Understand how corporations utilize futures to manage risks, gain insights on practical examples, and discern differences and similarities between forward and futures contracts.
Corporations use futures to manage risk in the same way that investors do. When a company needs to lock in the purchase price of an asset, it may decide to buy futures on the asset. Similarly, when a company needs to lock in the sale price of an asset, it may decide to sell futures on the asset.
Even though they take futures positions consistent with their risk management needs, companies usually offset their positions before expiration, rather than actually making or taking delivery of the underlying asset. However, futures can still satisfy a company’s risk management needs by providing price protection.
Scenario: In July, a brewery determines that it will need 100 tonnes of barley in October. Barley is trading in the spot market at $150 a tonne, and October barley futures are trading at $155 a tonne. The brewery’s regular barley supplier will not guarantee a fixed price for the October purchase, but instead will charge the spot price on the day that the brewery places the order. To protect itself from a sharp increase in the price of barley, the brewery buys five October barley futures at the current price of $155. Each barley futures contract has an underlying asset of 20 tonnes of barley.
October: In early October, barley is trading at $170 per tonne in the spot market. At the same time, October barley futures are trading at $171 per tonne. Rather than take delivery by holding its futures position until the expiration date, the brewery would like to buy the barley from its regular supplier. There are three reasons why the brewery might want to deal with its regular supplier:
The brewery’s operations may be located far from the standardized delivery location for barley futures.
If the brewery were to take delivery of the barley, it would incur the expense of shipping the barley from the delivery location to its own location.
The exact quality of the barley that underlies the barley futures contract may not match the quality the brewery normally uses. The brewery’s regular supplier would presumably be able to deliver the required quality.
The standardized delivery date of the barley futures contract may not coincide with the exact date that the brewery requires the barley. Again, the regular supplier would likely be able to deliver on the date the brewery required.
To get out of its obligation to buy barley by way of the futures contracts, the brewery offsets its position by selling five October barley futures at the current price of $171 per tonne. Because the price has risen, and the brewery had a long position, it earns a profit of $16 per tonne on the futures transactions.
At the same time, the brewery places an order to buy 100 tonnes of barley from its supplier. The supplier charges the brewery the current spot price of $170 per tonne. The brewery’s effective price, however, is lower because of the futures profit. The net effect is that the brewery ends up paying $154 per tonne (i.e., $170 purchase price minus $16 futures profit). So, even though barley rose $20 from late July to early October, the price the brewery actually pays is only $4 higher than the price back in July. The futures contract provided the brewery with price protection for the majority of the price increase. This process illustrates how companies use futures for price protection, rather than as an outlet to buy or sell the underlying asset.
| Forwards | Futures |
|---|---|
| Privately negotiated between two parties | Traded on organized exchanges |
| Non-standardized contracts | Standardized contracts |
| Higher counterparty risk | Lower counterparty risk due to clearing house |
| Settlement at maturity | Daily settlement (mark to market) |
Q1: How do futures help corporations manage risk?
Futures allow corporations to lock in purchase or sale prices of assets, thus providing price certainty and protection against unfavorable price movements.
Q2: Why do companies generally offset futures positions rather than taking delivery?
Companies often offset positions to avoid logistical complications, ensuring that the contract’s specifications meet their exact needs and minimizing extra costs, such as transportation.
Q3: How does a corporation benefit from a rise in asset prices when holding a long futures position?
A corporation can benefit from a rise in asset prices by selling the futures contracts at a higher price, thereby realizing a profit which can offset any increased costs in the spot market.
Q4: What are the primary differences between forwards and futures contracts?
The primary differences are in their structure, counterparty risk, and settlement methods, with futures being standardized and exchanged-traded, thus generally involving lower counterparty risk.