The Proper Hedging Strategy: Considerable Advantages for Hedgers and Speculator - Research Paper Example

 Introduction The futures market attracts parties who are risk averse, looking for the best means to protect their assets against certain risks. It is also a place where individuals with an appetite for high risks match wits and skill against others in what is called a zero-sum game in the expectation of high rewards. The futures market is mainly for those who want to hedge risk, but it is also a place for speculators who while trying to pursue substantial gains, also provide valuable liquidity to the futures market. It is the purpose of this paper to discuss the role of the futures markets and futures contracts, their usefulness as well as their limitations for those who are in search of strategies to control risks. Later, we will choose one of the three indicated types of futures contracts – namely, the short-term interest rate futures contracts – for a more detailed analysis and discussion. Hedging and hedging vehicles to control risk. `Hedging is a security transaction that reduces the risk of an existing position (Bernstein 195) The most frequently used hedging vehicles are derivative securities. They are called derivatives because they "derive" their value from the price of an underlying security or index. Derivatives may have linear or non-linear payoff patterns. Futures and forward contracts are the major linear types, meaning that they deal with risks that are symmetric, whereas options are non-linear because they are used to deal with asymmetric or downside risk. The asymmetrical characteristic of options consists in their being able to hedge or take advantage of favorable movement in prices but the downside risk is limited to the value of the premium paid. A comparison between a futures and forward contract would be important because they are two of the most common ways to hedge one's position. A forward contract gives an opportunity to contract today for the purchase or sale of an asset or security at a specified price, payment being delayed until a settlement date in the future. The purchaser of a forward contract commits to buy the underlying asset or security at a specified price at a specified future date. The seller of a forward contract commits to the sale of the underlying asset or security at a specified price at a specified date in the future. The date of future settlement is called a settlement or expiration date. The negotiated price for the future delivery of the asset or security is usually different from the current cash price because of the opportunity cost to the seller who must wait for payment in the future. The opportunity cost is the interest the seller might have earned by receiving payment now and investing it until the maturity of the forward contract. For example, if the current interest rate is 8 percent and the investor sells his stock worth £100,000 but has to wait 30 days before getting paid, the opportunity cost to him can be computed as follows: Opportunity cost = £100,000 (0.08) (30/360) = £ 667. Thus the fair price for the stock if payment is postponed by 30 days would be: £100,000 + 667 = £100,667. Such a contract is called a forward contract. A futures contract is a binding legal contract that calls for the future delivery of an asset (Hearth 614). It specifies the asset to be delivered, the delivery location, the amount or value to be delivered, the delivery date, and the price. There are two parties or positions involved. The long position agrees to accept delivery per terms specified in the contract, and the short position agrees to deliver the asset on the same terms. Not all futures contracts terminate with delivery, as one party may may close out by taking the opposite position before delivery date. Speculators, who provide most of the market liquidity, normally reverse their positions, unlike hedgers. A futures contract is similar in many respects to the forward contract; however, in the case of the futures contract, gains and losses are realized on a day-to-day basis. In other words, they are marked to market at the end of each trading day, reflecting the price fluctuations to which the futures contract is subject. No such convention applies to forwards where gains and losses are only realized on settlement date. Another difference is the fact that to open an futures trading account, one has to deposit with the broker a performance bond called an initial margin, intended to ensure against the risk of substantial losses and default on the part of the futures trader. Such deposit can vary depending on the price volatility of the underlying asset or security, and can range from 2 to 10 percent. A third difference is that futures contracts have standardized provisions regarding contract size and maturity date so that they can be traded interchangeably in the organized exchanges such as the Chicago Mercantile Exchange or the Chicago Board of Trade. Thus futures contracts are traded actively in those exchanges, unlike forwards which have a limited market and only within the banking system. Futures trading is regulated in the United States by the Commodity Futures Trading Commission, but forwards are unregulated. Both contracts are often used interchangeably. If the interest rates are constant and the term structure of interest rates is flat, the price difference between forward and futures contracts are usually small and users can be indifferent as to which vehicle to use. Other differences between the two linear-type hedging vehicles may be summarized as follows. Pricing is established through open outcry at the futures exchanges for futures, whereas forwards are based on bid and offer quotes made by the bank. In terms of counterparty, the exchange guarantees performance of the trade in the case of futures contracts, whilst in forward contracts, it is the broker or the bank . Futures commissions are paid directly to the broker, while the cost to the investor in the forward contract is embedded in the bid and offer quotations. Settlement of a futures position is done by reversing through an offsetting transaction; in the case of forward contracts, it is often settled in cash or physical delivery. Evolution of the Futures Market Forward and futures contracts are known to have existed since ancient times. The Greeks and the Romans actively trade in forwards contracts, particularly Roman emperors who wanted to ensure grain supply during winter. The modern futures exchanges began in 1848 with the establishment of the Chicago Board of Trade. Agricultural products, characterised by seasonality in production and supply, were the first commodities to be traded. Others were metals and energy products. The Chicago Mercantile Exchange followed in 1874. Other exchanges were formed in New York in the late 1800s, followed by others elsewhere in the world. Financial futures were created from 1972 in response to the decision of Western nations to allow their currencies to fluctuate. A host of other financial futures products were initiated, until 1980 when the stock index futures were introduced, specifically the Value Line index and the Standard and Poor's 500. In mid-1980s trading in financial futures exceeded that in commodity futures. Organization of the futures market The Chicago Board of Trade was the first to trade in a futures contract based on a fixed-income instrument, the GNMA certificates. The International Money Market of the Chicago Mercantile Exchange followed 3 months later with futures contracts in 13-week Treasury bills. Other exchanges followed with their own interest rate futures contracts (Fabozzi et al 510). The United States has the largest number of futures exchanges and the biggest volume of contracts in the world. There are several futures exchanges that develop their own futures instruments and compete intensely with one another by developing new varieties of contracts, advertising heavily, and encouraging traders to trade new contracts intensively (Kidwell et al 332). The Chicago Board of Trade and the Chicago Mercantile Exchange are the biggest futures exchanges in the world today. The CBT specializes in long-maturity instruments including Treasury Note, Treasury Bonds and GNMAs. The International Monetary Market specializes in short-maturity instruments such as Treasury Bills and Eurodollar futures. Exchanges tend to specialize. Other futures exchanges are found in London, The market participants consist mainly of hedgers and speculators. Hedgers try to reduce their risks while speculators are the risk takers, betting on the movement of prices by utilizing the leverage provided them by brokers through minimal initial and maintenance margins. Traders are a special type of speculators trying to profit from short-term price changes (scalping). The US market is being regulated by the Commodity Futures Trading Commission together with the Securities and Exchange Commission whereby they divide their jurisdictional responsibilities between themselves. A turf war occasionally erupts, however. Commodities and financial futures are the major products of the exchanges. The financial futures include currencies, interest rates, stock indexes and price indexes. We have picked interest rate futures as an focus of analysis and discussion. Interest rate futures The 13-week Treasury bill futures contract has a face value of $1million. The futures price will be the price at which the Treasury bill will be paid by the short and purchased by the buyer. While Treasury bills are quoted in the cash market in terms of annualized yields on a bank discount basis, the futures contracts are not quoted directly in terms of yield but on an index basis related to the yield on a discount basis. For example, a yield of 8 percent means an index price of 92. The other short-term interest rate futures, the Eurodollar CD futures, are denominated in US dollars but they represent liabilities of banks outside of the United States. The rate paid on Eurodollar CDs, the underlying of the the Eurodollar futures, is the London Interbank Offered Rate (LIBOR). The contract has a face value of $1million and is traded in both the IMM of the Chicago Mercantile Exchange and at the London International Financial Futures Exchange (Liffe). The parties settle in cash based on LIBOR at settlement date. The Eurodollar CD futures is more commonly used by institutional investors than the Treasury bill futures. Other interest rate futures are the Treasury bond futures, Treasury Note futures, and the Bond Buyer's Municipal Bond Index Futures, and don't fall within the scope of this study. Fabozzi et al 511 One may either speculate on the movement of short-term interest rates or one can use it for the purpose of hedging an existing position. The price of a futures contract moves in the opposite direction from interest rates. If interest rates rise, the futures price will fall, and when interest rates fall, the futures price will move up. A wise speculator who anticipates that interest rates will rise will take a short (sell) position; and conversely, if interest rates are expected to fall, he should take a long (buy) position. Speculating involves the risk that the direction of interest rates may not move as projected and this can mean substantial losses when one guesses very wrongly. Interest rate futures can be used to hedge against adverse interest rate movements (See Hearth 633). Such a strategy can lock in either a price or an interest rate. A pension fund manager who expects to liquidate a bond portfolio in order to make a large payment of, say £10 million after 3 months, may, if he believes that interest rates will rise, take a short (selling) position in order to lock in the price of the bonds. Without that hedging move, an increase in interest rates will find him selling his bonds at a lower than normal price, and he may have to liquidate more bonds than previously estimated in order to meet the target £10 million to be released to the beneficiaries. If the same pension fund manager expects to receive £10 million in new funds at the end of a 3-month period to be invested in bonds but he expects interest rates to fall (thereby earning low), he may hedge with a long (buying) position in order to take advantage of the current normal rate of interest. The same thing is true if some bonds are maturing and have to be reinvested when interest rates are anticipated to be low. The long position in this instance would be a good move that will increase the returns on the bonds. A corporation that plans to sell bonds 3 months from now would want to sell them at low cost -- when prevailing interest rates are low. If however, by then the interest rates are up, the interest cost will be high. To protect itself, the corporation may hedge by taking a short position in interest rate futures when the rates are still relatively high. A commercial bank may also hedge its cost of funds by using a Eurodollar CD futures contract, locking in via a short position in anticipation of an increase in interest costs. A well-known example of shorting the interest rate futures market was cited by Fabozzi et al (579): In 1979 Salomon Brothers had the burden of underwriting $1 billion worth of IBM bonds. A rise in interest rates could reduce the value of those bonds, so Salomon Brothers shorted Treasury futures. When in the last quarter of that year interest rates rose after the Fed announced that it was allowing interest rates to move more flexibly, the gains from the futures contracts reduced its loss on the IBM bonds that it was underwriting. Interpreting interest rate futures data The Wall Street Journal publishes the Eurodollar futures prices (Open, High, Low, and Settle) together with their yield and Open Interest for every trading day. The prices shown are bank-discounted prices. The settlement quotes for each 3-month maturity are of interest to the corporate financial manager. The annual yield is derived by deducting the settlement price from 100, so that if the settlement quote for September 2010, for example, is 94.53, the annual yield is 5.47 percent (100 less 94.53). Each contract for a 3-month period is based on a notional principal of $1 million, so that each basis point is worth $2,500 (0.01 x $1,000,000 x 90/360). for that length of time. If a financial manager has to make an interest payment for a floating rate note by September 2010, and he expects interest rate to rise by then, he can hedge his position by selling a Eurodollar futures contract. If he is right and interest rates rise, he will gain in the futures market, which gain will be enough to offset his loss in paying more interest. If he is wrong and the interest rates actually fall, then his loss in the futures contract will be offset by the reduced actual interest payment. Of course, if in this latter case he had not hedged at all, he would have gained rather than paying the locked-in normal rate of interest. Proper hedging strategy: A summation. We may now state succinctly the proper strategy that one should adopt in hedging a position. If one has the an obligation to make interest payment in the near specified future, he should sell (short) a futures contract, so that if interest rates go up, the short position earns a profit that will cover the increased cost. If rates actually go down, the loss in the futures position will be offset by the difference (reduction) in actual interest payment.(See Eiteman et al 383). If expecting to receive interest payment in the specified future time, one should buy (long) a futures contract. A reduction in interest rate means a gain in the futures and a loss in actual payment, one offsetting the other. If interest rates rise, the gain in interest rates will cover the loss in the futures position. Conclusion Because of their standardized features, futures contracts are more popular and tradeable compared to forward contracts. It has considerable advantages in terms of leverage for hedgers and speculator, who trade or take a position in the market even with less than 10 percent margin on the value of the asset.. However, it has some limitations. Being a symmetric hedge, it can be a bad bet when the price of the contract would have moved favorably in the investor's favor . It locks in a specific but inferior rate whereas the no-hedging alternative would have been profitable. At other times futures may also be inferior to an option when the market moves adversely against the speculator. In this instance, the option would have been able to limit the loss to the amount of the premium. WORKS CITED Bernstein, Peter L. ed. The Portable MBA in Investment. New York: John Wiley & Sons, 1995 Brealey, Richard A. & Stewart C. Myers. Principles of Corporate Finance. 6th ed. 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