Ross et al.: Fundamentals
of Corporate Finance, Sixth
Edition, Alternate EditionVIII. Topics in Corporate
Finance- Risk Management: An
Introduction to Financial
Engineering
(^816) © The McGraw−Hill
Companies, 2002
the agreement. As we discuss in the next section, a variation on the forward contract ex-
ists that greatly diminishes this risk.
Forward Contracts in Practice Where are forward contracts commonly used to
hedge? Because exchange rate fluctuations can have disastrous consequences for firms
that have significant import or export operations, forward contracts are routinely used
by such firms to hedge exchange rate risk. For example, Jaguar, the U.K. auto manu-
facturer (and subsidiary of Ford Motor Co.), historically hedged the U.S. dollar–British
pound exchange rate for six months into the future. (The subject of exchange rate hedg-
ing with forward contracts is discussed in greater detail in an earlier chapter.)
HEDGING WITH FUTURES CONTRACTS
Afutures contractis exactly the same as a forward contract with one exception. With
a forward contract, the buyer and seller realize gains or losses only on the settlement
date. With a futures contract, gains and losses are realized on a daily basis. If we buy a
futures contract on oil, then, if oil prices rise today, we have a profit and the seller of the
contract has a loss. The seller pays up, and we start again tomorrow with neither party
owing the other.
The daily resettlement feature found in futures contracts is called marking-to-market.
As we mentioned earlier, there is a significant risk of default with forward contracts.
With daily marking-to-market, this risk is greatly reduced. This is probably why orga-
nized trading is much more common in futures contracts than in forward contracts (out-
side of international trade).
Trading in Futures
In the United States and elsewhere around the world, futures contracts for a remarkable
variety of items are routinely bought and sold. The types of contracts available are tra-
ditionally divided into two groups, commodity futures and financial futures. With a fi-
nancial future, the underlying goods are financial assets such as stocks, bonds, or
currencies. With a commodity future, the underlying goods can be just about anything
other than a financial asset.
There are commodity futures contracts on a wide variety of agricultural products
such as corn, orange juice, and, yes, pork bellies. There is even a contract on fertilizer.
There are commodity contracts on precious metals such as gold and silver, and there are
contracts on basic goods such as copper and lumber. There are contracts on various pe-
troleum products such as crude oil, heating oil, and gasoline.
Wherever there is price volatility, there may be a demand for a futures contract, and
new futures contracts are introduced on a fairly regular basis. For example, by some es-
timates, the potential value of wholesale trade in electricity in the United States is more
than $100 billion a year, dwarfing the market for many other commodities such as gold,
CONCEPT QUESTIONS
23.3a What is a forward contract? Describe the payoff profiles for the buyer and the
seller of a forward contract.
23.3bExplain how a firm can alter its risk profile using forward contracts.
790 PART EIGHT Topics in Corporate Finance
23.4
futures contract
A forward contract with
the feature that gains and
losses are realized each
day rather than only on
the settlement date.