How Do Futures Provide Price Protection?
The last lesson provided insights into the basic idea behind futures contracts. As a quick review, we said that futures contracts are simply agreements to buy and sell at a future date at a predetermined price. We also said that futures contracts could provide price protection to the buyers and sellers. It's now time to take a closer look at a futures contract and see just how they protect the buyer from rising prices and protect the seller from falling prices.
A Closer Look at Futures Contracts
Let's assume I have a digital camera that is worth $500 -- that's the amount I could quickly sell it for in a few days. I will need $500 in three months, and I am willing to sell my camera to generate the cash. Because they are relatively new, there are many new competitors entering the market, which may drive prices down. At the same time, new technology is quickly making the cameras better, which allows for manufacturers to charge more for them. If prices move higher, the prices of used cameras will rise right along with them. Therefore, we are uncertain what will happen with prices -- we could experience sizeable price swings.
Because I need the money in three months, there is a risk that I may not be able to get $500 for it at that time. While it is possible I may get more, my concern is that I could get less. I would be very interested in finding a way to guard against that risk.
Let's say my friend wants to buy a similar camera but will not have the money for three months. He's willing to pay $500 for it and I'm willing to accept that offer. However, we cannot make the deal because he does not have the money today. If he waits for three months to buy the camera, he faces the risk of rising prices. While I am interested in guarding against falling prices, he is interested in guarding against rising prices.
When one guards against risk with financial assets, it is called a hedge. I need a hedge against falling prices and my friend needs a hedge against rising prices. A hedge is an asset whose value will move in the opposite direction as that of the asset you're trying to protect. In other words, if the price of the asset you're trying to protect falls, the price of the hedge will rise.
An asset used as a hedge is usually not intended to make money but only to offset losses. Insurance on your home is a hedge. If you buy insurance, the value of that policy declines as the year goes on assuming you make no claims. However, if you have $20,000 worth of hurricane damage, your policy -- your hedge -- now pays you $20,000. Notice how you do not profit from the hedge since you lost $20,000 and gained that same amount. Hedges just offset losses.
 | Key Point |
Hedges are financial assets that offset losses. Hedges are not used to make a net gain or profit. Instead, they are used to protect existing assets.
Is there a way my friend and I can create a hedge for each of our concerns of rising and falling prices respectively?
Yes there is. The two of us can hedge our respective risks by entering into an agreement (a contract) to sell and buy the camera for $500 in three months (the future). That's all a futures contract is (remember, this would technically be a forward agreement since it is a private arrangement and not traded on an exchange, but the concept is exactly the same). To make things a little more interesting, let's say I live in Florida and my friend lives in California.
Three months go by and it is time to make the deal. Prices, however, have risen and similar used cameras are now selling for $650. My friend definitely wants to buy mine at the agreed upon price of $500 because of the recent increase in prices. While I may not be so happy about selling it, I am under contract to do so.
| If I back away from the contract, then my friend is faced with default risk. This is the risk we talked about earlier and is a significant risk of forward contracts. It is default risk that the clearing firms guard against and the reason why standardized contracts are a financially practical concept, despite some of their shortcomings. |
There are a couple of ways we can settle this. One method is straightforward: I can ship the camera worth $650 to him and receive a $500 check in exchange. If so, the terms of the contract are satisfied and the contract is executed. I lose a $650 camera and gain a $500 check. My friend has the opposite set of transactions and gains the camera but loses the check. The net effect is that I'm out $150 and he gains by that amount. Figure 1.1 shows the effects on both of us if I ship the camera.
Figure 1.1
| Method #1: Ship the camera | |
| My perspective -$650 camera +$500 check | Friend's perspective +$650 camera -$500 check |
| -$150 | +$150 |
If I ship the camera to him, I have a lost opportunity of $150. That means had I not entered the contract with my friend, I could now sell my camera for $650, which would put another $150 in my pocket. Because I entered the contract though, I must ship the $650 camera and receive a $500 check for it. I will not realize the additional $150 of market value.
Let's look at another way to settle the contract. If my friend could buy a similar camera in California for $650, couldn't we call it even if I just send him a check for $150 to make up his loss from the $500 agreed upon price? That way I don't have to ship the camera and he doesn't face the cost or risk of damage during shipping. He buys the camera in his area through a local dealer for $650 but receives my check for $150 and effectively pays $500, which is the price we agreed upon three months ago. His $500 plus my $150 check nets him the $650 he needs to buy the camera at current market prices. He gets his camera for the contractual $500 and I'm out $150 regardless of whether I ship the camera or just send him a check.
In this second method of settlement, we could say I paid him $150 to let me out of the contract. I have effectively purchased the contract back from him, and it is now considered complete. Notice that when I purchased the contract from him I got out of the contract, so I am no longer obligated by its terms. Thus, I do not need to ship the camera. Figure 1.2 shows the effects of this second method of settlement on each of us:
Figure1.2
| Method #2: Close out for cash | |
| My perspective -$150 check +$650 camera proceeds | Friend's perspective +$150 check -$650 camera |
| +$500 | -$500 |
If I spend $150 cash, I get to keep the camera worth $650. Because I had to spend that money in order to keep the camera, its value was effectively lowered to $500. My friend now must spend $650 for a camera but receives a $150 check from me, which effectively lowers his purchase price to $500. Notice that I am left with a camera worth $500 (which I can sell locally) and my friend pays $500 to own a camera, which is exactly how we wanted to end up three months ago.
Compare Figures 1.1 and 1.2. In method #1, the net effect was that I lost $150 of value, but in method #2 I lost $150 cash. I also received $500 cash under method #1, but I received that same amount of value in method #2. The bottom line is that either method effectively makes the purchase price paid by my friend and sales price received by me the same -- $500. Although I never ship the camera in method 2, I effectively transferred its gain in value to my friend.
We have just seen two methods in fulfilling the contract if prices rise. Let's take a look at how we could complete the contract if, instead, prices fell.
Let's say that after three months similar cameras are selling for $300 instead of $650. While my friend certainly isn't interested in paying $500 for mine, he is under contractual obligation to do so. The first method of settlement is to execute the contract and ship the camera worth $300 and receive a $500 check from him. If so, I have an effective gain of $200 at his expense, since I am selling an asset for $500 that is only worth $300.
Figure 1.3 shows that shipping the camera causes me to lose a $300 camera but gain a $500 check, which was the agreed upon price. This nets me a $200 gain. Likewise, my friend is exposed to the opposite set of transactions and receives a $300 camera but spends $500 cash for a $200 loss.
Figure 1.3
| Method #1: Ship the camera | |
| My perspective -$300 camera +$500 check | Friend's perspective +$300 camera -$500 check |
| +$200 | -$200 |
But once again, rather than taking the time, cost, and risk to ship the camera, he could buy the camera in California for only $300 and send me a check for $200. This effectively makes him pay the agreed upon price of $500 for the camera. I could then sell my camera for $300 in Florida plus gain his $200 check, which nets me the $500 agreed upon sales price. Whether I ship the camera or accept his $200 check, he effectively pays $500 to obtain a camera and I effectively sell mine for $500, which is exactly how we wanted to end up three months ago.
So our second method of completing this agreement is for him to buy back the contract from me for $200 as shown in Figure 1.4:
Figure 1.4
| Method #2: Close out for cash | |
| My perspective +$300 camera proceeds +$200 check | Friend's perspective -$300 camera -$200 check |
| +$500 | -$500 |
The most important point to understand is that whether prices rise or fall and regardless of the method we choose to settle the contract, I receive $500 for my camera and my friend spends $500 to gain a camera. Our fears of rising or falling prices are perfectly hedged by simply entering into an agreement to prearrange these transactions three months earlier.
If we ship the camera, Figures 1.1 and 1.3 show that I actually receive a $500 check from my friend. However, if we choose to not ship the camera, figures 1.2 and 1.4 show that I gain $500 in value and my friend loses $500 in value. I either get a $500 check for certain or $500 in value for certain, which is exactly what I wanted three months earlier. My friend either spends $500 for the camera or spends $500 in value to gain a camera, which is exactly what he wanted at the onset of the contract.
In about 95% of the actual futures contracts, investors just offset their obligations by closing the contract out for cash and "offsetting" the contract, thus causing it to be closed. Investors and speculators just close out their positions by either paying or receiving money, which mathematically makes it equivalent to their buying and selling prices that they agreed to at the start of the contract.
Notice how easy it is for an untrained eye to only see my $150 "loss" when camera prices rose and my friend's $200 "loss" when prices fell and thus view this futures contract as a speculative, risky arrangement! But a close examination reveals that's not the case. Three months earlier when I wanted to sell my camera, I was concerned with getting less than $500 for it. I do not see sending somebody else a check for any amount above $500 as a loss. I am perfectly willing to do that. My concern of a lower price was perfectly hedged by the contract. Likewise, my friend was concerned with paying more than $500 to gain a camera in three months. He's perfectly willing to send a check if he's able to pick up the camera in three months for less money. His worry about paying more for the camera was perfectly hedged by the contract. Futures contracts allow people to hedge risks of rising or falling prices. In most cases, money just changes hands and the underlying assets are never delivered.
In some futures contracts, you could not even take delivery if you wanted to. Rather, they are cash settled but, as we've seen, there's really no difference in the two methods. Cash-settled futures most often occur with indices such as the S&P 500 or the Nasdaq 100. Rather than delivering every stock in the index, which would be rather burdensome, that contract only settles in cash.
Futures Markets Are a Zero-Sum Game
We said that hedges are not intended to provide profits but rather to offset losses. Just as with the home insurance example, the homeowner gained a $20,000 check but lost $20,000 in value of the home, which is a net breakeven. Any arrangement that operates where one person's gain is exactly another person's loss is called a zero-sum game. A zero-sum game just means that one person cannot be made better off without making another equally worse off. In other words, the sum of all gains and losses is zero.
Futures contracts are a zero-sum game. This simply means that, in the end, no new money is brought to market such as when new shares of stock are issued. Futures contracts do not provide a means to raise new capital, which is often the focus of criticism. In the camera example, when prices rose by $150, I lost that amount and my friend gained that amount. Likewise, when prices fell $200, I gained that amount and he lost that amount for a net zero gain or loss in the market. Keep this in mind as you hear about the "devastating" losses created in the futures markets. There is always a party on the other side of the trade who profited by the exact amount. So the futures markets do not create disastrous "holes" in the financial system but rather allow hedgers and speculators to hedge risks by simply passing money from one to another. Those "holes" are filled by gains of equal size, but you won't read about those gains in the newspaper. The financial press will only highlight the losing side of the trade.
Key Point Thought Questions:
In the introduction, we talked about Nick Lesson bankrupting Baring's Bank by losing 1.3 billion dollars in the futures markets.
1) Are those dollars gone for good?
2) Is it a true loss to the financial market as a whole?
Long and Short Positions
In order to better understand how futures contracts protect buyers and sellers, it is important to understand long and short positions.
In financial lingo, if you own an asset (stock, bond, futures contract etc.) you are long the position. With a long position, you are hoping to profit from an increase in that asset's price. You are attempting to "buy low, sell high." However, it is also possible to profit from a decrease in the asset's price. To do so you must reverse the transactions and sell the asset first and then buy it back later at hopefully a lower price. If you sell first, you are "short" the position. Short sellers attempt to "sell high, buy low." While it may sound complicated, short sales can be accomplished with relatively the same quickness and ease as purchasing a stock from your broker.
Short selling was even demonstrated in the comedy hit movie Trading Places with Eddie Murphy and Dan Aykroyd when the two were selling frozen concentrated orange juice futures contracts to get even with their heartless bosses. The bosses see the two down on the trading floor when one asks, "What are they doing down there?" The other suddenly realizes what's happening and replies, "They're selling, Mortimer!" After the crop report is released, the futures prices plunge and you see Eddie and Dan buying back the contracts (with big smiles)!
| Key Points |
- Long positions make money if prices rise
- Short positions make money if prices fall
Many people new to futures get easily confused when trying to decide if the hedger or speculator should buy or sell the futures contract. In other words, should they be the long contract or the short one? If you are speculating, the answer is easy and is no different from stocks, bonds, options, or other assets. If the think the price will rise, you buy the futures contract. If you think prices will fall, you short the contract. Where it gets tricky for some is when you consider a hedging transaction, such as when my friend and I wanted to hedge against rising and falling camera prices respectively. It's actually very easy to figure out and there are a couple of methods you may find helpful.
First, I was seller of the camera and was therefore afraid of falling prices. How can I protect myself? Obviously I would need an asset that rises in price as prices fall -- I need a short hedge. If I sell (short) the contract, I can protect myself from falling prices. That's because the short contract will rise in price if underlying prices fall.
My friend, on the other hand, was afraid of rising prices. He would need a long hedge for price protection. If he buys the contract, it will rise in price and offset his costs in the future if underlying prices should rise.
| Key Points |
- You buy a futures contract (long position) if you wish to hedge against rising prices in the future.
- You sell a futures contract (short position) if you wish to hedge against falling prices in the future.
Because I needed a short hedge and my friend needed a long hedge, we were able to match up our needs and create a "futures" contract. He would be the buyer of the contract and I would be the seller.
If you are not comfortable thinking in terms of long and short hedges, you can use another method, possibly more straightforward, to determine who should be long and short the contract.
Since I would be the seller of the camera in the future, I will need to be the seller (short position) of the contract. Similarly, my friend will be the buyer of the camera in the future, so he would be a buyer (long position) of the contract. Just remember that a buyer is a buyer and a seller is a seller. Buying a futures contract is the same as buying something in the future. Selling a futures contract is the same as selling something in the future. It's not any more difficult than that.
| Key Points |
- You buy a futures contract if you are willing to buy the underlying asset in the future.
- You sell a futures contract if you are willing to sell the underlying asset in the future.
Refer back to figures 1.2 and 1.4 for a moment. In Figure 1.2 we said that I could close out the contract by paying $150 to my friend. Now it should make more sense as to why that worked. He was the long position and I was the short position. Because prices rose, my short position was hurt by $150 dollars (remember, short positions profit if prices fall) so I can pay him that amount and the contract is considered complete. Notice it is the loser who pays the winner.
Likewise in Figure 1.4 we assumed that prices fell by $200. In that case, my friend would have to pay me $200 to close out the position. That's because his long position was hurt by the fall in price, and my short position was strengthened. The loser must pay the winner.
Notice that this contract was closed for equal gains and losses at the same time. In other words, if I wish to end the contract, I have to rely on my friend to take the opposing side and close it out, too. What if that person does not wish to do so at that time? In the real world of futures trading, it does not matter what the other person wishes to do. Because futures contracts are standardized, I would only need to buy the contract from another seller. In effect, I will have switched places with that person and they are the new short position paired with my friend. Likewise, if my friend wishes to close out the contract, he does not need me to agree to it. He simply sells the contract to another buyer. If so, that new buyer is now the new long position and I am still the short position. The ability to swap contracts like this (to allow buyers and sellers a way out at their discretion) is perhaps the biggest advantage of standardized contracts.
For every futures contract there must be one buyer (long position) and one seller (short position), which is why futures are a zero-sum game. Any gain in the long positions is canceled out by equal losses in the short positions. This is not true for the stock market. While there are usually some short positions for any given stock, it is not a necessary condition. It is therefore possible for all stockholders to have a profit on a given day. If Intel rises up $1 and there are no short positions, then all stockholders have increased their wealth by $1 per share. If this happens in the futures markets, then half the positions have a gain and half the positions have a loss.
The camera example represents the very essence of any futures contract. If you understand what took place with the different scenarios of rising and falling prices, you will be able to follow along with the more obscure commodities with a real futures contract. Then we'll be prepared to understand how these assets can be used to improve our performance in the stock market once single-stock futures are introduced. The next course will take you up another level of understanding and show you an example of a real futures contract. You’ll see how they can be used to hedge day-to-day business risks. The knowledge you have developed so far should make it easy to follow your first real futures contract!
Understanding a Real Futures Contract
Now that we have the basic mechanics of how a futures contract works, we can apply that same reasoning to a real contract and it will be much easier to understand.
We've learned that there are many types of futures contracts, and currencies are certainly one of the more popular contracts for businesses involved in importing and exporting. These firms face exchange rate risk and it can be a serious threat to firms in this industry. If a
For example, assume that one U.S. dollar is worth about 10 Mexican pesos, which is about accurate at the time of this writing. You take a trip to
Let's stick with our Lexus dealer from the second lesson and see how he could use futures contracts to hedgethe considerable risk of currency fluctuations.
Assume that the U.S. Lexus dealer is going to order 20 Lexus convertibles. The cars will be built in
How much is 125,000,000 worth in U.S. dollars? That depends on the exchange rate between the two currencies. Let's assume the current exchange rate is $1 = 125, which is how you will likely see quotes in your local newspaper. That just means that $1 can be exchanged for 125 yen . These quotes are called the spot rate since money can be exchanged "on the spot," or immediately, at that rate. If the car dealer needed to buy the cars today, he would need to pay 125,000,000/125 = $1,000,000 for the shipment. In other words, one million U.S. dollars will purchase 125 million Japanese yen, which is the current amount needed to fulfill the contract price.
In order to hedge the risk of rising yen prices, the dealer could buy the yen today. However, as with any payment, the car dealer does not want to pay for something that is not due immediately because the dealership may earn interest on the money in the meantime. Rather than buying the yen today, the dealer could wait for three months and buy them at that time. Of course, the risk of waiting for three months to pass before buying the Japanese yen is that the yen may be much more expensive at that time, which means the cars would cost significantly more than one million dollars. So what can the car dealer do? Just as our camera example showed how we could guard against rising prices of a camera, we can use the same principles, on a much bigger scale, to guard against rising prices of Japanese yen. The car dealer simply needs to prearrange the purchase of yen three months in the futures. He needs to enter a Japanese yen futures contract.
Remember what we learned earlier regarding long and short hedges. Our car dealer is afraid of rising yen prices so he needs a long contract in order to hedge that fear -- he will need to buy a Japanese yen futures contract, thus locking in today his future purchase price of yen. Using our alternative method to determine whether he should be long or short is that the car dealer is a buyer of yen in the future so he will be a buyer of the yen contract. Before we can understand how a futures contract works with currencies, we need to understand some basic notations for reading currency quotes
| Thought Questions: |
| A Brief Detour: Understanding Currency Quotes |
Sometimes you will see exchange rates listed from the viewpoint of the home country, which is called a direct quote(if the home currency is the U.S.). A direct quote is listed as one unit of the foreign currency and allows the home currency to float. It answers the question, "How many dollars does it take to buy one unit of the foreign currency?" If the indirect quoteis $1 = 125, the direct quote will be the reciprocal amount, which is 1/125 or 1 = $.008. Notice how the yen is fixed at one unit and the home currency is allowed to float.
These two methods of quoting are important to understand since most (not all) currency contracts are quoted in direct terms. If you do not understand how to read the quotes then you will not know what price at which you are agreeing to buy or sell in the future. To reduce the risk of rising yen prices (falling dollar), the car dealer can enter into a futures contract to buy Japanese yen in three months.
Earlier we said that futures contracts are standardized as to size, quality, delivery and other aspects. It just so happens that the size of the Japanese yen contract is fixed at 12,500,000 yen. If the dealer buys a yen futures contract, he will be purchasing that many yen in three months. Assume it is now December, which means the car dealer will need to buy the March Japanese yen futures contract (three months ahead), which is currently quoting 7850. What does this quote mean? Remember we said that most currency contracts are quoted in direct terms and the yen is no exception. However, because the value of the dollar to the yen is so strong, there's a little twist to the way quotes on the yen are displayed. A quote of 7850 is really the direct quote without the front two zeros, which means 1 = $.007850. If the car dealer buys one March contract, he will lock himself into a payment of 12,500,000 * $.007850 = $98,125 in three months.
On a technical note, the Japanese yen futures are really quoted in points with one point being equal to one millionth of a dollar, which is $.000001 or $1/1,000,000 per Japanese yen. A quote of 7850 points is equal to 7850/1,000,000, which equals $.007850 per yen and is exactly the same answer we arrived at previously. Whenever you see a quote on the Japanese yen, you simply divide that quote by 1 million and that's how many dollars you're agreeing to pay per yen.
Now back to our car dealer's problem. He has a guaranteed delivery of 20 cars in three months with a fixed payment of 125,000,000, which is anticipated to be valued at $1 million since the current exchange rate is $1 = 125 (or $.008 per yen). It is the uncertainty of the value of the yen in the future that he wishes to hedge. If the price of the yen rises, the dealer may end up with a much larger than anticipated expense.
He can do one of two things. One, he can pay the current rate for the Japanese yen and pay $.008 dollars per yen and hold onto the yen for three months. In order to do this, the car dealer will miss out on the interest that could be earned on $1 million over three months. It is possible the dealer can hold the yen in a Japanese bank to earn interest, but there may be differences in interest rates and the dealer would need an account at a Japanese bank, which may be more trouble than it's worth.
Second, he can enter into the futures contract and pay .007850 dollars per yen in three months. On the surface it certainly seems like the dealer should enter into the futures contract since he can delay the payment and get a more favorable exchange rate. Remember, the current yen price is $.008 for spot delivery but the dealer can enter into a futures contract and purchase them for .007850, which is a little cheaper, in three months.
Price Discovery
In this case, the markets are signaling they are expecting the dollar to strengthen against the yen over the next three months; that's why it will take fewer dollars to buy one yen in three months (.007850 vs. .008). This is yet another benefit of futures markets. They provide a forum for price discovery -- a way to collect opinions of market participants as to the direction of prices. Futures markets provide the forum to bring all the bids and offers together in one centralized location, which gives you the market consensus of direction by simply glancing at the quotes.
Normally, if most people were asked for an opinion as to whether the dollar would strengthen or weaken against the yen , they would be lost for an answer. With futures markets, the answer is easy and you simply look at the quotes -- that's price discovery. We will learn in Chapter 4 that there are some markets where price discovery works better than others but for now, just be aware that futures markets provide this very important economic function.
| Key Points |
Futures markets provide a forum for price discovery, which is a way to collect opinions about the direction of prices. This is a very important economic function of futures markets as they provide businesses with valuable production information.
The markets are signaling for a decrease in the price of yen relative to the dollar, so this actually opens up a third choice for the dealer. He may elect to use this information and simply wait for three months to pass and then make payment at that time for hopefully a more favorable rate. Just because the markets are signaling for a decrease, though, does not mean it will happen. Because the dealer is really concerned with the yen rising against the dollar, entering into the futures contract seems to be his best course of action. Of course, by entering into the March yen contract and locking into a rate of $.007850 per yen today, the dealer runs another type of risk in that the exchange rate may be even cheaper after three months. This is the same type of risk my friend was exposed to when buying the camera in Chapter 1. But futures contracts are not used to determine the optimal price; their function is to lock in costs and profits. The dealer's concern is that yen prices will rise; by entering into the futures contract, he can eliminate this fear.
Because he will pay 125,000,000 in three months and each contract is for 12,500,000 yen, he will need to buy 125,000,000/12,500,000 = 10 futures contracts on the yen. In most real-life cases, the number of required contracts will not work out this evenly; this was done intentionally to make the example easier to follow. But for now, just understand that many times the hedger will need to slightly under- or over-hedge, which is another drawback with standardized contracts. For example, if payments for the cars were 115,000,000, he would need to buy 115,000,000/12,500,000 = 9.2 contracts. If he only buys 9, he is a little under-hedged and over-hedged if he buys 10. If he could find someone to take the other side of the trade for him, he could enter into a forward agreement for exactly 115,000,000 and be perfectly hedged. Once again, finding this other person can be difficult, to say the least. If the dealer does find someone, he must have an attorney draw up the contracts and, well, you get the idea. It's not easy. The futures contracts can be executed in seconds and the clearing corporation guarantees its fulfillment. Sometimes being a little under- or over-hedged is worth it. Let's look at how the futures contract manages the risk for our car dealer under various scenarios.
Scenario #1: The Yen Falls
Let's assume that the yen does in fact fall relative to the dollar (which is predicted by the market through price discovery) to an exchange rate of $.007840 in March. If this is the case, the futures contract will be trading for very close to the spot rate and will be quoting 7840. The reason it must quote close to the spot rate is because the futures contract will almost be expired and is virtually the same as the spot rate. We'll show you a more formal arbitrage argument shortly.
We know that in March the dealer was expecting a cash payment of 125,000,000 * $.007850 = $981,250, so lets see what he could do in this scenario.
With the yen trading lower, the dealer has two choices:
1) He can use the futures contract and pay .007850 per yen, or
2) he can close out the futures contract and buy yen in the open market.
Just as with our camera example, we will soon see that it doesn't really matter which choice the dealer makes; both result in the same outcome. We'll step through both choices to better understand why it does not matter which choice he makes.
Choice 1: Yen falls. Dealer does not use his March futures contract:
Because the yen has fallen, the dealer may decide to not use the futures contract and will prefer to just purchase the 125,000,000 yen in the open market for the cheaper price of $.007840 or a total purchase price of $980,000. The dealer was locked into a purchase price, though, of $981,250, so he appears to be ahead by $1,250 by not using the futures contract. However, in order to get out of his futures contract, he must enter an offsetting position, which means he will have to sell the same contract as the one he is long. The March contract can currently be sold for the spot price of 7840. Because he agreed to pay 7850, this results in a loss of (.007850-.007840) * 125,000,000 = $1,250.
So even though the dealer appeared to be saving $1,250 by purchasing yen in the open market and not using the futures contract, it is only an illusion. He must pay that amount to get out of the futures contract. Remember, futures are not options, so the dealer is obligated to fulfill the contract unless he enters an offsetting futures position.
The dealer was ahead by $1,250 by purchasing yen in the open market and not using the futures contract; however, he lost $1,250 in closing out the contract for a net wash. This net wash situation will be true for any Japanese yet quote below the contract price of 7850 -- the loss on the futures will equal the gain in using the spot market.
However, had the dealer not entered the futures market back in December, he would be ahead by $1,250. An untrained eye may only see that using the futures contract resulted in a speculative loss of $1,250. The untrained eye does not see that the dealer is also ahead by that amount by using the spot market or that the dealer would be ahead had the yen risen against the dollar, which was their main reason for entering into the futures contract.
Choice 2: Yen falls. Dealer uses his March futures contract:
The dealer could elect to use the futures contract and take delivery of 125,000,000 yen at a price of $.007850 for a total payment of $981,250. If so, he is overpaying by $1,250 by not using the spot marketwhere yen can be purchased for $.007840 per yen or $980,000; however, he does not take a $1,250 loss on the futures contract either.
We can see that it makes no difference, mathematically, whether or not the dealer uses the futures contract to purchase the yen. However, no matter which choice he makes, there is a $1,250 loss when compared to the alternative choice three months earlier of not entering the contract at all. Had the dealer not entered the futures market back in December, he would be ahead by $1,250. Using the futures contract "cost" him an additional $1,250. Keep in mind, though, that the purpose of using the futures was not to protect against falling prices but rather to protect against rising prices.
Even though this futures contract appears to be a loser in this case, you have to remember that the dealer would have paid $1,000,000 back in December to insure (hedge) delivery for March. The dealer hardly sees his payment of $981,250 as a loss. That's the price he agreed to pay back in December. He's more than happy to pay $1,250 to close out the futures contract at a "loss" in order to save $1,250 in the spot market; . Remember, these "gains" and "losses" in the futures contracts just mathematically ensure that both the buyer and seller are locked into their originally agreed upon prices. The dealer pays $980,000 in the spot market plus incurs a loss of $1,250 on the futures contract for a total cost of $981,250 -- the original price he agreed to pay.
Scenario #2: The Yen Rises
Even though the market was predicting a fall in the value of the yen, this obviously does not mean the yen must fall. That is just a market consensus and, while the information is valuable, it is not always correct. Let's assume now that an unforeseen event happens and the yen rises to an exchange rate of $1 = 126.50 or 1 = $.007905. If so, the Japanese yen contract will be trading for (or very close to) the spot price of 7905.
Once again, the car dealer again has two choices with either choice, as before, resulting in the same outcome.
Choice 1: Yen rises. Dealer does not use his March futures contract:
With the yen trading at $.007905, the dealer can buy yen in the market for a total payment of 125,000,000 * .007905 = $988,125. However, in order to not use his futures contract he must close it out in the open market by selling the equivalent contract, which will be trading for 7905. He was under contract to pay 7850 but can sell that same contract for 7905, which is a gain of .007905 - .007850 = .000055 * 125,000,000 = $6,875. In effect, the dealer pays $988,125 in the spot market but also receives a gain of $6,875 from the sale of the futures for a net payment of $981,250, the price he expected to pay when he initiated the futures position back in December. Had the dealer not entered the futures contract then, he would be exposed to an unexpected $6,875 expense in March. By entering the futures contract, the dealer has controlled costs and is ahead by $6,875.
Choice 2: Yen rises. Dealer uses his March futures contract:
Because the yen is trading higher than his contract price of 7850, the car dealer could decide to use the contract to purchase the yen. If so, his payment will be $.007850 * 125,000,000 = $981,000, a savings of $6,875 as compared to using the spot market. A net gain will result for any spot price above $.007850 in March.
This savings of $6,875 is exactly the amount of the gain in the futures contract when the dealer opted to not use the contract under the first choice. If he uses the contract to purchase the yen, he cannot sell it for an equal gain either. Whether the dealer uses the futures contract or not, he is hedged against any price increase in the price of yen through March -- this is the reason he entered the futures contract.
Because it doesn't make a difference to the dealer whether he uses the contract or not, as stated before, most users of futures contracts will just close out the futures contract at either a gain or loss and then purchase or sell the underlying asset in the spot market.
Why not use the contract? Because there are specific guidelines for taking delivery of the underlying asset. Contrary to what you've probably heard, nobody is going to pull up in front of your house and dump a bunch of cattle on your front lawn. In fact, the CME rulebook describes approved stockyards for live cattle as follows:
CME Approved Stockyards
| Deliveries on exchange contracts of live beef cattle, feeder cattle, and lean hogs can be made only from public livestock yards designated and approved for delivery by the Exchange. A public livestock yard shall not be eligible for deliveries as an approved stockyard unless it is a stockyard within the definition of the Packers and Stockyards Act (Ch. 9 United States Code, Sections 181-3, 201-217a and 221-9) and has received notice to that effect from the Secretary of Agriculture. Approved stockyards shall be required to keep such records, make such reports and be subject to inspection and regulation by the Secretary of Agriculture, as provided in said Packers and Stockyards Act. |
Rather than dealing with the headaches of filing of delivery forms and other specific formalities for taking delivery, most hedgers will close out the contracts in the open market and then deal with their own suppliers on a local level. The important point to understand is that whether the dealer uses the contract or not, there are advantages and disadvantages and the net gains or losses to the car dealer are zero. These are summarized in Figure 1.6:
Figure 1.6
| | Yen Falls | Yen Rises | ||
| Advantage | Disadvantage | Advantage | Disadvantage | |
| Uses contract | Does not take loss on futures contract | Takes equal loss by paying more for Yen with contract | Pays less for Yen by using contract | Loses equal gain by not selling contract |
| Does not use contract | Pays less for Yen in open market | Closes contract for equal loss | Closes contract for gain | Loses equal amount by paying more for Yen in open market |
| Key Points |
It does not make a mathematical difference whether the long or short position closes the contract or goes through with delivery. The net effect is the same. Because of this, most futures investors just close out the contracts in the open market with an offsetting position
| Thought Question: |
Was the Car Dealer Speculating in the Futures Markets?
Now you can see why the financial press is often so hard on futures markets "derivatives" . It is often because they do not understand why someone would use them in the first place. With our car dealer example, the dealer was locked into a known expense of $981,250 three months into the future. That's it. Locking in an expense makes perfectly good business sense -- especially if the dealer already has the cars sold!
However, in the first scenario where we assumed the yen fell, the dealer realized a "loss" of $1,250. You should now understand why. The dealer entered into a long hedge to guard against rising yen prices. If the yen falls, the dealer will lose money on that long asset -- just as anyone would who buys high and sells low. What the press fails to see (or possibly, conveniently leaves out) is that the car dealer's loss in the long hedge was exactly offset by his ability to buy yen cheaper in the spot market . So was our car dealer speculating in the market? Is this a reckless gambling loss in the futures market? Hopefully you now understand that it isn't, but certainly could be misconstrued as such if you do not understand the whole story.
So why all the hype about risk in the futures markets? As we said in the introduction, it really depends on who is using them and what their motivation is for using them. It's now time to take a look at the key players in the futures markets: hedgers, speculators, and arbitrageurs. Once we understand their roles, it will be easy to see why many feel that futures are too risky when, in fact, that is not the case.
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