Ross et al.: Fundamentals
of Corporate Finance, Sixth
Edition, Alternate EditionVIII. Topics in Corporate
Finance- Risk Management: An
Introduction to Financial
Engineering
© The McGraw−Hill^817
Companies, 2002copper, wheat, and corn. Electricity producers, who own generating capacity, are “long”
(i.e., own) large quantities of the commodity. As the market develops, new futures con-
tracts will allow energy producers and (large) consumers to hedge their transactions in
electricity. Whether such contracts will be successful remains to be seen. Many new
contracts don’t pan out because there is not enough volume; such contracts are simply
discontinued.
Futures Exchanges
There are a number of futures exchanges in the United States and elsewhere, and more
are being established. The Chicago Board of Trade (CBT) is among the largest. Other
notable exchanges include the Chicago Mercantile Exchange (CME), the London Inter-
national Financial Futures Exchange (LIFFE), and the New York Mercantile Exchange
(NYME).
Table 23.1 gives a partial Wall Street Journallisting for selected futures contracts.
Taking a look at the corn contracts in the upper left portion of the table, note that the
contracts trade on the CBT, one contract calls for the delivery of 5,000 bushels of corn,
and prices are quoted in cents per bushel. The months in which the contracts mature are
given in the first column.
For the corn contract with a September 2001 maturity, the first number in the row is
the opening price (219 cents per bushel), the next number is the high price for the day
(219), and the following number is the low price for the day (217). The settlement price
is the fourth number (218^1 ⁄ 2 ), and it is essentially the closing price for the day. For pur-
poses of marking-to-market, this is the figure used. The change (^1 ⁄ 2 ), listed next, is the
movement in the settlement price since the previous trading session. The highest price
(276^1 ⁄ 2 ) and lowest price (192) over the life of the contract are shown next. Finally, the
open interest(17,020), the number of contracts outstanding at the end of the day, is
shown. At the end of a section, the volume of trading in all maturities is shown for that
day (57,000) and the previous day (67,959), along with the total open interest for all ma-
turities (357,192) and the change in the total open interest (1,467).
To see how large futures trading can be, we take a look at the CBT Treasury bond
contracts (under the interest rate heading). One contract is for long-term Treasury bonds
with a face, or par, value of $100,000. The total open interest for all months is about
550,000 contracts. The total face value outstanding is therefore $550 billion for this one
type of contract!
Hedging with Futures
Hedging with futures contracts is conceptually identical to hedging with forward con-
tracts, and the payoff profile on a futures contract is drawn just like the profile for a for-
ward contract. The only difference in hedging with futures is that the firm will have to
maintain an account with a broker so that gains and losses can be credited or debited
each day as a part of the marking-to-market process.
Even though there is a large variety of futures contracts, it is unlikely that a particu-
lar firm will be able to find the precise hedging instrument it needs. For example, we
might produce a particular grade or variety of oil, and find that no contract exists for ex-
actly that grade. However, all oil prices tend to move together, so we could hedge our
output using futures contracts on other grades of oil. Using a contract on a related, but
not identical, asset as a means of hedging is called cross-hedging.
When a firm does cross-hedge, it does not actually want to buy or sell the underlying
asset. This presents no problem because the firm can reverse its futures position at some
CHAPTER 23 Risk Management: An Introduction to Financial Engineering 791To get some real-world
experience at very low
cost, visit the fascinating
futures exchange at the
University of Iowa:
http://www.biz.uiowa.edu/iem.Surf over to these home
pages at http://www.cbot.com,
http://www.cme.com, and
http://www.liffe.com. All of
these web sites provide a
great deal of information
about the services and
financial products found
on the respective
exchanges.cross-hedging
Hedging an asset with
contracts written on a
closely related, but not
identical, asset.