440 Planning and Forecasting
A Cross-Hedge
A manufacturer of plastic water pistols wishes to hedge against increases in raw
plastic pellet prices. Unfortunately, there are no futures contracts covering
plastic prices. There is, however, a contract on oil prices, and the price of plas-
tic is highly correlated with the price of oil. By going long in an oil contract,
the manufacturer will be paid money when oil prices rise, which will likely
be also when plastic prices rise. Hedging an exposure with a contract tied to a
correlated underlying instrument is called a cross-hedge.
A Common Pitfall
The ease with which futures facilitate hedging sometimes coaxes managers to
occasionally take speculative positions. A photographic film manufacturer, for
example, might become experienced and comfortable hedging silver prices by
going long in silver futures. Managers at the firm might come to believe that no
one is better able to forecast silver prices than they are. A time may come when
they wholeheartedly believe that silver prices will fall. Not only might they
choose not to enter a long silver future hedge at this time, but they may choose
to go short in silver futures so as to capitalize on the falling price. If silver
prices fall they will not only benefit from a cheaper raw input, but the short sil-
ver futures will pay off as well. The danger here is that the manufacturer has
lost sight of the fact that it is in the film manufacturing business, and not the
business of speculating on commodity prices. Although silver prices might be
expected to fall, there is always the possibility that they will rise instead. The
probability of a rise might be small, but the consequences would be cata-
strophic. Not only will the firm’s raw material price rise, but the firm will suf-
fer additionally as it loses on the futures contract. The lesson here is that firms
should stay clearly focused on what their business line is, and what role the use
of futures plays in their business. Futures use should generally be authorized
only for hedging and not for speculation. Auditing systems should be in place to
oversee that futures are used appropriately.
Futures and Forwards Summary
As the above examples illustrate, futures and for wards are useful tools for
hedging a wide variety of business and financial risks. Futures and for ward
contracts essentially commit the two parties to a deferred transaction. No
money changes hands initially. As prices subsequently change, however, one
party wins at the other ’s expense. Futures and for wards thus enable businesses
to shed or take on exposure to changing prices. When used to offset an expo-
sure the firm faces naturally, futures and for wards reduce risk.
Options
Options are another breed of derivatives. They share some similarities with
futures and for wards, but they also differ in many important respects. Like