it’s relatively more liquid Relative lesser liquid, finding a counterparty is more difficult 4. Default risk Lower Higher 5. Valuation Marked to market daily Not possible to mark to market as they are not exchange traded 6. Closure Can be closed by offsetting trade Delivery compulsory A long position is equivalent to buy and / or own. A buyer of a contract is typically long on the contract. A long position holder benefits if the price of underlying asset increases during the period of the contract while suffers losses if the price of the underlying decreases. A short position is equivalent to sell without owning it. A seller is said to be short on the contract. A short position holder suffers losses if the price of underlying asset increases during the period of the contract while benefits if the price of the underlying decreases. As the payoffs are symmetrical in most of the derivative contracts, short position holder’s gains and losses are inverse to long position holder.

Example:

Sundaram Corporation has agreed to deliver an automobile 3 months down the line to a customer. The company has estimated that 60% of the cost of the automobile is towards steel whose prices fluctuate in international market. Company has used current steel prices to do the costing and has quoted a price which has been agreed by the customer. Sonali Sundaram, the Chief Procurement Manager has pointed out that in order to complete delivery 3 months down the line, the company needs to buy steel components around 2.5 months down the line to ensure sufficient time for assembly and shipment. What should Sonali Sundaram do to make sure the company doesn’t lose on account of foreign exchange fluctuations?

Solution:

Sonali Sundaram has got two alternatives available with her:

1. She buys all the steel components today itself at today’s prices, keep them in inventory and use them 2.5 months down the line for assembly. This is a naïve method but will eliminate the price fluctuation risk completely. However, this will lead to a significant inventory carrying cost to the company.
2. Sonali Sundaram enters into a hedging using futures contract. She enters into a future contract to buy steel at today’s price 5 months down the line. Let’s say steel price today is $ 100 / unit. Sundaram Corporation has done the entire costing using this rate. Steel components are required 2.5 months down the line. The future contract is entered into for delivery at $ 100/unit (today’s price).
   1. Case I: Let’s say 2.5 months down the line, the day on which steel components are to be bought and the day on which future contract expires, steel price has moved to $ 120 / unit. Due to increase in steel price, there is a loss in the customer order = $ 120 – 100 = $ 20/unit. However, since she has a future contract that enables her to buy steel at $ 100 / unit. She calls for delivery of steel at predetermined price of $ 100 / unit. She sells the delivered steel in the spot market on that very day at $ 120/unit and makes a profit = $ 120 – 100 = $ 20/unit. This profit will offset the loss she has incurred in the customer order.
   2. Case II: Let’s say 2.5 months down the line, the day on which steel components are to be bought and the day on which future contract expires, steel price has moved to $ 90 / unit. Due to decrease in steel price, there is an incremental profit in the customer order = $ 100 – 90 = $ 10/unit. However, since she has a future contract that enables her to buy steel at $ 100 / unit. She is forced to get delivery of steel at predetermined price of $ 100 / unit. She has no option but to sell the delivered steel in the spot market on that very day at $ 90/unit and thus incur a loss of = $ 100 – 90 = $ 10/unit. This loss will be offset by the profit she has incurred in the customer order.

This demonstrates in the simplest of the term, how hedging is done. Irrespective of the actual price on the day of purchase, the offsetting positions nullify the impact of price fluctuations. What Sonali did above was she bought future. This is called “Long Future” strategy. Similarly the counterparty has taken the position called “Short Future” or sell future.

A future is an exchange traded product. Hence, it's clearing is done by a clearing house and settlement is guaranteed. Hence, the probability of default is nearly zero here.

A forward contract is an over the counter product. The couterparty risk is there. And hence the probability of default is higher here.