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Futures and Hedging Explained

The futures market is an organised exchange in which futures contracts are bought and sold. Futures contracts may be used by hedgers to transfer, to another party, a risk exposure associated with an underlying financial transaction. The ‘other party’ may be a speculator who takes a position in the market based on their expectations about changes in the price of the contract during the period through which they hold the contract.

A hedger will enter into a futures contracts today at a price based on the underlying physical market product. At a later date, the hedger will close out its futures position by taking an opposite contract at a price based on current market yields. The difference between the two contract prices will represent either a profit or loss to the hedger. In a borrowing hedge, the hedger will make a profit on its futures market transactions if yields rise. However, the cost of borrowing will be higher in the physical market. This higher cost of borrowing will be offset by the profit made in the futures market, thus lowering the net, or effective, cost of borrowing.

The essence of the hedging strategy is to open a futures position ‘today’ that requires a closing transaction that is the reverse of the exposed transaction in the physical market. For example, if a business is to borrow at a future date through the sale of bank bills, it would sell bank bill futures contracts ‘today’ and close out its futures market position by buying the contracts on the day that it sells its bank bills in the physical market.

While futures contracts are useful in hedging, it is important to recognise that a perfect hedge may not be possible. Where the dollar value of the exposure is not perfectly matched by the dollar value of the futures contract, a small exposure will remain.

A more significant risk arises from the fact that price movements in the physical market may not be perfectly matched by price movements in the futures contract. The difference in prices between the two markets is referred to as ‘basis risk’. Initial basis risk may occur at the implementation of the futures hedging strategy, while final basis risk may occur when the futures position is closed out and the related physical market transaction takes place.

Another risk arises when, due to the limited range of futures contracts, the hedger uses a futures contract in a commodity that is not the same commodity as the one in which the exposure is experienced.

When a futures contract is entered into, a deposit or margin call is required to be paid to the clearing house. Futures market participants must also be aware of the risk that they will be called upon to meet future margin calls if contract prices mover adversely. Failure to meet the call results in the futures position being closed out by the exchange.

Forward Rate Agreements (FRAs) are tailor-made over-the-counter futures contracts. Unlike futures contracts, FRAs do not have a standard contract size or delivery date; nor are margins a feature of the FRA market. Through an FRA, a borrowing or lending rate of interest can be fixed ‘today’ The agreement related only to the rate of interest on a specified notional principle. The FRA dealer does not take responsibility for providing or taking the principal amount. The agreement will be based on a future reference interest rate such as BBSW. At the settlement date, one party to the FRA will compensate the other party for any movement in interest rates between the agreed FRA date and BBSW.  In a borrowing hedge, the writer of the FRA will compensate the buyer if interest rates have risen. The compensation receipt will offset the current higher cost of borrowing in the physical market.