The US Futures Markets as a Risk Management Technique - Case Study Example

The US futures markets as a risk management technique companies could use to reduce their risk” Introduction Some people say that the idea of futures trading had its roots in China at about 600 A.D. and that it was already in play in the Japanese rice market hundreds of years ago. However, futures trading as recognized by U.S. traders began in the middle of the 19th century in Chicago. Farmers brought their harvest to Chicago to sell it to food companies. The city provided one central location for buying and selling commodities; however, at harvest time, the supply of grain overwhelmed the demand driving prices down. Months later, when supply dwindled, prices would soar. This provided an unacceptable situation for farmers, who wanted to keep prices up, and users who wanted to ensure steady supplies to better predict their costs. Thus, parties from both sides started making deals to establish the price of grain and sure delivery in the future. To reduce “counterparty risk,” the Chicago Board of Trade (CBOT) created standardized contracts for the future sale of grain. The contracts were interchangeable, thereby allowing either party to get out of the obligation without any harm to the original counterparty. In the 1920s the CBOT designated a clearinghouse to become the ultimate counterparty to everyone who trades a futures contract. Up to the present, this clearinghouse system has never suffered a default. (Lind-Waldcock, 2005, p. 2) In retrospect, the futures market was created to fill the needs of suppliers and buyers of a particular, physical, commodity, in order to aid business. Until today, the futures market provides this facility to business – that of reducing the risk of erratic supply and price uncertainty. Participants in the Futures Trading Market A futures contract has been defined as an obligation to buy or sell an underlying product at a specific price at a specific time in the future. (Lind-Waldcock, 2005, p. 2) While the contract was originally conceived to meet the needs of commodities producers and sellers, the market has evolved to as to accommodate various participants with different purposes for trading. Sathye, Rose, Allen and Weston (2006, pp. 202-203) identify four main participants in futures markets: hedgers, speculators, arbitrageurs, and spreaders. A hedger is an individual or company owning or expecting to own a cash commodity, financial instrument or currency and that is concerned about the cost of this changing before either buying or selling it on the cash market. The hedger is able to secure protection against changing cash prices by buying (selling) futures contracts of the same or similar commodity. Later, in lieu of actual delivery/purchase, the hedger may offset the original position by selling (buying) futures contracts of the same quantity and type as the initial transaction in order to discharge the obligation of the contract. In effect, the hedger seeks a form of insurance by entering into the futures contract. The second group of participants in the futures market are the speculators. A speculator has no actual or expected underlying position to protect. His aim in buying/selling a futures contract is simply to try to profit from the expectation of future price movements. Speculators are essential to all futures contracts, except interest rate contracts when there are sufficient hedgers on both sides to assure liquidity in the futures markets (Sathye, et al, 2006, p. 202). By taking on risks in future market prices, speculators add liquidity to these markets, allowing the actual hedgers ease in taking positions or making exits from these positions. Arbitrageurs, the third group of market participants, simultaneously buy and sell the same or equivalent asset, currency or commodity trading on two different markets. Their purpose is to exploit price discrepancies to make certain, guaranteed profits. Finally, the fourth group of market participants are known as spreaders. Spreaders are important because they create depth in futures markets; they do this by taking market positions that are simultaneously long and short equivalent amounts of the same or related contracts to as to exploit non-normal positions. These market participants are accepted because they guarantee, through their actions, that the optimal price is attained. Of the four types of participants, the hedgers are those who most represent the interests of business firms. As mentioned, the reason for futures trading is primarily to reduce the uncertainties of the supply and price of commodities in the foreseeable future. These commodities represent either the raw materials that are inputs into the firm’s operations, or the products which are the result of operations. Business thus has an interest in at least ascertaining future prices in order to control costs or assure an acceptable profit. The Mechanics of Futures Hedging The hedger is a trader who enters the futures market in order to reduce a pre-existing risk. (Kolb, 2003, p. 111) The means by which the hedger seeks to reduce this pre-existing risk is to take a position in the futures market, which is either a long hedge or a short hedge, depending on the type of risk the hedger wishes to manage. In the case of a long hedge, the hedger buys a futures contract (i.e., he takes a long position) with the future obligation of buying the underlying commodity at a particular price and a specific time. As an illustrative example, suppose that the business which wishes to hedge is a jewellery manufacturer. It regularly purchases silver, the supply and price of which fluctuates. For the business, therefore, profits may be significantly affected by the volatility of the price of silver. If production schedules are to be effectively planned and executed, it is absolutely necessary that silver be acquired on a regular basis in large quantities. Assume that the jeweller needs 50,000 troy ounces of silver in two months and confronts the silver prices shown in Table 1 on August 10 (data from Bloomberg Financial Services). The current spot price as show in the table is 1280.1 cents per ounce, and the price of the OCT futures contract is at 1243.0, and the DEC futures contract trade at 1074.5. Expecting that the silver may become cheaper, the jeweller decides that with the price of 1074.5 he will receive an acceptable level of profits. To pay a price higher than 1074.5, however, could unreasonably cut down on profitability. With these reasons in mind, he decides to enter the futures market to hedge against the possibility of future unexpected increases in prices. Since the futures price is the best estimate of the future sport price, the jeweller expects to pay 1074.5 cents per ounce for silver in the spot market four months from now in December. He thus buys ten 5,000-ounce DEC futures contracts at 1074.5 cents per ounce. By December the spot price of silver has dropped to 1019.9 cents per ounce, more than 0.50 than expected. Needing the silver, the manufacturer purchases the silver on the spot market, paying a total of $509,950. This is $27,300 lower than expected. At the same time. the futures contract is about to mature, thus the futures price must equal the spot price. The jewellery manufacturer is able to sell his ten futures contracts at the same price of 1019.9 cents per ounce, taking a 0,54 loss on each ounce, and a total loss of $27,300 on the futures position. This is one case where the risk could have paid off with higher returns, but because the risk was hedged away, then the abnormal return was also foregone. The decision to hedge, however, is not necessarily wrong; had the lower prices materialized as feared, then the silver mine owner would have avoided some serious losses. The preceding example was a long hedge. There is also such a thing as a short hedge, that is, when the hedger sells a futures contract with the obligation of selling a certain amount of commodity at a price certain, at a definite future time. An example of such a short hedge is the case of a Nevada silver mine owner concerned that the profitability of her firm will be seriously affected by unexpected fluctuations in the price of silver. If the silver prices fall, said mine owner may have to suspend operations and lay off workers. The miner expects that 50,000 ounces of silver will be ready for shipment in four months. Based on the prices in Table 1, the projected future price will be 1074.5 per ounce of silver, at which the miner will expect to sell the firm’s output. The mine owner decides to hedge in order to avoid the risk that silver prices might fall in the next two months. Table 3 shows the results of the short hedge. Expecting to sell 50,000 ounces of silver in two months, the mine operator sells ten 5,000-ounce futures contracts for December delivery at 1074.5 per ounce. On December 10, silver prices reach 1019.9 cents per ounce. The miner sells the silver and receives $509,950, which is $27,300 more than originally expected. In the futures market, happily, the miner incurs an offsetting gain. In hindsight, it is clear that, unhedged, the miner would have lost by $27,300, since he would have incurred losses in the commodities spot market. This is one case where it paid off for the businessman to have the good sense to hedge. Implications of Hedging on Business From the examples given above, it is apparent that futures hedging is not a cure-all to address business risk. Sathye, Rose, Allen and Weston (2006, pp. 203-204) point out that while popular, futures contracts do have their limitations, including that the quantity specified in a contract may be simply too large (for small businesses) or too small (for financial institutions). Also, in buying or selling a futures contract an obligation is undertaken that must be monitored constantly so that margin calls may be met. It is also likely that the futures contract does not deal specifically with the commodity or financial instrument required by the potential hedger, since an exactly matching contract may not exist. In such cases, the hedger has the option to avail of a futures contract that has similar characteristics with the underlying exposure. However, while it is possible to find another commodity or asset that moves in the same direction and use that as a cross-hedge, even large financial institutions have difficulties in recognising when the cross-hedging ability of a particular contract has changed, reducing the effectiveness of the hedge. Don Chance urges that business ask the question as to whether a hedge is even desirable before undertaking one, as business is itself the taking on of risk for higher return. “Hedging is done to reduce risk, but is that desirable? If everyone hedged, would we not simply end up with an economy in which no one takes risks? This would surely lead to economic stagnancy. Moreover, we must wonder whether hedging can actually increase shareholder wealth.” (Chance, 2001, p. 401) Chance also points out that hedging eliminates the opportunity to take advantage of favourable market conditions, reducing the gain potential as well as the loss potential. When overdone, hedging can eliminate any reason for being in business in the first place. Chance urges selectivity, reducing certain risks while maintaining exposures where an advantage is perceived. (Chance, 2001, p. 403) Kolb (2003, pp. 120-122) considers five market imperfections that can make hedging important and that may impose real costs on firms: taxes, costs of financial distress, transaction costs, principal-agent problems, and the costliness of diversification. Taxes as an incentive to hedge. While in a perfect market tax effects are ignored, in real markets taxes levied on annual accounting income can provide an incentive for a firm to hedge. Take for example a firm that will mine 1,000 ounces of gold bullion this year at a cost of $300 per ounce. If the futures price for gold is $400 per ounce, the firm expects to realize a profit of $100,000. However, this is only an expected price, and the actual price may be, say, $300 or $500 per ounce. Assuming the tax rate to be 20% and that the firm has a tax credit of $20,000 that it can apply to offset income taxes, the firm would sell futures for its 1,000 ounces of production at the $400 per ounce futures price. Table 4 shows the different outcomes depending on the sale price of gold and the firm’s decision to hedge or not to hedge. For the unhedged firm, there is no futures result. Because the hedge involved selling 1,000 ounces in the futures market at $400, the firm would gain $100,000 if gold price hit $300 and loses $100,000 if the gold price were $500. Given that production costs are $300,000 for all scenarios, the pretax profits for the unhedged firm will be either zero or $200,000, depending on the price of gold. For the hedged firm, the pretax profit will be $100,000 in both cases, due to the hedging. Considering the effect of taxes and the $20,000 tax credit, a tax credit can be used only if the firm owes taxes. The $300 price means that the unhedged firm has zero net income and no taxes due, and thus cannot use the tax credit. At $500, the unhedged firm can use its tax credit fully, yielding after-tax net income of $90,000. For the hedging firm, however, pretax income will be $100,000 whatever the price of gold. Since its tax obligation will be $20,000 in both cases, the hedged firm is able to use its tax credit. The hedging firm realizes $100,000 in net income after tax, whether gold is $300 or $500 an ounce. By hedging, the firm guarantees that it will be able to use its tax credit. By not hedging, the firm runs a 50 percent chance of not being able to use the $20,000 credit. In this example, taxes create a legitimate incentive to hedge. With hedging, the firm is able to increase its expected after-tax income and thus its value. Cost of financial distress as an incentive to hedge. In Table 4 above, while the expected pretax profits are the same for both the hedge and unhedged firms, hedging nevertheless reduces the risk inherent in the pretax profits. In the real world, unlike in perfect market conditions, there are real costs associated with bankruptcy and financial distress, such as legal and professional fees for lawyers and accountants. Furthermore, assets cannot be deployed instantly to earn the same return. Therefore, a risk-reducing strategy can help avoid these costs of financial distress, and hedging can consequently increase the value of the firm. Transaction costs as a disincentive for hedging. The expected cost of a hedge is approximately the transaction costs associated with placing and managing the hedge. For any one hedge, the actual result can be wildly favourable or negative, but the expected result is to lose the transaction costs. Consistent hedging can be expect to lose the transaction costs in the long run. This high probability of a negative result due to transactions costs provides a disincentive for hedging. (Kolb, 2003, p. 121) Principal-agent conflicts as an incentive to hedging. In real firms, managers and shareholders often have different desires, leading to conflicts between the principals (shareholders) and their agents (managers). For example, managers may like to have perquisites for which shareholders have to pay. In the hedging decision, shareholders may opt to tolerate more risk than managers, since shareholders can hold a portfolio of stocks, so one company may be only a small fraction of the shareholder’s portfolio. The managers, on the other hand, work full-time for the firm and may have a very large portion of their wealth committed to the firm and thus would be more anxious than the shareholders to reduce risk. The managers’ higher risk aversion may predispose them to hedge when shareholders would really prefer that the firm be unhedged. (Kolb, 2003, p. 121-122) Lack of Owner Diversification as an Incentive to Hedge. In the case when some shareholders may not be fully diversified, they may be highly risk-averse like managers. This is true, for example, when a farmer may have his or her entire wealth committed to a farm. The lack of diversification on the part of the owner can also be the cause of an incentive to hedge. Other considerations. Other considerations important to business include the effect of hedging on a firm in comparison to its unhedged competitors. If hedging is not the industry norm, then it may not be wise to hedge. Recall that while a hedge may improve profits when prices move in the direction anticipated by the hedge position, it may, however, cause losses when prices move in the opposite direction. In extreme conditions, the profit margin of the hedged firm could become negative as a result of the ‘hedging’ carried out, while its unhedged competitors’ margins remain the same. (Hull, 2005, p. 50) Finally, hedging may send a signal to potential creditors that the firm is making a concerted effort to protect the value of the underlying assets. This can result in more favourable credit terms and less costly, restrictive covenants. (Chance, 2001, p. 403) Conclusion For all its attendant caveats, the arguments favoring hedging are, according to Hull, “so obvious that they hardly need to be stated”. Most business firms are primarily engaged in manufacturing, retailing or wholesaling, or providing a service. The skills necessary for predicting variables such as interest rates, exchange rates, and commodity prices, are not central to their concern. It thus is reasonable for them to hedge the risks associated with those variables that are determinant or influential in their profit strategies. By hedging, firms can therefore focus on their main business for which they possess particular skills and expertise. They thus avoid unpleasant surprises such as sharp rises in the market price of their products or some essential input. (Hull, 2005, p. 50) Wise use of hedging is a tool in the businessman’s arsenal that he must always judiciously consider. References Chance, D.M. (2001) An Introduction to Derivatives and Risk Management, Fifth Edition.. Harcourt College Publishers, Orlando FL. Financial Suite by Bloomberg Financial Services Hull, J.C. (2005) Fundamentals of Futures and Options Markets, Pearson-Prentice Hall, New Jersey Kolb, R. W. (2003) Futures, Options and Swaps, 4th Edition. Blackwell Publishing, Cornwall, UK Lind-Waldock, a division of Man Financial, Inc. (2005) The Complete Guide to Futures Trading, John Wiley & Sons, Hoboken, N.J. Reilly, F.K. and Brown, K.C.(2006), Investment Analysis and Portfolio Management, 8th Edition, Thomson-South Western, Mason, OH Sathye, M., Rose L., Allen L. and Weston R. (2006), International Financial Management, John Wiley and Sons, Sydney Read More