Using Futures Contracts: Hedgers

<< THE FUTURES MARKET

Financial Futures: Short Hedges, Long Hedges >>

Investment Analysis & Portfolio Management (FIN630)

Lesson # 42

FUTURES Contd...

Using Futures Contracts:

Who uses futures, and for what purpose? Traditionally, participants in the futures market

have been classified as either ledgers or speculators. Because both groups are important in

understanding the role and functioning of futures markets, we will consider each in turn.

The distinctions between these two groups apply to financial futures as well as to the more

traditional commodity futures.

Hedgers:

Hedgers are parties at risk with a commodity or an asset, which means they are exposed to

price changes. They buy or sell futures contracts in order to offset their risk. In other words,

hedgers actually deal in the commodity or financial instrument specified in the futures

contract. By taking a position opposite to that of one already held, at a price set today,

hedgers plan to reduce the risk of adverse price fluctuations--that is, to hedge the risk of

unexpected price changes. In effect, this is a form of insurance.

In a sense, the real motivation for all futures trading is to reduce price risk. With futures,

risk is reduced by having the gain (loss) in the futures position offset the loss (gain) on the

cash position. A hedger is willing to forego some profit potential in exchange for having

someone else assume part of the risk.

How to Hedge with Futures:

The key to any hedge is that a futures position is taken opposite to the position in the cash

market. That is, the nature of the cash market position determines the hedge futures market.

A commodity or financial instrument held (in effect in inventory) represents a long position,

because these items could be sold in the cash market. On the other hand, an investor who

sells a futures position not owned has created a short position. Since investors can assume

two basic positions with futures contracts, long and short, there are two basic hedge

positions;

1. The short (sell) hedge:

A cash market inventory holder must sell (short) the futures. Investors should think of short

hedges as a means of protecting the value of their .portfolios. Since they are holding

securities, they are long on the cash position and need to protect themselves against a

decline in prices. A short hedge reduces, or possibly eliminates, the risk taken in a long

position.

2. The long (buy) hedge:

An investor who currently holds no cash inventory (holds no commodities or financial

instruments) is, in effect, short on the cash market; therefore, to hedge with futures requires

a long position. Someone who is not currently in the cash market but who expects to be in

the future and who wants to lock in current prices and yields until cash is available to make

the investment can use a long hedge which reduces the risk of a short position.

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Hedging is not an automatic process. It requires more than simply taking a position.

Hedgers must make timing decisions as to when to initiate and end the process. As

conditions change, hedgers must adjust their hedge strategy.

One aspect of hedging that must be considered is "basis" risk. The basis for financial futures

often is defined as the difference between the cash price and the futures price of the item

being hedged:

Basis = Cash price - Futures price

The basis must be zero on the maturity date of the contract. In the interim, the basis

fluctuates in an unpredictable manner and is not constant during a hedge period. Basis risk,

therefore, is the risk hedgers face as a result of unexpected changes in the basis. Although

changes in the basis will affect the hedge position during its life, a hedge will reduce risk

as long as the variability in the basis is less than the variability in the price of the asset

being hedged. At maturity the futures price and the cash price must be equal, resulting in

a zero basis.

The significance of basis risk to investors is that risk cannot be entirely eliminated. Hedging

a cash position will involve basis risk.

Speculators:

In contrast to hedgers, speculators buy or sell futures contracts in an attempt to earn a

return. They are willing to assume the risk of price fluctuations, hoping to profit from

them. Unlike hedgers, speculators typically do not transact in the physical commodity or

financial instrument underlying the futures contract. In other words, they have no prior

market position. Some speculators are professionals who do this for a living; others are

amateurs, ranging from the very sophisticated to the novice. Although most speculators

are not actually, present at the futures markets, floor traders (or locals) trade for their own

accounts as we'll as others and often take very short-term (minutes or hours) positions in

attempt to exploit air short-lived market anomalies.

Why speculate in futures .markets? After all one could speculate in the underlying

instruments. For example, an investor who believed interest rates were going to decline

could buy Treasury bonds directly and avoid the Treasury bond futures market. The

potential advantages of speculating in futures markets include:

1. Leverage: The magnification of gains (and losses) can easily be 10 to 1.

2. Ease of transacting: An investor who thinks interest rates will rise will have

difficulty selling bonds short, but it is very easy to take a short position in a Treasury

bond futures contract.

3. Transaction costs: These are often significantly smaller in futures markets.

By all accounts, an investor's likelihood of success when speculating in futures is not very

good. The small investor is up against stiff odds when it comes to speculating with futures

contracts. Futures should be used for hedging purposes.

FINANCIAL FUTURES:

This section covers financials futures mostly from a speculator's perspective. The following

two chapters, dealing with the management of equity portfolios and fixed income portfolios,

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show other uses from the hedger's point of view. The chapters explain how financials

futures can logically be used to improve e a portfolio's characteristics.

Stock index futures:

As with other futures contracts, a stock index future is a promise to buy or sell the

standardized units of a specific index price at a predetermined future date. Table 15-2 lists

the characteristics of the S$P 500 stock index futures contract. Unlike most other

commodity contracts, there is no actual delivery mechanism at expiration of the contract. Al

settlements are in cash. It is not practical to have speculators or hedgers deliver 500

different stock certificates in the appropriate quantities to satisfy the requirements of the

contract. The value of the index is known at delivery time, and crediting or debiting

accounts with accrued gains or losses is much more convenient.

A speculator might believe the overall stock market is about to advance and therefore

decide to buy one S$P stock index future contract. Suppose in early may the S$P 500 index

is at 1415.70 and the speculator buys a June S$P 500 future contract at settlement price of

1417.70. The dollars value of the futures contract is set at $250 times the settlement price,

so the purchaser of the contract promises to pay 1417.50x$50, or $354,425, at the delivery

date. Several weeks later the stock market has advanced, and the future contract now trades

at 1420. the speculator might decide to close out the position and take her profit of (1420-

1417.70)x$250,or $575.note that only the net gain or loss changes hands; the speculator

never actually needs to come up with $354,425.large gains or losses are possible with stock

index futures, and the leverage they provide is attractive to many people.

Delivery Procedures:

Suppose someone wants to deliver a 5% bond with 20 years, 11 months remaining in its

life, and that the settlement price for the T-bond futures contract on position day is 91-00.

By exchange policy, the remaining maturity is rounded down to the nearest quarter, giving

20 years and three quarters. The invoice price is then

0.9100

Futures settlement price

$100,000

Contract size

0.8821

Conversion factor

$80,271.10

Principal due

2,083.33

Accrued interest

$82,354.53

Total due = invoice price

Note the accrued interest calculation. The bond matures in 20 years and 11 months,

meaning it is 5 months into the interest rate cycle. Accrued interest on one bond is therefore

5/6 * $25, or 420.83. On $100,000 par, the total is $2,083.33.

At any given time, several dozen bonds are usually eligible for delivery on the T-bond

futures contract. Normally one of these bonds will be cheapest to deliver. The cheapest to

deliver bond is the deliverable bond preferred by the sellers, because it costs them the least

to use.

For technical reasons, the conversion factors make all bonds equally attractive for delivery

only one when the bonds under consideration yield 6%. If they yield more or less than this,

one bond is going to have the lowest adjusted price, and hence the cheapest to deliver.

An investor who must buy bonds to deliver against a futures contract will want to get these

bonds as cheaply as possible.

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Investment Analysis & Portfolio Management (FIN630)

Foreign Currency Futures:

Foreign currency futures contracts trade at the International Monetary Market of the

Chicago Mercantile Exchange. They all call for delivery of the foreign currency in the

country of issuance to a bank of the clearing house's choosing.

When a U.S investor buys a foreign security, there are really two relevant purchases. The

actual purchase of the security is one of them, but before the security can be bought, the

investor must exchange U.S. dollars for the necessary foreign currency. In essence, the

investor is buying the foreign currency, and its price can change daily. To the investor, the

changing relationships among currencies of interest constitute foreign exchange risk.

Modest changes in exchange rates can result in significant dollar differences.

Foreign currency futures were the catalyst that caused the rapid growth in the financial

futures market. These products were immediately successful. Most major corporations face

at least some foreign exchange risk and quickly discovered the convenience of these futures

as a hedging vehicle. Speculators saw a contract easy to understand and use, and therefore,

foreign currency futures were of interest to both hedgers and speculators. Their success led

the exchanges to spawn similar products to hedge other types of financial risk.

Hedging With Stock-Index Futures:

Common stock investors hedge with financial futures for the same reasons that fixed-

income investors use them. Investors, whether individuals or institutions, may hold a

substantial stock portfolio that is subject to the risk of the overall market; that is, systematic

risk. A futures contract enables the investor to transfer part or all of the risk to those willing

to assume it. Stock-index futures have opened up new, and relatively inexpensive,

opportunities for investors to manage market risk through hedging.

Investors can use financial futures on stock market indexes to hedge against an overall

market decline. That is, investors can hedge against systematic or market risk by selling the

appropriate number of contracts against a stock portfolio. In effect, stock-index futures

contracts give an investor the opportunity to protect his or her portfolio against market

fluctuations.

To hedge market risk, investors must be able to take a position in the hedging asset (in this

case, stock-index future) such that profits or losses on the hedging asset offset changes in

the value of the stock portfolio. Stock-index futures permit this action, because changes in

the futures prices themselves generally are highly correlated with changes in the value of

the stock portfolios that are caused by market wide events. The more diversified the

portfolio, and therefore the lower the nonsystematic risk, the greater the correlation between

the futures contract and the stock positions.

Index Arbitrage and Program Trading:

A force of considerable magnitude hit Wall Street in the 1980s. It is called program trading,

and it has captured much attention and generated considerable controversy. It leads to

headlines attributing market plunges at least in part to program trading, as happened on

October 19,1987, when the DJIA fell over 500 points. Because program trading typically

involves positions in both stocks and stock-index futures contracts, we consider the topic

within the general discussion of hedging.

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Investment Analysis & Portfolio Management (FIN630)

The terms program trading and index arbitrage often are used together. In general terms,

index arbitrage refers to attempts to exploit the differences between the prices of the stock-

index futures and the prices of the index of stocks underlying the futures contract. For

example, if the S&P 500 futures price is too high relative to the S&P 500 Index, investors

could short the futures contract and buy the stocks in the index. In theory, arbitrageurs

should be able to build a hedged portfolio that earns arbitrage profits equaling the difference

between the two positions. If the price of the S&P 500 futures is deemed too low, investors

could purchase the futures and short the stocks, again exploiting the differences between the

two prices.

If investors are to be able to take advantage of discrepancies between the futures price and

the underlying stock-index price, they must be able to act quickly. Program trading involves

the use of computer-generated orders to coordinate buy and sell orders for entire portfolios

based on arbitrage opportunities. The arbitrage occurs between portfolios of common

stocks, on the one hand, and index futures and options on the other. Large institutional

investors seek to exploit, differences between the two sides. Specifically, when stock-index

futures prices rise substantially above the current value of the stock-index itself (e.g., the

S&P 500), they sell the futures and buy the underlying stocks, typically in "baskets" of

several million dollars. Because the futures price and the stock-index value must be equal

when the futures contract expires, these investors are seeking to "capture the premium"

between the two,-thereby earning an arbitrage profit. That is, they seek high risk-free

returns by arbitraging the difference between the cash value of the underlying securities and

the prices of the futures contracts on these securities. In effect, they have a hedged position

and should profit regardless of what happens to stock prices.

Normally, program traders and other speculators "unwind" their positions during the last

trading; hour of the day the futures expire. At this time, the futures premium goes to zero,

because, as noted, the futures price at expiration must equal the stock-index value.

The headlines about program trading often reflect the results of rapid selling by the program

traders. For whatever reason, traders' decide-to sells the futures. As the price falls, stock

prices also fall. When 'the futures price drops below the price of the stock index,

tremendous selling orders can be unleashed. These volume sell orders in stocks drive the

futures prices even lower.

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