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Hedging with Futures Contracts - 1

Futures Contracts

A futures contract is a binding agreement to buy or sell a specific asset at an agreed price and quantity in the future at a price agreed today. The underlying asset may include currencies, financial assets, metals, energy or agricultural commodities.

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The terms of a contract will always outline, at minimum, the type and quantity of the deliverable asset, the delivery date and the details of that delivery. The parties to a futures contract reach their agreement using a futures exchange and clearinghouse, trading the types of standardized contracts available on the exchange. The contract agreement is on-exchange with standardisation of terms, collateral (margin) requirements relative to price moves, and the clearinghouse assumes the credit risk or risk of a party not meeting a contractual obligation or defaulting. For example,

GBP/USD Futures contract:

  • Contract size: GBP62,500
  • Price Quotation: USD per GBP, USD0.0001 per GBP increments (USD6.25/contract)
  • Contract Month Listings: Six months in the March quarterly cycle (March, June, September, December)
  • Settlement procedure: Physical Delivery
  • Ticker & Venue: CME Globex Electronic Markets - 6B, Open Outcry - BP, AON Code - LP
  • Last Trade Date/Time: 9:16 a.m. Central Time (CT) on the second business day immediately preceding the third Wednesday of the contract month (usually Monday)

Light Sweet Crude Oil (Physical) WTI Futures contract:

  • Contract Size: 1,000 barrels
  • Price Quotation: US Dollars and cents per barrel
  • Contract Month Listings: Monthly
  • Settlement Type: Physical
  • Product Symbol & Venue: CME Globex, CME ClearPort, Open Outcry (New York) - CL
  • Termination of Trading: Trading in the current delivery month shall cease on the third business day prior to the twenty-fifth calendar day of the month preceding the delivery month.
  • Delivery: Made at any pipeline or storage facility in Cushing, Oklahoma; no earlier than the first calendar day of the delivery month and no later than the last calendar day of the delivery month

The party selling or delivering the asset at an agreed price is referred to as having a short position, the party buying or taking delivery has a long position. The daily profit or loss from the changes in price are credited or debited to the respective parties’ accounts daily, referred to as marking-to-market. Because the exchange clearinghouse is assuming the underlying credit risk, referred to as novation, initial and maintenance margin must be paid by the parties to the exchange, as a means of ensuring ongoing obligations can be fulfilled. Initial margin is a deposit, still belonging to the buyer or seller, paid relative to the position size and the price volatility of the asset traded, intended to cover the risk of some loss. Maintenance or variation margin is a top up to that called upon when, due to changes in the asset market price and daily marking-to-market, the margin balance falls below the maintenance margin level.

Margin means that relative to buying or selling the underlying asset in the spot market (today, on the spot transactions), futures contracts require a much smaller proportion of money to be put down at the onset. This implies greater leverage, in that for a given sum of money a larger position can be taken via futures contracts than with cash in the spot market. When the contract matures, settlement may be in cash terms or by physical delivery. However, both the buyer and seller are able to offset, or close-out, their position by respectively selling or buying the same contract on exchange prior to maturity.

Forward Contracts

The definition of a forward contract is almost identical to that for futures. The differences however are significant. A forward is referred to as OTC or over-the-counter, which means specifically negotiated and tailored to the needs of the parties and settled at contract maturity rather than marked-to-market. Due to the private specificities of particular requirements which could refer to size, start and maturity dates, choice of collateral or more, a particular asset derivative, it is not possible to trade forwards on a broad standardised exchange. As a non-standardised contract there is not usually a secondary market. This also means each party has to take on the credit or default risk of the other themselves, rather than using an exchange as middle-man.

Hedging or speculating

Futures and forward contracts may be used to hedge or speculate. Hedging is protecting or offsetting against price risks; decreasing risk. An example of a hedger would be a producer or exporter buying or selling futures contracts to lock in a future price with the intention is to later sell the asset in the cash market. Speculating is simply aiming to buy low and sell high, or sell high and buy low, for a profit; increasing risk. Generally, but not always, speculators betting on price will use liquid, standardised futures contracts and close-out their position prior to maturity without delivery. Correspondingly hedgers will generally, but not always, use forwards where commonly available and make or take physical or cash delivery.

Foreign Exchange Markets: Using currency futures

In the foreign exchange (FX) markets there is a distinction between an investor who transfers the exchange rate risk inherent in a currency trade and one who is merely speculating, or betting, on an outcome. The reduction of uncertainty through the ability to lock in prices is of fundamental importance in currency hedging. The strategic exploitation of anomalies between two or more currencies may be broken down into geographic arbitrage (differing prices of an exchange rate between locations), triangular arbitrage (between a trio of exchange pairs, for example GBP/USD, EUR/USD and EUR/GBP) and interest rate arbitrage. Trading realities dictate that simple risk-free profits from market anomalies simply do not exist. Mispricings that may exist in immature markets are instantly corrected within the hugely liquid foreign exchange markets. Thus, the best case scenario will be the ability to profit at the minimum possible risk.

Profiting in the foreign exchange markets comes down to issues of parity and equilibrium in and across markets. General trading styles will form either a directional or relative value outlook. The profitability of directional trading is dependent on the direction of the underlying currency market. Establishing positions with relative value between two or more currency variables is a decision over which is relatively cheap and which is relatively expensive.

In order to assess the use of any foreign exchange derivative instruments or spot currencies it helps to understand the efficient markets hypothesis as applied to the spot and forward markets for foreign exchange. It may be applied as a view in which prices always fully reflect available information, which combines equilibrium returns and the assertion that all market players have rational expectations. In basic and risk-neutral terms, an investor may expect to profit when the forward rate differs from the expected future spot rate. If risk averse, the forward rate will not be driven to complete equality with the expected future spot rate, because of the inherent risk of taking open forward positions (explaining the existence of a risk premium): f(t,T) = rT1). There is strong evidence to conclude that the forward FX rate is a biased and inefficient predictor of the future spot rate.

Covered interest differential (CID) is the measure of a country’s premium, the difference between the interest rates of the domestic and overseas interest rate when hedged. If foreign exchange markets are operating efficiently, foreign exchange arbitrage (taking advantage of a price differences between markets) should ensure that the covered interest differential on similar securities is always equal to zero. Thus Covered Interest Parity (CIP), a zero difference between the interest differential between two assets, should hold: (i-i*)t - (f-s)T = 0. These efficiency tests of the forward exchange market may be assessed as indirect tests of Uncovered Interest Rate Parity (UIP) because they rely on a maintained hypothesis of CIP2).

Futures do not overcome the problems of imperfect correlations between the underlying exchange rate and the gains on the futures contracts yet do present a means of better ensuring an exposure to a future asset or liability. An uncovered position in FX spot will expose an investor to all the risks existing within and between the underlying currencies and therefore all the risks of foreign investments.

Currency futures contracts - Practical example of hedging

Today is the 19 December 2012. A small business has a GBP75,000 liability due on 21 February 2013. With concerns about exchange rate risk, that the USD may depreciate against the GBP over the two-month period until the liability is due (i.e. that their dollars will exchange into fewer GBP), they hope to use GBP/USD futures contracts to reduce or eliminate risk.

Assumptions before explaining transactions:

  • With no access to intraday prices, all opening spot (S) FX trades use the previous day’s close.
  • One GBP/USD futures contract size (zf) = GBP62,500
  • This is a ‘real-world’ example, where hedging must be undertaken in whole contracts in the case that asset/liability ≠ whole number multiple of futures contract size.
  • Any futures positions (F) opened/closed are done so at the market open/close respectively.

UNHEDGED:

19 December 2012: S0 (18/12/12 closing price) = 1.6252 GBP/USD * GBP75,000 = USD121,890

21 February 2013: S1 (21/02/13 closing price) = 1.5254 GBP/USD * GBP75,000 = USD114,405

Dollar gain on unhedged position = (USD121,890 - USD114,405) = USD7,485

Remaining completely unhedged against exchange rate risk over this period would earn USD7,485.00 due to the USD appreciation/GBP depreciation. This return was subject only to the fortune of exchange rate change over the period.

HEDGED:

With a short GBP liability, the business wants to go long in the futures contract (long hedge). The profit/loss in the futures will offset any loss/profit in the underlying GBP/USD spot rate.

  • Using one futures contract:

19 December 2012: Open (long) one futures contract at F0 = 1.6245 (GBP/USD)

This will leave the business under-hedged by GBP12,500 (75,000 liability – 62,500 contract size)

S0 (18/12/12 closing price) = 1.6252 GBP/USD

21 February 2013: Close out (sell) positions with loss in futures at F1 = 1.5239 (GBP/USD)

Loss in futures = Nf(F0 - F1)zf = 1 * (1.6245 - 1.5239) * 62,500 = (USD6,287.50)

S1 (21/02/13 closing price) = 1.5254 GBP/USD

Spot dollar payment = S1(FVS0) = 1.5254 * GBP75,000 = USD114,405.00

Total payment = (USD114,405.00 + USD6,287.50) = USD120,692.50

This translates to an effective ‘exchange rate’ over the period of 1.6092 (USD120,692.50 / 75,000). The difference of -0.0153 USD/GBP between this effective rate and the futures rate at t=0 (on 19 December 2012) of 1.6245 is due to basis risk. This is the risk that remains, arising from uncertainty about the basis in the future. With a short GBP liability of GBP75,000 translating to USD121,890 on 19 December 2012, the total payment of USD120,692.50 demonstrates the hedging approach and outcome.

  • Using two futures contracts:

19 December 2012: Long (buy) two futures contracts at F0 = 1.6245 (GBP/USD)

This will leave the business over-hedged by GBP50,000 ((62,500 contract size * 2) – 75,000)

S0 (18/12/12 closing price) = 1.6252 GBP/USD

21 February 2013: Close out (sell) positions with loss in futures at F1 = 1.5239 (GBP/USD)

Loss in futures = Nf(F0 - F1)zf = 2 * (1.6245 - 1.5239) * 62,500 = (USD12,575)

S1 (21/02/13 closing price) = 1.5254 GBP/USD

Spot dollar payment = S1(FVS0) = 1.5254 * GBP75,000 = USD114,405

Total payment = (USD114,405 + USD12,575) = USD126,980

This translates to an effective 'exchange rate' over the period of 1.6931 (USD126,980 / 75,000). Again, the small difference of 0.0686 USD/GBP between this rate and the futures rate of 1.6245 at t=0 is due to the basis risk. The greater difference using two futures contracts may be simply explained by the fact that the GBP75,000 liability is much closer to that of one futures contract than two, so with translating to the hedging total payment of USD120,692.50.

Note:

Initial basis = b0 = (S0 – F0) = 1.6252 – 1.6245 = 0.0007 GBP/USD (referred to as 7 pips)

Final basis = b1 = (S1 – F1) = 1.5254 – 1.5239 = 0.0015 GBP/USD (15 pips)

ΔS - ΔF = (1.5254 – 1.6252) – (1.5239 – 1.6245) = -0.0998 – (-0.1006)

= b1 - b0 = 0.0015 – 0.0007 = 0.0008 (8 pips)

Thus ΔS – ΔF have moved reasonably in line. The analysis was done for imperfect hedges (i.e. not simply calculating Nf as the value of the spot position / value of one futures contract to leave the business with a fraction of a futures contract), so the hedges are not perfect.

References

Fabozzi, F.J. (1999) Investment Management
Srinivasan, S (2001) Using Currency Futures to Hedge Currency Risk

www.cmegroup.com


Finance, Derivatives

1) where f(t,T) is current forward rate f(t,T,T+1), rT is spot, = represents a 'no arbitrage condition'
2) Fabozzi (1999)

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