Utilization of the US Future Markets as a Risk Management Techniques for Companies - Research Paper Example

Utilization of US future markets as a Risk Management Techniques For Companies Contents Introduction 2 2. Understanding futures Markets 3 2 How prices are resolute in Future Markets 4 2.2 The Clearing Association 5 2.3 Hedging in futures 6 2.4 Speculation and Its functions 7 3. Utilization of Futures Market as a Risk Management Technique 7 4. Conclusion 10 5. Bibliography 10 Word Count - 2450 1. Introduction In United States of America, “Futures trade” on an official futures exchange was derived with the development of the “Chicago Board of Trade” (CBT) during mid 19th century when Grain dealers operational in Illinois experienced nuisance in arranging finance for their grain inventory. (www.usfe.com) The anticipated risk of downfall in grain prices after harvest encouraged lenders averse to extend grain dealers credit to procure grain for ensuing trade in Chicago. In array to trim down the threat exposure, grain dealers came up with phenomenon of “To Arrive” agreements which comprised that on the agreed upcoming date a particular amount of grain would be conveyed to the pre-specified warehouse at a price agreed at the time of agreement. The process of advanced selling concentrated the trader’s risk exposure and provided an ease to attain credit facilities to fund further grain procurement from farmers. The “To Arrive” agreements were a predecessor of the “futures contracts.” However, as of the traders concern they found inadequacies in forward cash contract markets and created “futures exchanges.” In the year 1848, the US witness introduction of it first Futures Exchange titled as Chicago Board of Trade (CBT). (ALEXANDER, Carol, 2007) Formation of Futures Exchanges were result of the fact that the sellers were required to liberate themselves of the cost risk allied with holding inventories of several commodities and purchasers sought after to ascertain prices for the same merchandises in advance. In current years futures contracts had propagated, predominantly in the fiscal field, as trades have become more knowledgeable of the price risks and hunt for methods and techniques to diminish the impact of these risks. Futures Markets are identified as unremitting auction marketplace and clearing houses to acquire most up-to-date information relating to supply & demand. Futures Markets are international convention places of purchasers and traders of an continually intensifying catalogue of commodities comprising of monetary mechanisms like “U.S. Treasury bonds, stock indexes and foreign currencies together with traditional agricultural commodities, metals, and petroleum products.” (GOSS, B. A., 2000) Evolution of E-technologies into Futures Markets had provided novel and improved trading tools and added varied operating opportunities. In a number of cases, wholly electronic markets task along with open-outcry markets that had survived for over a century. Electronically order placement procedure is gradually more applied in the market. The prime rationale of futures markets is to endow with a competent and effectual system for the organization of price risks via buying/selling futures agreements that institute a current price for a acquisition or auction to be executed in future, individuals and trading companies are capable to attain what quantity to indemnity protection adjacent to adverse price changes this process of insurance against price fluctuation is also known as Hedging. 2. Understanding futures Markets For the purpose of better understanding, the functions of futures markets are classified into categories that are detailed below: How prices are resolute in Future Markets The Clearing Association Hedging in futures Speculation and Its functions (KLINE, Donna, 2000) 2.1 How prices are resolute in Future Markets Prices in the futures market depends solely by the circumstances influenced by the supply and demand of commodities. If there are availability of added customer as compared to the sellers, prices will shoot up on the other hand if there are more sellers than buyers in the market, prices will go down. Trading of orders, which derive from all resources and are striated to the exchange’s operations floor for implementation are in point of fact decide prices. (KOLB, Robert W., 2006) These instructions to purchase and vend are interpreted into authentic procurements and auctions on the exchange’s trading floor and as per the directives this is ought to be completed by public outcry across the trading ring and not by undisclosed conciliations. The prices at which transactions executed are taken into official records and instantaneously released for circulation over a live network. In all probability the most excellent technique to envision how acquisition and transactions are performed on the level of a commodity exchange is to assume in stipulations of what ensues at a public auction. The theory is the same, excluding in the futures market a 2-way auction is constant on for the duration of trading hours. (BARRY J. EICHENGREEN, Donald J. Mathieson, 1998) This 2way auction is feasible due to the harmonized futures contract, which requisites no account of offers made at the point of deal. Moreover, the 2way auction is viable as the inflow of both buying and selling instructions to the exchange floor is usually in adequate quantity to formulate buying and selling of equivalent significance. The rationale of a futures exchange is to grant an controlled platform for market in which members can liberally purchase and sell a variety of commodities. The exchange itself does not manoeuvre for yield. It simply present the amenities and ground system for its affiliates to do business in commodity futures and for non-allies also to do business by selling throughout a affiliate negotiator and paying a brokerage charge. 2.2 The Clearing Association A short description of the clearing association and its function in futures trading is important to understand the manoeuvre of the futures markets. Each futures exchange has possession of its own clearing association or house. It is obligatory for all affiliates of a futures exchange to perform their transactions via the clearing house at the ending of every trading session and to deposit a definite sum of money i.e. foundational on preset margin requirements that are adequate to settle the trader’s debt account. (PHLIPS, Louis, 1991) For instance, if a associate agent reports to the clearing house at the ending of the session with entire purchases of 100,000 bushels of “May wheat” and overall trade of 50,000 bushels of “May wheat” (which might be intended for himself, his clientele or mutually), he would be net elongated 50,000 bushels of May wheat. (SIEGEL, Daniel R., 1994) Presuming that this is the agent’s only situation in futures and that the clearing house margin is 6 cents/bushel, this would indicate that the agent would be requisite to have at least $3,000 on deposit with the clearing house. As all associates are mandatory to clear their transactions through the clearing house and ought to uphold ample funds to cover their debit accounts, the clearing house is accountable to all affiliates for the execution of contracts. (WILLIAMS, Jeffrey C., 1989) 2.3 Hedging in futures The rationalization for futures trading is that it endow with the means for those who yield or transact in cash commodities to hedge or cover against volatile price changes. (BARRY J. EICHENGREEN, Donald J. Mathieson, 1998) There are loads of varieties of hedges and a few instances might adequately describe the ideology of hedging by taking case of a business involved in storage and retail of wheat. By early June, just in front of the novel crop yield the company’s storage houses will be moderately poured out. As the fresh crop s anticipated in June, July and August, these storages will once more be packed and the wheat will stay in storage during the season until it is sold. Throughout the crop movement when the company’s account of cash wheat is being refilled, these cash wheat procurements will be hedged by retailing a corresponding quantity of futures short. (BARRY J. EICHENGREEN, Donald J. Mathieson, 1998)Then as the cash wheat is sold the hedges will be isolated by covering with an offsetting acquisition, the futures that were formerly sold petite. In this mode the storage business’s stock of cash wheat will be persistently hedged, avoiding the threat of a potential price decline. In the illustration provided above, if the company procures cash wheat at $4/bushel and hedges this acquisition with an corresponding sale of December wheat at $4.05 a ten cent split in prices amid the point in time the hedge is positioned and the period it is engaged off would consequence in a ten cent loss on the cash wheat and a ten cent revenue on the futures trade. In the incident of a ten cent advance there would be a ten cent return on the cash and a ten cent loss on the futures deal. In any case, the company would be sheltered against losses ensuing from price variability’s due to counteracting income and losses, except in case if cash and futures prices not succeed to progress or rejected by the similar sum. The risks of price fluctuation cannot be eradicated excluding it is possible to convey to others via a “futures market hedge.” 2.4 Speculation and Its functions The main role of the speculator is to presume the fiscal threats hedged in the futures market. Even though speculation in futures is seldom referred to as “gambling” usually, this price relationship is amply close to create hedging a comparatively secure and sensible responsibility. The speculators lay their currency at risk in the expectation of profiting from a unpredictable price change. (GOSS, Barry A., 1992) 3. Utilization of Futures Market as a Risk Management Technique The most important difference between a futures market and a market involving tangible buying and selling of commodities irrespective of instantaneous or later delivery, is that the futures market deals merely in uniform contractual contracts. These futures contracts endow with deliverance of a specific quantity of a meticulous product throughout a precise future month excluding there’s no involvement of instantaneous transfer of possession of the concerned product. (ALEXANDER, Carol, 2007) Utilization of the US futures market for the purpose of risk management might drastically condense a firm’s revelation to the risk of astonishing commodity price arrangements consequence in superior retribution constancy and development opportunities. If a firm is already organizing this exposure via the appliance of forward contracts, the threat of losses owing to non-performance by contradict parties to these contracts are of greater possibility. The overheads of payment defaults sometimes prevail to be a main part in destroying a successful business. It comprises of unswerving revenue loss from unexpected fluctuation in “market prices, legal costs, management time and the inconvenience of having to find a new supplier or buyer.” (SIEGEL, Daniel R., 1994) The futures market delivers a globally acknowledged, protected, in-expensive and exceedingly supple monetary instrument to assist a company in managing its price risk. The six reasons why risk management might increase the value of a firm are that it allows corporations are to: 1. Amplify their employ of debt 2. Sustain their capital budget over time 3. Evade costs allied with fiscal distress 4. Utilize their relative benefits in hedging qualified to the hedging capability of individual investors (GOSS, Barry A., 1992) 5. Reduce the risks and costs of borrowing by means of swapping, and 6. Trim down the high taxes those upshots from intermittent earnings. There are numerous methods to diminish a companys risk exposure. a. Firm can relocate its risk to an insurance company requiring episodic premium payments set by the insurance company biased on its discernment of the trading company’s risk exposure. b. The firm can transmit “risk-producing functions” to a third party. (PECK, Anne E., 1985) c. The firm can procure “derivatives contracts” to trim down contribution and fiscal risks. d. The firm can obtain precise actions to decrease the prospect of incidence of unfavourable events. e. The firm can take measures to trim down the extent of the loss related with unfavourable measures. The futures markets are used to safeguard against interest rate and input price risk in the course of the use of hedging. If the main concern of a company is of fluctuating interest rates then it ought to imply a short-hedge or trade fiscal futures contracts. In case of interest rates escalation, losses on the subject owing to the elevated interest rates would be counterbalance by profits apprehended via re-procurement of the futures at maturity i.e. for the reason that of the raise in interest rates, the worth of the futures would be a lesser amount of than at the moment of issue. (WILLIAMS, Jeffrey C., 1989) On the other hand, if the raise in input price is of highest concern of a company then it should exercise a long hedge or invest in commodity futures. At the futures maturity date, the company will be proficient to acquire the input at the genuine contract price regardless if market prices had augmented in the pro tem. “Swaps” facilitate companies to trim down their monetary risk by substituting their liabilities with another party’s liability; generally it is performed as the traders have a preference for the others debit contract terms. There are numerous ways in which “swaps” trim down risk. Currency swaps, where companies swap over debt responsibility denominated in diverse forex exchange might eradicate the exchange rate risk formed in the case where currency ought to be initially be converted into a different currency prior to initiating planned debt payments. (KLINE, Donna, 2000)Interest rate swaps, where counterparties deal fixed-rate debt intended for floating rates are capable of reducing risk for all parties fundamental on their entity outlooks with reference to future interest rates. 4. Conclusion The appliance of futures markets offers a process for hedging adjacent to adverse modification in predictable prices. The mercantile use of the futures market evidently imitates such hedges. The marketplace provides a key financially viable function in that the risk from unfavourable merchandise price movements can be abridged by captivating suitable futures positions. Though it is possible for companies to hedge in opposition to expected price movements, the achievement from hedging depends on approximation and construing the basis precisely. Via adoption of US future exchanges risk management techniques a company can surely reduce its losses and risks mutually. The functioning of US futures markets provides companies with a sense of security and with careful study of futures, it enables a company to minimize their losses and increase the revenues. 5. Bibliography ALEXANDER, Carol. 2007. The Professional Risk Managers Guide to Financial Markets. McGraw Hill Professional. BARRY J. EICHENGREEN, Donald J. Mathieson. 1998. Hedge Funds and Financial Market Dynamics. International Monetary Fund. GOSS, Barry A. 1992. Rational Expectations and Efficiency in Futures Markets. Routledge. GOSS, B. A. 2000. Models of Futures Markets. Routledge. KLINE, Donna. 2000. Fundamentals of the Futures Market. McGraw-Hill Professional. KOLB, Robert W. 2006. Understanding futures markets. Blackwell Publishing. PECK, Anne E. 1985. Futures Markets: Their Economic Role. American Enterprise Institute for Public Policy Research. PHLIPS, Louis. 1991. Commodity, Futures, and Financial Markets. Springer. PIRRONG, Stephen Craig. 1993. Grain Futures Contracts: An Economic Appraisal. Springer. SIEGEL, Daniel R. 1994. The Futures Markets: The Professional Traders Guide to Portfolio Strategies, Risk Management & Arbitrage. Probus Pub. WILLIAMS, Jeffrey C. 1989. The Economic Function of Futures Markets. CUP Archive. www.usfe.com. [online]. Read More