Hedging with futures

The element of speculation intrinsic in futures contracts is first of all aimed at ensuring their liquidity or permanent supply and demand for them. Speculators buy and sell futures several times a day and their constant presence helps to solve one of the most essential tasks of the market – redistribution of risks. Speculators take price volatility risks in exchange for high profit potential, while releasing from risks another group of market participants – hedgers.

Hedgers buy futures as insurance against price fluctuations of the underlying asset, because typically their main business is related to it. For example, if the management of a power-intensive manufacturing company want to protect the company from rise in oil or gas prices during the next half-year they can buy futures contracts for the type of fuel they need instead of physical inventory buildup. If the price of fuel goes up so will the price of the contracts they hold. Thus, by selling these contracts on financial markets the company will realize precisely the profit it needs to cover the growing operational costs related to buying the physical fuel at the new price. In that way, having avoided the outlays related to stockpiling and long-term contracts with suppliers, the company has made sure that its operational costs will be stable and it will receive its profit within a particular period of time.

Another example of hedging is profit insurance. In this case in order to protect itself from decrease in the price of the commodity it manufactures a company sells futures contracts for its expected future output. A short position in futures will provide the profit, which has not been received as a result of fall in the commodity price.

Historically, the first futures ever were futures for agricultural commodities, because prices in this branch of the economy fluctuate more than anywhere else. Nowadays, the world’s largest food processing companies use the following basic types of futures contracts to straighten out their risks:

  • corn
  • wheat
  • rice
  • soybeans
  • barley
  • coffee
  • cocoa
  • dry milk
  • orange juice
  • sugar
  • live cattle
  • pork.

The most characteristic feature of all futures contracts is their high degree of standardization. Contracts are standardised as to quantities, specifications and places and dates of delivery. It is worth mentioning that because some underlying assets cannot be standardised futures contracts only exist for the most basic ones. Nevertheless by applying certain strategies to the basic types of futures contracts it is possible to regulate almost all operational risks of a company.

Equally interesting are contracts for:

  • lumber
  • cotton
  • gas
  • oil
  • copper
  • gold
  • platinum
  • silver.

These commodity futures allow regulating cost-related risks practically in all processing industries from consumer goods and wood industries to metallurgy.

Companies engaged in large-scale export and import operations can reduce currency exchange rate fluctuation risks by hedging. If a company needs to make a payment in a foreign currency at a future date it can protect itself from unexpected future costs, which may arise if that currency rises in price. By buying a futures contract for that currency with a delivery date close to the date of the payment a company prevents possible losses from currency exchange rate fluctuations. Conversion costs are thus offset by profit from the futures contract. Currently, Chicago exchange lists futures for the following currencies:

  • AUD
  • GBP
  • CAD
  • EUR
  • JPY
  • MXN
  • CHF.

You can also use hedging methods to regulate the risks of your investment portfolio by making use of futures contracts for various indices, which reflect aggregate stock price indicators in major sections of the market. Index futures can make your portfolio management much easier because of their absolute diversification.

For example, your portfolio consists of US corporate stocks whose future potential you do not doubt. You believe that the price of these stocks is going to grow faster than the prices of other similar securities. However, you are not quite sure that major macroeconomic factors, which affect the whole market, will not have some negative influence on your portfolio as well, as a result of which its price might follow the overall downward trend though not so seriously as that of other securities. To offset the overall market factors you can sell several contracts for the S&P index, which reflects the overall market indicator for all US economy sectors. In that case your yield profile will be as follows:

Realizable yield = Yield on your portfolio – Overall market performance.

In other words the income you will realize will be adjusted by the average market indicator and you will be able to cash on your portfolio regardless of common trends. Based on the structure of your portfolio you can choose an index that will best suit your hedging goals. For example, US stock market trends are reflected in the following indices:

  • DJIA
  • NASDAQ 100
  • NYSE Composite
  • Russel 2000
  • S&P 500.

Interest rate hedging makes sense for floating rates, i.e. rates containing a variable part, such as interbank offered rates.