Institutional Detail and Futures Mechanics
Futures markets exist because of fundamental uncertainty about how future events will unfold and the concomitant risk that events may turn against us. Uncertainty breeds two types of futures market participants—hedgers, who lock in prices in an effort to eliminate future price volatility and speculators, who bet on their beliefs about future directional movements in prices.
A cattle rancher, for example, may have 120,000 pounds gross weight in a herd that he intends to bring to market in three months. The rancher wants to hedge the uncertainty that cattle prices may fall in the interim. He could enter a contract with a counterparty to sell his cattle forward for a price agreed upon today, thereby locking in a price. Alternatively, he could sell futures contracts. As we'll see, forwards are simpler versions of futures, not in how they are priced but in how they are managed. If we assume that the live cattle futures contract on the Chicago Mercantile Exchange (CME) is for delivery of 40,000 pounds, the rancher could sell (short) three contracts to deliver his cattle in three months at a price determined today. His short futures position locks in the price of cattle, thereby eliminating the risk of a price decline. The other side of this trade could be taken by a beef processor (or a speculator) who buys the futures contract (goes long), agreeing to take delivery of the cattle at the futures price and thereby eliminating the risk that cattle prices may rise in the interim.
One difference between forwards and futures is that participants generally take delivery in forward markets. In futures markets, this is rarely the case. With a futures hedge, the cattle rancher will still transport his herd to market in three months and receive the spot price (S). Separately, he will close out the short futures position by taking an equal and opposite position; in this case, by buying three long contracts with the same delivery date at price F1. His cash flow will be the sum of the spot price received plus the gain or loss on his futures position, that is, S1 + (F0 – F1). The futures position will therefore offset the spot price if the price of the futures contract falls by the time he closes out his position. The futures position was just an overlay, whereby the gain or loss on the futures position countered any impact from a change in the spot price. To see this, suppose the spot (market) price for cattle today is $1 per pound and that the rancher sells three futures contracts at $1 per pound. If the spot price three months from now is $0.50 per pound, then the gain on the short futures position offsets the loss in the spot market. That is, he closes out the short futures position (worth $1 per pound) by buying the long futures contract just before delivery at $0.50 per pound. The net $0.50 per pound gain in the futures position in this case exactly offsets the loss in the spot market.
Delivery months differ by commodity type. Corn futures, for example, traded on the Chicago Board of Trade (CBOT) have delivery in March, May, July, September, and December. Crude oil futures, on the other hand, that are traded on the New York Mercantile Exchange (NYMEX) and Treasury bond futures, traded on the CBOT, are quoted in dollars and trade continuously.
Futures are traded on established exchanges using standardized contracts with daily settlement (contracts are marked to market daily) and with a range of settlement dates. As we saw earlier, contracts are typically closed out prior to delivery. Futures also have virtually no credit risk because participants are required to post margin. Table 15.1 illustrates how margin works. Suppose you were taking the long end of the cattle futures trade outlined earlier, obligating you take to delivery at $1 per pound for a total of $120,000. The broker who sold you this contract is exposed to credit risk in the event that you decide to walk away from your end of the deal if spot prices fall. Suppose the broker requires 20 percent ($24,000) margin to be posted and imposes a 75 percent maintenance margin (minimum margin balance in the account) equal to $18,000. Margins are set by the exchange and are generally proportional to the price volatility of the underlying. Each day, the futures position is marked to market, and if the margin balance falls below the maintenance level, there is a margin call whereby the broker requests the investor to post additional margin. The following table illustrates the process of daily settlement over a fictional 14-day period.
Table 15.1 Futures Mechanics.
On day six, the futures price has fallen enough to deplete the margin account to the point at which the broker calls for the investor to deposit $6,000 in the margin account. On the tenth day, the maintenance margin is again breached, whereby another $2,400 is called and on the thirteenth day, $1,200 is called. By the end of the fourteenth day, the futures price has fallen to $0.79, requiring a margin call of $9,600. The investor then decides to close out the position and sell the three contracts for a total loss of $25,200.
Forward contracts differ from futures on several levels—they are typically nonstandardized, nonexchange, private contracts between parties that are traded over the counter (OTC) with a single delivery date and are usually held to the delivery date. More importantly, since forwards are settled only at the end of the contract period, there exists some credit risk. A typical example would be the case in which an exporter has a contract to sell goods to a foreign buyer at some specific future date and will get paid in foreign currency. The exporter may wish to enter into a forward trade with a counterparty by selling forward the foreign currency today. If, for example, the sale will be paid in euros, the exporter risks receiving fewer dollars if the euro falls against the dollar in the interim (that is, the dollar appreciates and the dollar cost of the euro declines between now and the time the euros are to be exchanged). Shorting a forward contract to deliver euros hedges the risk of a stronger dollar in the future. In this case, if the euro depreciates, meaning it exchanges for fewer dollars, then the short position will increase in value, exactly offsetting the loss. Table 15.2 illustrates the case for a short position taken in January against 500,000 euros to be received in May. For illustrative purposes, I include an identical futures position that is settled monthly.
Table 15.2 Short Futures.
Clearly, the dollar has strengthened against the euro—in this case, by $0.25 per euro. With no forward or futures position, the exporter would have lost $125,000 when exchanging the 500,000 euros for dollars; that is, whereas euros became cheaper in dollar terms, dollars on the other hand became more expensive in euro terms. Thus, the 500,000 euros would have bought, not $1.52 × 500,000 = $760,000, but $1.27 × 500,000 = $635,000. As shown in the table, shorting euros in the forward market, therefore, would have generated a $125,000 profit that would exactly offset the loss to being long euros in May.
A similar position in futures would produce the same qualitative result. The distinction is that futures are settled monthly in this example and interest paid on margin balances at 12 percent annually. Thus, over the course of the contract, the margin account grows in principal and interest, and that explains why the short futures position is worth more. It also shows why margin is important to protect against credit risk; after all, had the dollar depreciated, then the short futures position would have had to adjust margins accordingly to provide protection while no such action would be taken regarding the forward position.