The general use of futures contracts in risk management companies can use trading on US exchanges

I Table of Contents

II Executive Summary

III Table of Figures

IV List of Tables

1 Introduction

2 Literature Review

3.1 Problem definition
3.2 Risk exposure
3.2.1 Exchange of foreign currency at spot rate in October
3.2.2 Exchange of foreign currency at spot rate in December
3.3 Exchange of foreign currency using FX futures

4 Conclusion

V References

I Executive Summary

Since the 1970s futures contracts have proven a real success story, but in the course of the crisis, several futures-trading businesses went bankrupt. Because of a lack of trust, futures trading volumes started decreasing. But, even though the futures market has been adversely affected, futures contracts still serve as a fundamental risk management tool.

This paper provides an insight into the use of futures contracts in risk management, trading on US exchanges. After a brief introduction to the topic of futures contracts, current literature will be reviewed. The literature review focuses primarily on current issues and developments on the futures market, while the third chapter explains step by step - based on an example of foreign exchange hedging - the use of futures contracts as well as how futures transactions are processes. Finally, the third chapter summarises relevant criteria a company has to reflect when considering to invest in futures contracts.

III Table of Figures

Figure 1: Three possible scenarios for the development of the USD/EUR spot rate

Figure 2: USD/EUR spot rate (06/10/11 - 17/10/12) (Bloomberg Financial Suite, 2012b)

Figure 3: Bloomberg description of CME-traded December Euro FX future (Bloomberg Financial Suite, 2012a)

IV List of Tables

Table 1: Margin account exemplarily shown for the US company

1 Introduction

Futures contracts are complex derivative instruments to manage risk in the global financial market that derive their value from underlying assets (Souza et al. 2010, p. 574). Greenspan (1999) honoured their development as “the most significant event in finance during the past decade“, while Buffett warned only a few years later against derivatives by calling them „financial weapons of mass destruction“ (Berkshire Hathaway Inc., 2004, p. 15) and prophetically linking them to the global financial crisis.

While derivatives compromise a range of financial instruments, futures contracts are an agreement between two parties to buy or sell an asset at a certain time, certain place, for a certain price and amount in the future. These underlying assets can vary from a wide range of assets like live animals or products, commodities, bonds, currency, stocks or the weather. (Hull, 2012a, p. 7)

Since the first futures contracts was introduced, the list of underlying assets has expanded and they provide effective mechanisms to manage price risk (National Futures Association, 2006, p. 6). However, during the financial crisis and with the collapse of MF Global, customers have lost trust in futures contracts - visible at decreasing trading volumes at the Chicago Mercantile Exchange. (Weitzman & Meyer, 2012)

Based on various motivations, futures traders follow different strategies. Hull (2012a, p. 37) determined a general classification of future contract traders by categorizing them into hedgers, speculators and arbitrageurs.

The following paper will focus on futures contracts with regard to hedging strategies in the field of risk management. Thus, current literature on future contracts will be analysed under the prospect of hedging risk. After that, an explicit example will be constructed to show risks and opportunities of hedging in foreign currency markets for a US company trading with a European business partner. For this application, current Bloomberg data will be used. In a final step, the key elements of this paper will be pointed out and a concluding recommendation will be given.

2 Literature Review

In risk management, futures contracts are used to manage and limit price risk. This means that current holdings of a particular asset are secured against adverse price changes (National Futures Association, 2006, p. 18). Nance, et al. (1993, p. 267) characterised them as off-balance-sheet instruments, reducing the volatility of a company’s value.

Tamiso and Freedman (1995, pp. 210-213) believe that futures’ risk is much smaller than the risk of the underlying asset. Traditional risk management techniques may even decrease futures contract risk, when combining timevalue (limiting the loss of unexpected market movements) and diversification techniques (spreading risk across a portfolio). Difficulties are to use both techniques without constraining profits and that underlying theoretical assumptions may not hold in reality.

Futures contracts are exchange-traded derivatives. Regulated exchanges act as intermediaries between contract parties (Souza, et al., 2010, p. 481). According to Tsetsekos and Varanis (2000, p. 87) future exchange platforms in America and Europa “have different arrangements for clearing and settling transactions, even though both [ ] trade similar contracts”. For futures contracts, clearinghouses like the CME or NYMEX act as guarantors, ensuring fulfilment of contracts, even if the counterparty defaults (Hull, 2012a, p. 29 ff.). As in 2010 already brought to attention by Turbeville (2010, p. 8), the default of a clearing member could cause sizable damage and involve large price movements. In October 2011, the prediction became true when MF Global defaulted with debts of approximately 1.6 billion USD (Barrett & Lucchetti, 2012), shortly followed by Peregrine Financial Group in July 2012 (Bunge, et al. 2012).

Despite strong market regulations by the SEC, National Futures Association and Commodity Futures Trading Commission (CFTC), in conjunction with clearinghouses guaranteeing for contracts, CME Group’s trading volume in futures are currently declining and risk managers are rethinking their hedging strategies. (Hull, 2012a, p. 38) (Weitzman & Meyer, 2012) (Lamar, 2012) Regardless the current situation, futures contracts are a fundamental risk management instrument. Characteristics of futures contracts are their standardised features (unlike forward contracts) and varying delivery months depending on the underlying asset. CME Group (2012c) for example settles energy futures like heating oil or gasoline every month, whereas agricultural products like wheat or corn are only delivered in March, May, July, September and December.

Because future contracts are highly standardised, chapter three will demonstrate the use of futures contracts by hedging foreign exchange risk exemplarily for future contracts with different underlying assets.

Since futures contracts exist with a variety of underlying assets, their traders come from different backgrounds all along the commodity chain (Gibbon, 2000). Ederington and Lee (2002, p. 356) established a classification for potential hedgers on the heating oil market - ranging from refiners, pipeline companies to commercial banks and end users. The CFTC (2012) categorises their clients as commercial, non-commercial and non-reportable. Commercial traders hold their contracts for hedging purposes, while owning the underlying asset and the futures contracts on that asset. Non-commercial traders hold only positions in futures contracts, but do not own the underlying asset. Finally, non-reportable traders are usually small traders, not meeting reporting standards set by the CFTC.

With regards to market participants, Anderson and Ibendahl criticised (2000, p. 1) that futures may not be attractive to all commodity chain participants and are predominantly used by large corporations. Especially those lacking financial means to post the margin or cover margin calls, and those having limited production capacity find it hard to fulfil the futures contracts’ requirements. Alternatives are options on futures contracts, which avoid futures’ negative aspects, by establishing price floors, offering benefits from favourable price changes and having lower entry requirements. (Anderson & Ibendahl, 2000, p. 1; Nance, et al., 1993, p. 268)

Carlton (1984, p. 240) added that another real world complication is the variety or location of the underlying asset, which may differ from the one specified in the contract. Especially with regard to products of various qualities, like wheat where quality and price differ from town to town, using standardised futures contracts to hedge risk is difficult.

3 Application

In this chapter the hedging of transaction exposure will be explained based on a practical example. Transaction exposure exists when future cash flows are affected by exchange rate fluctuations (Madura, 2003, p. 333).

Although this particular example focuses on hedging exchange rate risk, the overall issue that futures contracts shall eliminate is always the same - the risk of price movements. Therefore, the basic techniques used in this example are universally applicable to other types of futures contracts.

3.1 Problem definition

Suppose a US company has concluded a contract on the 17th October 2012 with a German company to buy a large machine for 1,000,000EUR. The payment is due upon delivery on the 19th December 2012. The USD/EUR spot rate on 17th October 2012 is 1.3122USD/EUR. The following subchapter will now evaluate the risk the US company is exposed to when either exchanging USD to EUR at October’s spot rate or exchanging the currency at the spot rate in 2 months time. After that the actual hedging procedure with future contracts will be demonstrated.

3.2 Risk exposure

3.2.1 Exchange of foreign currency at spot rate in October

One possibility to convert USD to EUR is at the spot rate on the 17th October 2012 (see Figure 1): 1,000,000EUR are 1,312,200USD at an exchange rate of 1.3122USD/EUR.

The risk in this transaction is that the USD may loose value against the EUR until December and the cost for the US company to buy EUR would have fallen, in comparison to the amount payable at spot-rate in October.

If however the USD would increase in value against the EUR, the US company would have done it correctly to exchange USD to EUR at spot rate in October because otherwise they would have to pay a higher amount of USD to receive 1,000,000EUR.

[...]