The Advantage of Futures Contracts

Introduction

Futures are a form of forward contract, which gives a fixed rate for a financial instrument, such as security prices, exchange rates and interest rates at a future date. Financial futures can be used to hedge against risks that appear in gilt prices, interest rates, foreign currency exchange rates, share prices and bond prices. For a manufacturing company, the principal advantage of a future is hedging of interest rates and possibly prices of shares, where the company holds an equity portfolio. Other products, such as forward contracts, are available for the reduction of exchange rate exposure. A company with a large amount of borrowing, which is concerned about possible rise in the level of interest rates, could sell interest rate futures with the expectation that if interest rates rise, the same type of future contracts could be bought at a cheaper price to close out the futures commitments. The profit made on the futures deals would compensate for any extra interest that the company could pay. In as much as a company may want to use its futures, hedges are unlikely to be perfect due to a number of reasons. The movement of futures prices may not be an exact reflection of the movement of interest rates. Furthermore, futures contracts are of a standardized size and it may not be possible to match exactly the amount of the borrowings.

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Strategies for the Minimisation of Futures Risk

Internal rules should be formulated to allow the use of futures in hedging against known specific financial risks. However, the rules should restrict the use of futures in open speculation. Principles to be used include strict limits on the size of contracts that may be used. The responsibility for reporting on futures activity should be separate from the responsibility for decision making on futures trading. The use of derivatives should be centralised, with local management not being allowed to trade in derivatives. Futures activity should be subjected to regular detailed scrutiny, by independent department such as internal or external audit. Reporting to the audit committee would also regulate the performance of futures (Anand 2007, p. 56).

Most financial and real asset transactions occur in what is known as the spot or cash market. Here, the asset is delivered immediately, or within a few days. Futures or future contracts on the other hand call for the purchase or sale of a financial or real asset at some future date, but at a price that is fixed today. Future contracts are divided into two that is, financial futures and commodity futures. Financial futures include treasury bills, Eurodollar deposits, foreign currencies and stock indexes. Commodity futures include grains, livestock, fibres, metals, and many more. A future contract is therefore a definite agreement on the part of one party to buy something on a specific date, and at a specific price. The other party should agree to sell on the same terms. Financial futures could be used as a tool of foreign exchange risk management. This could be enabled by entering into future currency contracts, which are standardized contracts that trade in an organized future market. The trader with foreign currency transaction therefore reduces the risk of foreign currency exchange rate fluctuations since he would buy or sell a foreign currency at a fixed exchange rate. The major limitation of using financial futures to hedge risk is associated with transaction costs, which tend to be very high. The exchange rate may also move against the future contracts and therefore, the trader loses profit. A futures contract is an agreement to buy or sell an asset at a certain time in future for a stated price.

An option on futures gives the buyer the right, but not the obligation, to buy or sell a futures contract at a later date at a price agreed upon today. The writer of the call option on futures, upon exercise, establishes a short position in the futures contract at the exercise price. The writer of the put option on futures establishes a short position in the futures contract at the exercise price. The holder of a put option on futures, upon exercise, establishes a short position in the futures contract at the exercise price. The writer of the put option on futures establishes a long futures position at the exercise price. Futures and options can affect the risk and return on distribution for a portfolio. In effect, being long in futures is identical to subtracting cash from the portfolio. Long futures positions have the effect of increasing the exposure of the portfolio on the asset. Shortening futures decreases the portfolio’s probability distribution of returns. Long position’s of futures on the portfolio’s underlying asset increases the portfolio’s exposure (or sensitivity) to price changes. Shortening futures has the effect of decreasing the portfolio’s sensitivity to the underlying asset. Since options provide the choice of whether or not to exercise the option, it means that options do not have a symmetrical impact on returns, at least where there is a free trade. A free trade area exists when there is no restriction on the movement of goods and services between countries. This may be extended into a customs union when there is a free trade area between all member countries of the union. In addition, they might be extended in case common external tariffs apply to imports from non-member countries. In other words, the union promotes free trade among its members but acts as a protectionist bloc against the rest of the world.

A common market encompasses the idea of a customs union but has a number of additional features. In addition to free trade among member countries, there is also a complete mobility of the factors of production. A British citizen has the freedom to work in any other country of the European Community. A common market will also aim to achieve stronger links between member countries, for example by harmonising governmental economic policies and by establishing a closer political confederation. Foreign exchange exposure can be defined as the vulnerability of the group to risk, arising from denominating the transactions in more than one currency. For an international company, exposure may arise due to reasons, which are discussed below.

Transaction exposure

This arises due to the time taken to complete normal trading transactions. For example, there is normally a time delay between invoicing and receipting of payment. During this time, the exchange rate may move against the supplier, causing a loss in the settlement of the account.

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Translation exposure

This arises when the group holds assets and liabilities, which is denominated in different currencies. The value of these items will fluctuate with the exchange rate and this may influence lenders and investors in their dealings with the group.

Economic exposure

This relates to the longer term competitiveness of the group and arises from the economic performance of countries in which the group operates and trades. For example, the group might decide to serve the European market from a facility in France. If the franc strengthens, the competitiveness of the operation would be eroded.

The precise policy to be adopted will depend on the group’s attitude to risk. Different approaches and techniques are available to handle the different types of exposures described above. Transaction exposure can be minimised by using forward exchange contracts. This entails arranging to buy or sell a currency at a predetermined future date and rate (Hubbard, 2007, p. 12). Such contracts can be matched to the known future operational transactions, which would reduce the uncertainties associated with exposures. However, the group may miss the opportunity to make a profit on the exchange rate. It might also fail to match receipts and payments in a given currency. Generally, using a bank account denominated in a particular currency is another means of minimising exposure to risk.

The firm may also choose to using the currency market to borrow or lend amounts in local currencies. This would subsequently be counterbalanced against the payment or receipt that has to be made in the future. Currency options can be useful in situations where the actual date and amount of the transaction are uncertain, for example where the company issues a price list in a local currency. The company decides buy or sell a currency at an agreed rate and date in the future. If exchange rate movements are unfavourable, the option can be abandoned. Options are expensive but they do allow the company to take advantage of any favourable movements in rates, as well as avoiding any losses. Currency swaps may be made directly with another company or through a bank. The futures market can be used to hedge against possible gains or losses on exchange. Translation exposure can be minimised by ensuring that, as much as possible, assets and liabilities denominated in given currencies are held in balanced amounts.

However, if the group is willing to tolerate a higher level of risk then it may try to arrange its financial structure to take advantage of the relative strengthening or weakening of different economies. Economic exposure is harder to avoid since long term decisions are involved, such as where to locate production facilities. However, it can be reduced by diversifying the trading base across different countries. Capital structure decisions will also be important. Over the counter trading occurs when stocks are not traded using the normal centralised system. In this case, brokers negotiate for the prises. It normally happens when stocks are not listed. This method is ideal for companies that may not meet the conditions required before being listed in the stock market. The advantage of this method is that trading is done on the spot that is, there is no time wasting which in turn might expose a trader to fluctuation arising from foreign exchange. It is almost immediate and can be executed in small bits and not standardised like futures. In this case, over the counter method may be useful in risk minimisation

List of References

Anand, S. (2007). Optimizing Corporate Portfolio Management: Aligning Investment Proposals with Organizational Strategy. New York, NY: Wiley.

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Hubbard, D. (2007). How to Measure Anything: Finding the Value of Intangibles in Business. New York, NY: John Wiley & Sons.

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