• Market commonly takes place at Commodity Exchanges which act as CLEARING HOUSES • Future markets trade contracts for future delivery • A futures contract is an agreement to make or take future delivery of a commodity at a price agreed to today • Future contracts are standardized in time, place, quality and quantity of delivery • Future contracts are contractual in nature, but not necessarily directly between producers and buyers as other risk takers might be willing to act as the counterparty and thus provide liquidity to the market (usually these are very liquid markets both in & out) Hedging with Futures - Back to Back Operations
Transcript
• Market commonly takes place at Commodity Exchanges which act as CLEARING HOUSES
• Future markets trade contracts for future delivery
• A futures contract is an agreement to make or take future delivery of a commodity at a price agreed to today
• Future contracts are standardized in time, place, quality and quantity of delivery
• Future contracts are contractual in nature, but not necessarily directly between producers and buyers as other risk takers might be willing to act as the counterparty and thus provide liquidity to the market (usually these are very liquid markets both in & out)
Hedging with Futures - Back to Back Operations
Hedging with Futures
• Hedging with futures involves taking a position thru a Financial Instrument in a Commodities Exchange
• This position has to be equal and opposite to that which is held on PHYSICALS side
• A gain in one side (either the PHYSICALS’ side or the FINANCIAL INSTRUMENT’S side) should be OFFSET by a corresponding loss on the other side
• When a coffee trader holds a long physical position in a commodity he is exposed to the risk of a price fall ie, the trader does not know the price at which he would be able to sell his coffee in the future
• This risk can be managed or hedged by taking out an offsetting short futures position
FUTURES Contracts
• Once the hedge is in place, price movements causing gains (losses) on the physical position are offset by losses (gains) on the futures position
• BACK to BACK hedging requires HIGHLY correlated prices between domestic markets and commodities exchanges (Basis Risk)
• On BACK TO BACK hedging operations, Commodities Futures Exchanges supply a counterparty for those cases when seasonality of S&D does not allow for two counterparties to encounter themselves at the market place to celebrate a business contract
• Whenever a counterparty is encountered then the hedge at the Commodities Exchange is lifted
Hedging with Futures
FUTURES Contracts
Coffee traders can either buy or sell futures contracts to take a position, this is known as taking a LONG or a
SHORT position
LONG POSITION
BUY futures contracts
On date of contract expiry holder of the long futures position will receive delivery of the contracted quantity and quality at the price determined at time of buying the futures
SHORT POSITION
SELL futures contracts
On date of contract expiry seller of the futures contracts will have to deliver the contracted quantity and quality at the price determined at time of selling the futures
Hedging with Futures
FUTURES Contracts
SHORT HEDGE
This involves a short position in the futures contract
Applicable when a trader already owns coffee and expects to sell it in the future
PLACE HEDGE
160.00 futures price
155.00 physical coffee price
-5.00 basis
LIFT HEDGE
192.00 futures price
187.00 physical coffee price
-5.00 basis
NET SALE PRICE
187.00 physical coffee sale less 32.00 futures loss (sold at 160.00 and bought back at 192.00) equals 155.00 net price
PHYSICAL POSITION FUTURES POSITION
APRIL:
Buy Coffee at 155 cents / lb
for sale in September
SEPTEMBER:
Sell Coffee at 187 cents / lb
(32 cents/lb gain)
APRIL:
Sell futures contacts at 160 cents / lb
(155 + 5 cents basis)
SEPTEMBER:
Buy futures contacts at 192 cents / lb
(32 cents/lb loss)
September – international coffee price at 192 cents / lb
Hedging with Futures
FUTURES Contracts – Short Hedge Example
LONG HEDGE
This requires taking a long position in the futures contract
Appropriate when a trader would purchase coffee in the future and is interested in locking in the price now
PLACE HEDGE
160.00 futures price
155.00 physical coffee price
-5.00 basis
LIFT HEDGE
192.00 futures price
187.00 physical coffee price
-5.00 basis
NET PURCHASE PRICE
187.00 physical coffee sale less 32.00 futures loss (sold at 160.00 and bought back at 192.00) equals 155.00 net purchase price
PHYSICAL POSITION FUTURES POSITION
APRIL:
Contract to sell coffee in September at
155 cents/lb
SEPTEMBER:
Buy Coffee at 187 cents / lb
(32 cents/lb loss)
APRIL:
Buy futures contacts at 160 cents / lb
(155 + 5 cents basis)
SEPTEMBER:
Sell futures contacts at 192 cents / lb
(32 cents/lb gain)
September – international coffee price at 192 cents / lb
Hedging with Futures
FUTURES Contracts – Long Hedge Example
MARKET ORDERExecuted at best available price on market
Key Terms:
LIMIT ORDERExecute order only till a target minimum or maximum price
STOP-LOSS ORDERExecuted if market reaches a particular price, to cap losses
GOOD TILL CANCELLED ORDEROrder remains on the market unless cancelled
Normally, orders are good for the date only
Hedging with Futures
FUTURES Contracts – Types of Future Contracts
• Delivery process may be required, if contract is held to maturity
• As such it is best to off-set the transaction prior to contract expiry to avoid hassles of giving/ taking delivery on a global warehouse
• Liquidate the contract - if you bought it, sell- if you sold it, buy it back
• Gain/loss determined by the sale/purchase differential
• Financial settlement- some exchanges may provide for financial settlement of contract, especially if trading lot size and delivery lot size are not matched
FUTURES Contracts
Hedging with Futures
Definitions:
“Placing a hedge” refers to either the selling of futures contracts or the purchasing of futures contracts
Offsetting a hedge is also known as “lifting a hedge”. This involves closing down a position by either purchasing futures to negate previous sales of future contracts, or selling futures to negative previous purchases of futures contracts
FUTURES Contracts – Placing & Lifting Hedges
Hedging with Futures
Brokers/ traders place a good faith deposit with the clearing house/ exchange in return for the benefit of novation
•This is the initial margin deposit•Objective is to minimize possibility of loss due to default
Investors provide cash or other acceptable security to the broker
Initial margins may be charged as a fixed amount per contract, or as a percentage of the market value of the contract, this varies as per rules of the clearing house/ exchange
Mark-to-market gains/ losses increase/ decrease the balance in the margin account
When the balance falls to the level of the specified maintenance margin, the holder of the positions is required to top-up the balance back to initial margin level
FUTURES Contracts – Margins
Hedging with Futures
• Financial gain or loss on a futures trade depends on the difference between the initial price and the price when the position is closed. When futures are used to hedge exposure of physicals traded any losses or gains should be mostly offset by the losses or gains on the physicals
• An initial margin deposit (usually 10% of the futures contract value) is required, and daily profits and losses are credited to this margin account.
• Because unlimited additional margin calls can be made whenever a trader’s futures position experiences continued losses, trading futures requires significant reserves of cash and/or credit
• Brokerage fees are an additional cost when utilizing futures
FUTURES Contracts – Margins
Hedging with Futures
Advantages of using Futures:1. Common platform for all traders2. Price transparency3. Lower transaction costs4. Absence of counterparty credit risk5. Market prices available to wider world6. Liquid Market7. Standardized contract size8. Thus, futures contracts can be a cost-effective solution as compared to
over-the-counter contracts
Limitations of using Futures:1. Basis Risk2. Physical volume risk3. Imperfect – gains and losses in futures markets won’t exactly match
gains and losses from the physical market
FUTURES Contracts – Advantages & Limitations to their use
Hedging with Futures
• Futures can be used to assist traders in hedging their exposure to coffee price movements
• Futures can be useful when a trade can not rely solely on physical trading to control their exposure
• Futures enable traders to take financial positions which are equal and opposite to their physical positions, hence protecting their businesses from coffee price volatility
• Futures are not perfect and traders must take account of basis when using futures to manage their risk exposure
• We shall now consider the use of options contracts for hedging operations
