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A Primer on Futures Contracts

Dr. Hassan Shirvani

Futures contracts, together with options and swaps, are examples of the derivative securities which are so-called because they derive their values from the performances of other financial assets or commodities.  As such, they are essentially side bets, not unlike placing bets in a horse race.  Given their wide popularity on Wall Street as highly effective investment and hedging instruments, this post briefly introduces the futures contracts and discusses some of their applications.      

Futures Contracts Defined

Futures contracts are standardized contractual obligations that entitle their holders to buy or sell a financial asset, such as shares of a common stock, or a commodity, such as gold, to be delivered at some future date, say, there months hence, but at a price that is set today. The futures contracts in financial assets are referred to as financial futures, while those in commodities are called commodity futures.  As investment vehicles, futures contracts are heavily leveraged and, hence, can significantly magnify the rates of return (or loss).  As hedging tools, they can also provide protection against a variety of financial risks without requiring the burdensome insurance premiums, as is the case, for example, with options.  

Futures Contracts as Investment Tools

Futures contracts are favored by many investors for their highly leveraged character.  That is, investors can use futures contracts to control a substantial amount of investment with a relatively small stake.  For example, consider a futures gold contract which promises to deliver 100 ounces of pure gold in three months at a price of, say, $1,800 per ounce.  Investors who buy this contract with a total market value of $180,000, are required to place a margin (down payment) of only about 5 percent of the value of the contract.  Thus, with a relatively small stake, $9,000, investors can control some $180,000 of investment in gold.  This could be quite a lucrative arrangement, provided that the price of gold rises.  To see this, suppose that the price of gold increases by $50 per ounce over the next three months.  This means that the buyers of the contract will make a profit of $5,000 ($50 x 100) over an initial investment of $9,000.  That is, they will earn a return of 55 percent over three months.  Of course, if the price of gold drops by $50, the investors will lose almost half of their initial investment.

In practice, the profits and losses on the futures contracts are settled on a daily basis.  That is, by the end of each trading day, the change in the value of the contract will be added to or subtracted from the initial margin.  For the above gold contracts, for example, should the price of gold drop by, say, $5 on a given day, the balance of the margin will be reduced by $500.  In addition, should this downward trend in the price of gold continue, it may eventually necessitate some additional margin calls.  It is thus clear that the investors who are bullish on the future prospects of certain assets or commodities will be buying the futures contracts on them, while those with bearish sentiments will sell them.  Finally, while in principle all futures contracts can be fulfilled by the actual delivery of the underlying assets or commodities, in practice most do not. That is, the futures contracts are mostly settled in cash.

Forward versus Futures Prices

Like other investors, those who trade in futures contracts need to have an idea of the fundamental values of these contracts.  These fundamental values are given by the forward prices of the futures contracts.  A forward price, for an asset or a commodity, will simply show the cost of buying and carrying forward the underlying asset or commodity.  For example, the forward price of a gold contract, which contains 100 ounces of gold, will include the current cost of the gold, the financing cost of buying the gold, and the costs of insurance and storage of the gold.  Thus, suppose an ounce of gold is currently selling for $1,750 in the spot market.  An investor will purchase 100 ounces of gold for $175,000, to be financed by borrowing at 3% annual interest rate.  In addition, suppose further that the annual insurance and storage costs will amount to 1% of the value of the gold.  This means that the forward price of the gold for, say, three months from today, will be:

Forward price = Cost of gold + Interest cost + Insurance and storage cost = $175,000 + 0.0075($175,000) + 0.0025($175,000) = $176,750.

Thus, the fundamental value of a gold futures contract that expires in three months is $176,750.  If the futures price for the same contract exceeds this amount, then investors will be motivated to sell the futures contract and then buy gold and carry it forward.  This, in turn, will tend to both lower the futures price of gold and raise the forward price of gold, until all arbitrage profit opportunities are eliminated. Likewise, should the futures price of gold fall short of its forward price, then some investors will start buying gold in the futures market and simultaneously get rid of their spot gold holdings.  This arbitrage process will also work for the futures contracts in financial assets, such as bonds or equities.  That is, investors will, for example, buy bonds or equities in the spot markets and sell futures contracts on them to exploit any existing arbitrage profits.   

Futures Contracts as Hedging Tools

Many investors and financial institutions also use futures contracts for hedging purposes.  Before we discuss how this is done, it is important to draw a distinction between insurance and hedging, even though both are designed to provide protection against threats to the values of assets.  Under insurance, in return for the payment of a non-refundable premium, insurance companies provide protection against potential loss, while leaving all potential benefits to the insured.  For example, if a household buys home insurance, then the insurance policy provides protection against the destruction wrought by, say, fire or flood.  However, in the absence of any such damage, any appreciation of the value of the house goes exclusively to the owner of the house.  In contrast, under hedging, there is no payment of premium.  The insured will simply trade away all potential gains to avoid any potential losses.  To see how this works, consider the case of the same home owner, who lacking any money to buy insurance, agrees to the terms of a hedging offer.  According to this offer, the insured property will be sold after, say, one year.  Any profit resulting from the appreciation of the value of the house over the coming year will accrue to the insurance company.  In return, the insurance company will agree to compensate the owner for any capital loss on the value of the house.  In this light, it is clear that while options provide insurance, futures can be used for hedging.

Basic Rule for Hedging with Futures Contracts

There is a basic rule for using futures contracts for hedging purposes:  Whatever the spot position, the opposite position should be taken in the futures market.  More specifically, if we have a long position (own) in the spot market, we should go short (sell) in the futures market. This is called a short hedge. Conversely, if we are short in the spot market (owe), then we should go long (buy) in the futures market.  This is called a long hedge.  For example, suppose we have a long position in 100 ounces of gold, which has a current price of $2,000 per ounce, and we are concerned that the price of gold may fall over the next three months.  According to the hedging rule just cited, since our spot position is long, we need to take a short position in the futures market, that is, we need to sell a 3-month futures contract on gold.  For simplicity, suppose that the futures price of gold is also $2,000.  Now, suppose that, over the next three months, the price of gold rises from its current level of, say, $2,000, to $2,300.  This means that we have clearly made a profit of $300 per ounce on our spot position.  That is the good news.  The bad news, however, is that three months from now we must buy gold at $2,300 and deliver it for only $2,000, thus losing $300 per ounce on our futures contract.  Obviously, the gains and losses will offset each other, maintaining our status quo of holding our original $200,000.  Now, take the case of the price of gold falling from its current level of $2,000 to $1,700 over the next three months.  Without selling the futures contract, we would have suffered a loss of $300 per ounce.  However, our futures contract enables us to buy gold for $1,700 in three months and deliver it for $2,000, thus making a compensating gain of $300 per ounce.  Again, we have managed to maintain our current $200,000.  In other words, the hedging has not made us any gains, but it has also helped us to avoid any losses.      

Portfolio Insurance

The foregoing analysis equally applies to the use of futures contracts for hedging against the risk of major corrections in the stock market.  Suppose a stock fund manager has a portfolio of stocks and is concerned about a stock market correction.  Since the spot position is long, the hedging rule calls for a short futures position.  That is the manager has to sell some futures contracts on the stocks in the portfolio.  This action is broadly referred to as portfolio insurance, even though it is really hedging.  Regardless, the next question is what types of the futures contracts need to be sold for hedging a portfolio of stocks.  This is not a difficult question to answer, provided that the spot portfolio bears some similarity to some existing stock price index.  For example, if we own a portfolio that closely matches the S&P 500 index, then we should use this same index for our hedging purposes.  Likewise, we can use the more specialized stock indices, like NASDAQ, or a host of sector ETFs, to hedge our less diversified portfolios.  More specifically, to hedge a spot stock portfolio, we need the value of the portfolio together with a sense of how volatile the portfolio is relative to the broad stock market indices.  For the latter, that is, the measure of relative volatility, we can use the beta of the portfolio.  

To clarify the foregoing discussion, let us consider an example.  Suppose we would like to hedge a portfolio of stocks that is currently worth, say, $1,300,000.   Suppose further that we are going to use the standard S&P 500 futures contract for this purpose.  We know that each futures contract is for 250 units.  That is, we multiply the futures value of the S&P 500 index by 250 to get the value of one S&P futures contract.  For simplicity, assume that the index has a futures value of 4,500.  Thus, a futures contract is worth 250 x $4,500 = $1,125,000.  This means that, assuming that our portfolio is as volatile as the market, that is, it has a beta of one, we need to sell only one futures contract to hedge our spot position.  Of course, this hedging is not exact, because we are really hedging only $1,125,000 out of our $1,300,000.  A better way to hedge will be to use the mini version of the S&P contract that has only 50 units.  The value of this contract will be 50 x $4,500 = $225,000.  Using this futures contract, we can hedge much better by selling 6 mini contracts for $1,350,000, that is much closer to the value of our portfolio of $1,300,000.

On the other hand, let us suppose that the beta for our portfolio is 2, that is, our portfolio is twice as volatile as the market.  This could be because our portfolio contains many technology stocks which are relatively more volatile than the average stock.  Under these conditions, we need to sell 2 standard S&P contracts for a sum of $2,250,000.  To see why, suppose the market drops by 10%, causing the two futures contracts to gain a total of $225,000.  However, our $1,300,000 portfolio will lose 20%, because of our beta of 2, so that our loss will be 20% x $1,300,000 = $260,000. While a relatively close match, we can do even better by using the mini version.  If we had instead sold 12 such contracts, the loss of $260,000 in our spot portfolio would have been almost exactly matched by our gain of $270,000 on our futures contracts.

In short:

The number of the S&P 500 futures contracts needed to hedge a stock portfolio is roughly equal to:

(The value of the portfolio to be hedged / The value of the S&P 500 futures contract used) x beta of the portfolio. 

Conclusion

This post has presented a brief introduction to the nature and applications of futures contracts.  As the post has indicated, futures contracts can be very useful vehicles for both investment and hedging purposes.  However, as history has also repeatedly shown, the reckless and unregulated use of the futures contracts can be highly destabilizing and, hence, potentially quite hazardous to the economic and financial health of a country.

About the Author — Hassan Shirvani

AvatarDr. Hassan Shirvani is the Cullen Endowed Chair of Economics. His research areas include macroeconomics, investments and international finance.

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