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FUTURES, THE MARKET AND ITS PARTICIPANTS (I): HEDGING
Published Wednesday, May 03, 2006 by Carlo Giuntoni | E-mail this post
To trade future markets succesfully one must be aware of various things but the first thing to know is the role of futuremarkets and it's main participants.
Live is full of risk and especially to those producing or merchandising products with varying prices. When after the Middle Ages market economy came into development people tried to avoid and to handle these risks and one of the ways they managed this was by creating option and future markets. Not surprisingly the first time in the economic centre of the world in those days Amsterdam.
Futures are contracts between a buyer (he is been said to go long>) and a seller (he is said to go short), a contract in which they agree on a price for a delivery in the nearest future for some kind of product, a product known as underlying.
Suppose a farmer producing some kind of crop. He doesn't know the outcome, and the price of his crop nor from his competitors. A potential buyer doesn't know either.
A future contract between these two parties, the farmer and the potential buyer, to deliver the crop in harvest for a certain price guarantees both a fixed price to diminish their risks. It is important to stress that the fixed price is in itself a risk because the real price of the crop may and will be differ from the fixed price in the contract. They both assume their expections on future prices of the crop on hisitorical and current prices of the crop, amongst various other things as the weather conditions, technology, expectations on future demand and so on and on.
An example may clarify this. A farmer produces somekind of corn. He expects his costs to be 100 euro per ton. Last years price was 105 euro per ton. The farmer knowing his efforts and the problems he has with this years crop expecting his price at the market only to be at 95 euro. The farmer having inside information about his product. The potential buyer at the other hand has a more broader view of the overal market, the competitors, the demand and the total supply. This is his job. He has a market overview and is expecting this years harvest price to be 115 euro.
So both parties, the producer and the buyer of the crop, have different expectations about the price of the same product, both based on different assumptions and information. They both know this and hence there is a risk to be wrong. So they decide to agree at a fixed price of the delivery of the crop at harvest at say in between their expectations at 110 euro per ton. Three things can happen.
1. The price at harvest is exactly 110 euro. The delivery of the crop to the buyer at 110 euro, the future contract will be ended with this delivery, a proces which is known as final settlement. The farmer wil get 110 euro, a price which he also would have get without the future contract, making 10 euro (110 minus 100 the cost) per ton. The buyer getting delivered for 110 euro making no loss nor gain, but also a price he would have get elsewhere. This being rarely the case.
2. The price will be 120 euro. The settlement is arranged at 110 euro, but now the buyer of the crop is getting a profit of 10 euro (120 minus 110) because he can sell the crop at market for 120 euro, which is the current market price. The farmer at the other hand has a profit of again 10 euro, his delivery price 110 minus his costs at 100, but now he also experiences what is called an opportunity loss of 10 euro because he could have sold his crop directly to the market at 120 euro, but he is obliged to deliver at the buyer at 110. This opportunity loss is the risk the farmer takes by making a future contract for his crop.
3. The market price will be lower than fixed settlement price at say 95 euro. Now the buyer loses money. He has to buy at 110 euro but only can sell at 95 at market making a loss of 15 euro. The farmer still making a profit of 15 euro (110 minus 95) but after costs making a win of 10 euro. The future assuring him of getting a price above markets (and in his case even above his costprice).
This proces to assure the producer of a fixed price of his product is called the hedging function of the future market and is still nowadays the most important function of this market. Futures nowadays are traded on almost any product ranging from commodities as oil, gold, soybeans, cattle, the moneymarkets as euro/dollar or euro/yen to stock indices as the S&@P 500 future.
Traded originally at the floor at market places, called pit trading, but the last 10 years with the use of computers they are more and more executed at virtual places called electronical markets like GLOBEX organised by the Chicago Mercantile Exchange or the EUREX organised by Deutsche Boerse AG in Frankfurt.
Some futures still being traded solely at the pit as some commidities are, others traded both at the pit and electronically such as the big S&P 500 future, others as the German future at the DAX index (FDAX) or the mini S&P500 are traded only electronically.
It is important to note that the oponent of the hedger is bearing all the risk of the contract so why is he doing this anyway? This will be the subject of the next posting which will be about the other important function of the futuremarkets: speculation.
Live is full of risk and especially to those producing or merchandising products with varying prices. When after the Middle Ages market economy came into development people tried to avoid and to handle these risks and one of the ways they managed this was by creating option and future markets. Not surprisingly the first time in the economic centre of the world in those days Amsterdam.
Futures are contracts between a buyer (he is been said to go long>) and a seller (he is said to go short), a contract in which they agree on a price for a delivery in the nearest future for some kind of product, a product known as underlying.
Suppose a farmer producing some kind of crop. He doesn't know the outcome, and the price of his crop nor from his competitors. A potential buyer doesn't know either.
A future contract between these two parties, the farmer and the potential buyer, to deliver the crop in harvest for a certain price guarantees both a fixed price to diminish their risks. It is important to stress that the fixed price is in itself a risk because the real price of the crop may and will be differ from the fixed price in the contract. They both assume their expections on future prices of the crop on hisitorical and current prices of the crop, amongst various other things as the weather conditions, technology, expectations on future demand and so on and on.
An example may clarify this. A farmer produces somekind of corn. He expects his costs to be 100 euro per ton. Last years price was 105 euro per ton. The farmer knowing his efforts and the problems he has with this years crop expecting his price at the market only to be at 95 euro. The farmer having inside information about his product. The potential buyer at the other hand has a more broader view of the overal market, the competitors, the demand and the total supply. This is his job. He has a market overview and is expecting this years harvest price to be 115 euro.
So both parties, the producer and the buyer of the crop, have different expectations about the price of the same product, both based on different assumptions and information. They both know this and hence there is a risk to be wrong. So they decide to agree at a fixed price of the delivery of the crop at harvest at say in between their expectations at 110 euro per ton. Three things can happen.
1. The price at harvest is exactly 110 euro. The delivery of the crop to the buyer at 110 euro, the future contract will be ended with this delivery, a proces which is known as final settlement. The farmer wil get 110 euro, a price which he also would have get without the future contract, making 10 euro (110 minus 100 the cost) per ton. The buyer getting delivered for 110 euro making no loss nor gain, but also a price he would have get elsewhere. This being rarely the case.
2. The price will be 120 euro. The settlement is arranged at 110 euro, but now the buyer of the crop is getting a profit of 10 euro (120 minus 110) because he can sell the crop at market for 120 euro, which is the current market price. The farmer at the other hand has a profit of again 10 euro, his delivery price 110 minus his costs at 100, but now he also experiences what is called an opportunity loss of 10 euro because he could have sold his crop directly to the market at 120 euro, but he is obliged to deliver at the buyer at 110. This opportunity loss is the risk the farmer takes by making a future contract for his crop.
3. The market price will be lower than fixed settlement price at say 95 euro. Now the buyer loses money. He has to buy at 110 euro but only can sell at 95 at market making a loss of 15 euro. The farmer still making a profit of 15 euro (110 minus 95) but after costs making a win of 10 euro. The future assuring him of getting a price above markets (and in his case even above his costprice).
This proces to assure the producer of a fixed price of his product is called the hedging function of the future market and is still nowadays the most important function of this market. Futures nowadays are traded on almost any product ranging from commodities as oil, gold, soybeans, cattle, the moneymarkets as euro/dollar or euro/yen to stock indices as the S&@P 500 future.
Traded originally at the floor at market places, called pit trading, but the last 10 years with the use of computers they are more and more executed at virtual places called electronical markets like GLOBEX organised by the Chicago Mercantile Exchange or the EUREX organised by Deutsche Boerse AG in Frankfurt.
Some futures still being traded solely at the pit as some commidities are, others traded both at the pit and electronically such as the big S&P 500 future, others as the German future at the DAX index (FDAX) or the mini S&P500 are traded only electronically.
It is important to note that the oponent of the hedger is bearing all the risk of the contract so why is he doing this anyway? This will be the subject of the next posting which will be about the other important function of the futuremarkets: speculation.
graph from eurex delayed 15min
Contributors
- - Joao & Fernando from Portugal.
- - Carlo Giuntoni from Netherlands (you can also check his own blog)
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