Financial Management of Risks 437price is recorded at $4.55. The last mark-to-market payment is from short to
long for 25 cents per bushel, equal to the difference between the spot price
upon expiration and the previous day’s futures price.
Upon expiration, the futures contract might stipulate that the short party
now deliver to the long party the specified quantity of wheat. The long party
must now pay the short party the spot pricefor this wheat. Yes, the spot price,
not the original futures price! The difference between the terminal spot price
and the original futures price has already been paid via marking-to-market. A
numerical example will make the mechanics of futures clearer, and show how
similar futures are to for wards.
Suppose with five days remaining until expiration, the wheat futures
price is $4.00 per bushel. A baker “buys” a futures contract in order to lock in a
purchase price of $4.00. Suppose the futures prices on the next four days are
$4.10, $3.90, $4.00, and $4.25. The spot price on the fifth day, the expiration
day, is $4.30. Given those price movements, short pays the long baker 10 cents
the first day. The long baker pays short 20 cents on the second day. On the
third day, short pays long 10 cents, followed by a payment from short to long of
25 cents on the fourth day, and a payment from short to long of 5 cents on the
last day. On net, over those five days, short has paid long 30 cents. When long
now pays the spot price of $4.30 to short for delivery of the wheat, long indeed
is paying $4.00 per bushel, net of the 30 cents profit on the futures contract.
Recall that $4.00 was the original futures price. Thus, the futures contract did
effectively lock in a fixed purchase price for the wheat.
A contract that stipulates a spot transaction in which the underlying com-
modity is actually delivered at expiration, is called a “physical delivery” con-
tract. Many futures contracts do not stipulate such a final spot transaction with
actual delivery of the underlying asset. After the last marking-to-market, the
game is over. No assets are delivered. Contracts that stipulate no terminal spot
transaction are called “cash settled.” It should make little difference to traders
whether a contract is cash settled or physical delivery. A cash settled contract
can be turned into a physical delivery deal simply by choosing to make a spot
transaction at the end. Likewise, a physical delivery contract can be turned
into a cash settled deal by either making an offsetting spot transaction at the
end, or by exiting the futures contract just before it expires.
Examples of the Use of Forwards and
Futures in Risk Management
A wide variety of underlying assets is covered by futures and for wards con-
tracts these days. For example, exchange-traded futures contracts are available
on stocks, bonds, interest rates, foreign currencies, oil, gasoline, grains, live-
stock, metals, cocoa, coffee, sugar, and even orange juice. Consequently, these
instruments are versatile risk management tools in a wide variety of situations.
The most actively traded futures, however, are those that cover financial risks.
Consider the following examples.