Commodity and financial futures
Futures contracts are bought and sold on organized futures exchanges. Note that our
farmer and miller are not the only business that can hedge risk with commodity
futures. The lumber company and the builder can hedge risk with commodity futures.
The lumber company and the builder can hedge against changes in lumber prices, the
copper producer and the cable manufacturer can hedge against changes in copper
prices; the oil producer and the trucker can hedge against changes in gasoline prices,
and soon.For many firms the wide fluctuations in interest rates and exchange rates have become
at least as important a source of risk as changes in commodity prices. Financial futures
are similar to commodity futures, but instead of placing an order to buy or sell a
commodity at a future date, one can place an order to buy or sell a financial asset at a
future date. Financial futures have been a remarkably successful innovation. They
were invented in 1972; within a few years, trading in financial futures significantly
exceeded trading in commodity futures.
The Mechanics of future trading
When you buy or sell a futures contract, the price is fixed today but payment is not
made until later. You will, however, be asked to put up margin in the form of either
cast or treasury bills to demonstrate that you have the money to honor your side of the
bargain. As long as you earn interest on the margined securities, there is no cost to
you.
In addition, futures contracts are marked to market. This means that each day any
profits or losses on the contract are calculated; you pay the exchange any losses and
receive any profits. For example, suppose that our farmer agreed to deliver 100 tons
of wheat at Rs.2080 per ton. The next day the price of wheat futures declines to
Rs.2075 per ton. The farmer now has a profit on his sale of 100 X Rs.500. The
exchanges clearing house, therefore pays this Rs.500 to the farmer. You can think of
the farmer as closing out his position every day then opening up a new position. Thus
after the first day the farmer has realized a profit of Rs.500 on his trade and now has
an obligation to deliver wheat for Rs.2075 a ton. The Rs.5 that the farmer has already
been paid plus the Rs.2075 that remains to be paid equals the Rs.2080 selling price at
which the farmer originally agreed to deliver wheat.Of course, our miller is in the opposite position. The fall in the futures price leaves
her with a loss of Rs.6 for ton. She must, therefore, pay over this loss to the exchanges
clearing house. In effect the miller closes out her initial purchase at an Rs.6 loss and
opens a new contract to take delivery at Rs.2075 for ton.
Notice that neither the farmer nor the miller need be concerned about. Whether the
other party will honor his or her side of the bargain. The futures exchange guarantees
the contract and protects itself by setting up profits and losses each day.