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10.6.5 Futures Strategies For Corporations

Understand how corporations utilize futures to manage risks, gain insights on practical examples, and discern differences and similarities between forward and futures contracts.

Futures Strategies for Corporations

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.

Practical Example

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:

  1. The brewery’s operations may be located far from the standardized delivery location for barley futures.

  2. 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.

  3. 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.

  4. 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 and Futures

Differences Between Forwards and Futures Contracts

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)

Similarities Between Forwards and Futures Contracts

  • Both are used as derivatives to hedge against price risks.
  • Both involve an obligation to buy or sell an asset at a future date.
  • Both can be used for speculative as well as hedging purposes.

Key Takeaways

  • Risk Management: Futures offer corporations an effective way to manage price risks associated with various assets.
  • Offsetting Positions: Corporations usually offset futures positions before expiry to avoid taking actual delivery of the asset.
  • Price Protection: Futures can provide significant protection against price increases, as illustrated by the example of the brewery.
  • Understanding Forwards and Futures: Knowing the differences and similarities between forwards and futures can aid in choosing the best financial instruments for hedging purposes.

Frequently Asked Questions (FAQs)

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.

CSC® Exams Practice Questions

📚✨ CSC Exam Questions ✨📚

Welcome to the Knowledge Checkpoint! You'll find 10 carefully curated CSC exam practice questions designed to reinforce the key concepts covered. These questions will help you gauge your grasp of the material, identify areas that need further review, and ensure you're on the right track towards mastering the content for the Canadian Securities certification exams. Take your time, think critically, and use these quizzes as a tool to enhance your learning journey. 📘✨

Good luck!

## Why do corporations engage in futures contracts? - [ ] To invest in new opportunities - [ ] To speculate on price changes - [ ] To comply with regulatory requirements - [x] To manage risk and lock in prices > **Explanation:** Corporations use futures contracts primarily to manage risk and lock in prices for assets they need to buy or sell, not for speculative reasons. ## What do companies typically do with their futures positions before the contract's expiration? - [ ] Hold till expiration for physical delivery - [ ] Convert them into forward contracts - [x] Offset them before expiration - [ ] Turn them into exchange-traded funds > **Explanation:** Companies usually offset their futures positions before expiration to avoid physical delivery and nonetheless achieve their risk management objectives. ## Why might a company prefer not to take delivery of the actual commodity futures? - [ ] They do not trust the futures exchange - [ ] The quality of the underlying commodity is unknown - [ ] They are concerned about regulatory scrutiny - [x] Due to logistical issues like location, quality, and timing > **Explanation:** Companies prefer not to take delivery due to logistical issues such as delivery location, commodity quality, and timing that may not align with their specific needs. ## What initial action does the brewery take in the example provided? - [ ] Sells 100 tonnes of barley in the spot market - [x] Buys five October barley futures contracts - [ ] Enters a forward contract for barley - [ ] Buys barley directly from the supplier > **Explanation:** The brewery buys five October barley futures contracts to lock in the price and protect against future price increases. ## How much does the brewery earn per tonne from the futures transactions? - [ ] $15 - [x] $16 - [ ] $20 - [ ] $171 > **Explanation:** The brewery earns a profit of $16 per tonne as it sells the futures at $171 per tonne, having bought them at $155 per tonne. ## What is the brewery’s effective price per tonne of barley after accounting for futures profit? - [ ] $150 - [ ] $155 - [ ] $170 - [x] $154 > **Explanation:** The brewery’s effective price per tonne of barley is $154, which is the $170 spot price minus the $16 profit from futures. ## Which of the following is NOT a reason for the brewery to deal with its regular supplier? - [ ] Location of brewery operations relative to delivery location - [ ] Quality consistency of barley - [x] Higher future prices - [ ] Preferred delivery date matching > **Explanation:** All other options are valid reasons. Higher future prices are not related to why the brewery would deal with its regular supplier instead of using futures. ## How does the usage of futures help the brewery when prices rise sharply? - [ ] It eliminates the need to purchase barley - [ ] It ensures the brewery gets barley for free - [x] It provides price protection - [ ] It allows for immediate delivery > **Explanation:** The use of futures provides price protection for the brewery, mitigating the impact of sharp price rises. ## What role does the underlying asset's quality play in the brewery's decision to use its regular supplier? - [ ] It is irrelevant because barley is a standard commodity - [ ] It guarantees better transportation conditions - [x] Different quality might not meet the brewery’s standards - [ ] It affects the regulatory compliance > **Explanation:** The quality of the underlying asset might not meet the brewery’s standards, which is why the brewery prefers its regular supplier. ## What demonstrates the brewery’s use of futures for price protection rather than purchasing the asset? - [ ] Holding the contract until expiration - [x] Offsetting their position to gain a price benefit - [ ] Engaging in speculative trading - [ ] Using only forward contracts > **Explanation:** The brewery offsets its position to gain a futures profit, demonstrating the use of futures for price protection rather than for purchasing the underlying asset.

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Sunday, July 21, 2024