Futures are a popular asset class used to hedge against risk. Strictly speaking, investment risk can never be completely eliminated, though its impact can be mitigated or passed on. Hedging through future agreements between two parties dates to the 1800s. The Chicago Board of Trade standardized futures contracts in 1865 to allow farmers and dealers to trade grain and other soft commodities at future transaction dates throughout the year.
Let’s look at some basic examples of the futures market, as well as the return prospects and risks.
For simplicity's sake, we assume one unit of the commodity, which can be a bushel of corn, a liter of orange juice, or a ton of sugar. Let's look at a farmer who expects one unit of soybean to be ready for sale in six months’ time. Assume that the current spot price of soybeans is $10 per unit. After considering plantation costs and expected profits, he wants the minimum sale price to be $10.10 per unit, once his crop is ready. The farmer is concerned that oversupply or other uncontrollable factors might lead to price declines in the future, which would leave him with a loss.
Here are the parameters:
Futures contracts, by their specifications, fit the above parameters:
Assume a futures contract on one unit of soybean with six months to expiry is available today for $10.10. The farmer can sell this futures contract (short sell) to gain the required protection (locking in the sale price).
If the price of soybeans shoots up to say $13 in six months, the farmer will incur a loss of $2.90 (sell price-buy price = $10.10-$13.00) on the futures contract. He will be able to sell his actual crop produce at the market rate of $13, which will lead to a net sale price of $13 - $2.90 = $10.10.
If the price of soybeans remains at $10, the farmer will benefit from the futures contract ($10.10 - $10 = $0.10). He will sell his soybeans at $10, leaving his net sale price at $10 + $0.10 = $10.10
If the price declines to $7.50, the farmer will benefit from the futures contract ($10.10 - $7.50 = $2.60). He will sell his crop produce at $7.50, making his net sale price $10.10 ($7.50 + $2.60).
In all three cases, the farmer is able to shield his desired sale price by using futures contracts. The actual crop produce is sold at available market rates, but the fluctuation in prices is eliminated by the futures contract.
Hedging is not without costs and risks. Assume that in the first above-mentioned case, the price reaches $13, but the farmer did not take a futures contract. He would have benefited by selling at a higher price of $13. Because of futures position, he lost an extra $2.90. On the other hand, the situation could have been worse for him the third case, when he was selling at $7.50. Without futures, he would have suffered a loss. But in all cases, he is able to achieve the desired hedge.
Now assume a soybean oil manufacturer who needs one unit of soybean in six months’ time. He is worried that soybean prices may shoot up in the near future. He can buy (go long) the same soybean future contract to lock the buy price at his desired level of around $10, say $10.10.
If the price of soybean shoots up to say $13, the futures buyer will profit by $2.90 (sell price-buy price = $13 - $10.10) on the futures contract. He will buy the required soybean at the market price of $13, which will lead to a net buy price of -$13 + $2.90 = -$10.10 (negative indicates net outflow for buying).
If the price of soybeans remains at $10, the buyer will lose on the futures contract ($10 - $10.10 = -$0.10). He will buy the required soybean at $10, taking his net buy price to -$10 - $0.10 = -$10.10
If the price declines to $7.50, the buyer will lose on the futures contract ($7.50 - $10.10 = -$2.60). He will buy required soybean at the market price of $7.50, taking his net buy price to -$7.50 - $2.60 = -$10.10.
In all three cases, the soybean oil manufacturer is able to get his desired buy price, by using a futures contract. Effectively, the actual crop produce is bought at available market rates. The fluctuation in prices is mitigated by the futures contract.
Using the same futures contract at the same price, quantity, and expiry, the hedging requirements for both the soybean farmer (producer) and the soybean oil manufacturer (consumer) are met. Both were able to secure their desired price to buy or sell the commodity in the future. The risk did not pass anywhere but was mitigated—one was losing on higher profit potential at the expense of the other.
Both parties can mutually agree with this set of defined parameters, leading to a contract to be honored in the future (constituting a forward contract). The futures exchange matches the buyer or seller, enabling price discovery and standardization of contracts while taking away counter-party default risk, which is prominent in mutual forward contracts.
While hedging is encouraged, it does come with its own set of unique challenges and considerations. Some of the most common include the following:
With new asset classes opening up through local, national, and international exchanges, hedging is now possible for anything and everything. Commodity options are an alternative to futures that can be used for hedging. Care should be taken when assessing hedging securities to ensure they meet your needs. Bear in mind that hedgers should not get enticed by speculative gains. When hedging, careful consideration and focus can achieve the desired results.