Futures Contracts

The futures contract is a type of derivatives and is used for hedging (reducing risk of a company).   They can also be used to enhance the risk (called speculating).  In concept, they are very similar to forward contracts, but for a few minor differences:

Table of Contents

Futures contracts for Foreign Exchange

For managing risk (hedging) and for speculating (betting) on changes in value of foreign exchange rates;  use a contract today to lock in an exchange rate in the future (see discussion about Currency).  This is one way of hedging to reduce risk of a firm conducting international business.  For example, in foreign exchange:  the nice thing about futures contracts is that they lock in a guaranteed exchange rate in the future, so that you will know for sure exactly how much money you will receive (or, will owe) in the future.  These contracts are publicly traded and sold in big chunks. (big lots) on Chicago Mercantile Exchange (CME). 

These contracts are similar to the "forward exchange rate", in that this instrument is also a future exchange of currencies. One key difference is that Futures come in pre-set sizes, and pre-set time to maturities. They are quite a bit bigger, and are therefore designed for institutional investors (not individuals). They are bought in large trading blocs, and have expiration dates every 1/4 of the year.  One key difference is that "Futures" can be traded on an organized market (like selling stocks, bonds). (Forwards can not.) This gives the "futures" additional flexibility, which in turn reduces the risk.

• set dates (every 3rd Wednesday of every quarter...ie March, June, September, December)
• set sizes ($50k+)
• 90 days is most poplular
• consumers can purchase through stock broker
• do not need to put cash down now...instead, you just take the "liability" now (ie. you have to pay in the future).
• If you want a large amount of futures, you might need to purchase multiple contracts (note you will need 1/2 as many options as "futures contracts" )
• hold a margin account - shares are held to protect broker against loss
• individual can be a speculator by purchasing futures  (like gambling in Vegas, except you are betting on countries and currencies)
• bet 3 months at a time

comparing futures & forwards:

Example, Foreign exchange currency contracts:

1. Futures are publicly traded on exchanges
2. Futures are traded in blocks.  With forwards, its easier to specify exactly the dollar amount that you want to trade.
3. Futures contracts expire at specified times (on the 3rd Wednesday of the quarter - March, June, September, December - and not in between.  So, if you are looking to hedge currency exposure till the middle of July, you might not choose to use futures contracts because the contract will expire in June, and would leave you naked (exposed) until July.
4. To buy/ trade futures contracts, an individual calls their stockbroker, who will require a "margin account" to insure against losses.  In forward contracts, the individual calls their bank, and makes a private deal with their banker.   No collateral is required, but you must have a bank that trusts you, and is willing to make the deal
5. Futures are not traded in every currency.  Look on the Chicago Merc exchange to see what is traded.  Usually its dollar, euro, yen, and other major currencies.  To trade less common currencies, it is sometimes difficult to find futures contracts traded on exchanges.  Instead, you will likely need to use a forward.
6. The good thing about Futures is that they trade on a very liquid market (easy to net out your position and trade your contract with someone else). 
7. Futures prices are quoted in daily papers, and online
8. There is a middle man, called a "clearing house" in futures contracts
9. Futures are "marked to market" on a daily basis, which results in many cash flows (daily), rather than just one big cash flow at the end (like with forward contracts)

Agriculture Examples:

You might be a farmer who is selling corn, but you are afraid that the price of corn might fall before you can get your product to the market.  So, to avoid the risk, you offer to sell your inventory at a specified price in the future.  Because you are offering to sell your (expected) inventory, you are "selling" a futures contract.  The person that is willing to buy your future corn, is willing to "buy" your futures contract on your corn.  That means that he is willing to make a contract for a specific price to purchase your corn in the future.  What you have done essentially is to eliminate any risk that the market price will fall below a level where you can make a profit.  Therefore, by "selling" a futures contract, you have protected yourself against a fall in prices on your (asset) corn.   This is called "short" selling, which we will get to in a minute (see below).    Think about it like this...the buyer of the corn is the buyer of the futures contract.  He is locking in a price, but is hoping that the actual market price of corn in the future will be above your agreed upon price.  If the market price were to rise, and he has a guaranteed low price from you, then he stands to make allot of money.  He is essentially betting that the price of corn will rise, and his contracts with you will be worth allot of money.   We say that he is taking a "long" position (see more discussion below).

Types of Futures Contracts

1. financial assets (see interest-rate futures)
2. agricultural commodities
3. metals and petroleum

Terminology

1.  Long - benefit if market price of asset goes up 

2.  Short - benefit if market price of asset goes down 

                      Forward     Type        when to use                                example

Book seller:       sells       short        if your hurt by price decrease     selling inventory

Book buyer:       buys       long        if your hurt by price increase       if purchasing for resale (and have fixed sales price)

*See the book seller example for derivatives  for an easy way to think about who is "long", and who is "short"

How FX Futures rates are determined by banks:

If you compare two interest rates of two countries, then the one with the HIGHER interest rate will have the (LOWER) currency depreciate in the futures (and forward) markets.   Imagine if the Japanese Yen had a lower rate of return (than the US dollar) for an investment, then you would expect that investors should be compensated for that lower return by appreciation of their currency...or else...no one would keep their money in Japanese Yen...everyone would convert it to USD.  So, the currency with the lower interest rate must have appreciation, and the currency with the higher interest rate must see depreciation. (for more discussion, see interest rate parity).

Risk Management

 When dealing with foreign exchange risk, you have a few choices as a business manager

1. Operationally hedge - balance your assets and liabilities so that currency is generated in revenues in the same country where liabilities are owed.   Another way to operationally hedge is to have operations in multiple countries, so that if one currency goes down, another will go up, etc.
2. Avoid - you can try to avoid currency risk by passing along the risk premium to your customers.  You can charge a risk premium, say for example 7% extra to all clients, and keep a fund ready for incase the currencies change, and then, that way...you will have money ready.  Its not a very good method, but some companies do it.
3. Protect yourself - hedge - transfer the risk to someone else that is more willing / able to take on that risk... if there is someone that is willing to take on risk for a fee, then sell them that risk, and take the money now.  This is the essence of currency hedging . 

• The four main choices for currency hedging are
  • (a) forward contracts  (see forward exchange rate)
  • (b) futures contracts  (see Futures market)
  • (c) options (see Options)
  • (d) use the money market to hedge
  • (d) sell your A/R to someone else  ....companies that buy your receivables at a discount.
    1. Bankers Acceptance -
       • is an agreement between an importer and exporter,
       • with payment in 30 days
       • cover goods in transit
       • irrevocable letter of credit (L/C) = confirmation + insurance + Bill of Lading (BL)
       • Then, if you have the irrevocable L/C...then you can get the "Bankers Acceptance
       • you sell the package of contracts
       • go to bank
       • sell those receivables at a discount...to get money today.
    2. factoring
       • might buy next 15 shipments
       • multiple shipments
       • but, because there is no guarantee, then the banks charge a higher commission
       • get money today
    3. forefeiting
       • committment by a country (government)
       • host country guarantee
       • popular in older times, and in Middle east.

Links from KookyPlan

• interest-rate futures 
• derivatives
• hedging
• speculating
• risk
• forward contracts
• marked to market

• foreign currency trading

  spot exchange rate

  forward exchange rate

  foreign exchange Swaps

  Currency

  appreciation

  depreciation

   

   

External Links

• http://en.wikipedia.org/wiki/Futures_contract
• Chicago Board of Trade
• Chicago Mercantile Exchange
• Commodity Futures Trading Commission
• National Futures Association
• Kansas City Board of Trade
• New York Board of Trade