Chapter 3-2 Hedgers and Speculators
The two most common uses for futures contracts are hedging and speculation. Hedging is defined as the purchasing of protection to mitigate the risk of an assed losing value. Speculation is defined as the purchasing of an asset based on an opinion of the future value of that asset. In essence, hedgers seek protection while speculators seek profit. Hedging often takes two forms- companies hedge to lock in their prices for the purchase or sale of tangible assets that they intend to use while investors hedge to protect the value of their investment accounts. Investors often choose options over futures because the premiums, or cost of the option, may be more suited to their investment style or account size. Because of their elective nature, options provide their holders with the flexibility they desire, often enough to justify the premium paid. Companies, however, often have a decision to make. Generally speaking, the more likely a payment is the more appropriate hedging with futures becomes. This makes sense because if a cash flow is uncertain a company is better off having the right to exchange the funds rather than the obligation. Imagine if you were forced to convert a large amount of money into an asset for a purpose you no longer needed!
The following are several examples of how hedging and speculation occur in the futures market:
The airline industry is one of the largest industries in the global economy. Airlines have two major recurring expenses- people and jet fuel. Airlines employ hundreds of thousands of people around the world, but this expense is pale in comparison to the amount of money they spend fueling up their fleets. The main ingredient in jet fuel, crude oil, is the most heavily traded futures contract around the world. The price of crude oil is subject to a number of political and economic forces and as a result is fairly volatile despite its high liquidity. To combat this volatile airlines use futures to hedge their exposure to fluctuations in the price of crude oil. Furthermore, by locking in their prices in advance airlines are better able to forecast their expenses and set ticket prices.
Consider the following examples of hedging fuel prices in the airline industry:
- At the beginning of September crude oil is trading at $80
- An airline has presold flights that will consume 1 million barrels of oil during December for $90,000,000
- The airline decides to purchase futures at $78.75
- At the beginning of December crude oil is trading above $88
- Cost savings is almost $10 million
- Profits are $11,250,000 with the futures vs. $2,000,000 without
This can be shown graphically:
As you can see in the above example hedging costs with futures can make a major impact on the costs incurred by businesses. In the previous example the company saved several million dollars, no small feat. However, this is not always the case. The following example shows the downside risk to hedging with futures.
Consider the coffee farmer who has begun harvesting 50,000 standard lots of beans to be sold at the end of the year. In an effort to expand his business in the New Year he decides to plant twice as much as he turns over the land. This requires a capital injection, and thus the farmer sells his entire harvest in the futures market at the end of September.
- At the end of September the farmer sells his beans for $175
- The farmers revenue from the sale is $8,750,000
- Over the next 3 months global demand for coffee increases during the winter months and coffee beans appreciate to well above $200
- At the end of the year the spot price of coffee is $224.65
- The farmers beans are now worth $11,232,500
- Unfortunately, the farmer has already sold for $8,750,000 and misses out on a little over $2.5 million
This can be shown graphically:
As you can see in this example the coffee farmer, in an effort to raise cash in the immediate term, lost out on the appreciation of his product. This is a common occurrence in the commodities market as producers are constantly trying to get the best price for their goods while minimizing risk. Had the price of coffee decreased significantly the farmer would have looked like a genius, but unfortunately that was not the case.