Hedging with Futures - Back to Back Operations

Market commonly takes place at Commodity

Exchanges which act as CLEARING HOUSES
Future markets trade contracts for future delivery
A futures contract is an agreement to make or
take future delivery of a commodity at a price
agreed to today
Future contracts are standardized in time, place,
quality and quantity of delivery
Future contracts are contractual in nature, but not
necessarily directly between producers and
buyers as other risk takers might be willing to act
as the counterparty and thus provide liquidity to
the market (usually these are very liquid markets
both in & out)

Hedging with Futures

FUTURES Contracts

Hedging with futures involves taking a position thru a

Financial Instrument in a Commodities Exchange

This position has to be equal and opposite to that which is
held on PHYSICALS side
A gain in one side (either the PHYSICALS side or the
FINANCIAL INSTRUMENTS side) should be OFFSET by a
corresponding loss on the other side
When a coffee trader holds a long physical position in a
commodity he is exposed to the risk of a price fall ie, the
trader does not know the price at which he would be able
to sell his coffee in the future
This risk can be managed or hedged by taking out an
offsetting short futures position

Hedging with Futures

FUTURES Contracts

Once the hedge is in place, price movements causing gains

(losses) on the physical position are offset by losses (gains)
on the futures position
BACK to BACK hedging requires HIGHLY correlated prices
between domestic markets and commodities exchanges
(Basis Risk)
On BACK TO BACK hedging operations, Commodities
Futures Exchanges supply a counterparty for those cases
when seasonality of S&D does not allow for two
counterparties to encounter themselves at the market
place to celebrate a business contract
Whenever a counterparty is encountered then the hedge
at the Commodities Exchange is lifted

Hedging with Futures

FUTURES Contracts

Coffee traders can either buy or sell futures contracts to

take a position, this is known as taking a LONG or a
SHORT position

LONG POSITION

SHORT POSITION

BUY futures contracts

SELL futures contracts

On date of contract expiry holder of the

long futures position will receive
delivery of the contracted quantity and
quality at the price determined at time
of buying the futures

On date of contract expiry seller of the

futures contracts will have to deliver
the contracted quantity and quality at
the price determined at time of selling
the futures

Hedging with Futures

FUTURES Contracts Short Hedge Example
SHORT HEDGE
This involves a short position in the
futures contract
Applicable when a trader already owns
coffee and expects to sell it in the future
PLACE HEDGE
160.00 futures price
155.00 physical coffee price
-5.00 basis
LIFT HEDGE
192.00 futures price
187.00 physical coffee price
-5.00 basis

NET SALE PRICE

187.00 physical coffee sale less 32.00
futures loss (sold at 160.00 and bought
back at 192.00) equals 155.00 net price

PHYSICAL POSITION

FUTURES POSITION

APRIL:

APRIL:

Buy Coffee at 155

cents / lb

Sell futures contacts

at 160 cents / lb

for sale in September

(155 + 5 cents basis)

September international coffee price at 192 cents / lb

SEPTEMBER:

SEPTEMBER:

Sell Coffee at 187

cents / lb

Buy futures contacts

at 192 cents / lb

(32 cents/lb gain)

(32 cents/lb loss)

Hedging with Futures

FUTURES Contracts Long Hedge Example
LONG HEDGE

PHYSICAL POSITION

This requires taking a long position in the

futures contract

APRIL:
Appropriate when a trader would
purchase coffee in the future and is
interested in locking in the price now

PLACE HEDGE
160.00 futures price
155.00 physical coffee price
-5.00 basis
LIFT HEDGE
192.00 futures price
187.00 physical coffee price
-5.00 basis
NET PURCHASE PRICE
187.00 physical coffee sale less 32.00
futures loss (sold at 160.00 and bought
back at 192.00) equals 155.00 net
purchase price

Contract to sell coffee

in September at
155 cents/lb

FUTURES POSITION
APRIL:
Buy futures contacts
at 160 cents / lb
(155 + 5 cents basis)

September international coffee price at 192

cents / lb
SEPTEMBER:

SEPTEMBER:

Buy Coffee at 187

cents / lb

Sell futures contacts

at 192 cents / lb

(32 cents/lb loss)

(32 cents/lb gain)

Hedging with Futures

FUTURES Contracts Types of Future Contracts
Key Terms:
MARKET ORDER
Executed at best available price on market

LIMIT ORDER
Execute order only till a target minimum or maximum price

STOP-LOSS ORDER
Executed if market reaches a particular price, to cap losses
GOOD TILL CANCELLED ORDER
Order remains on the market unless cancelled
Normally, orders are good for the date only

Hedging with Futures

FUTURES Contracts

Delivery process may be required, if contract is held to maturity

As such it is best to off-set the transaction prior to contract expiry
to avoid hassles of giving/ taking delivery on a global warehouse
Liquidate the contract
- if you bought it, sell
- if you sold it, buy it back
Gain/loss determined by the sale/purchase differential
Financial settlement
- some exchanges may provide for financial settlement of
contract, especially if trading lot size and delivery lot size are not
matched

Hedging with Futures

FUTURES Contracts Placing & Lifting Hedges

Definitions:
Placing a hedge refers to either the selling of
futures contracts or the purchasing of futures
contracts
Offsetting a hedge is also known as lifting a
hedge. This involves closing down a position by
either purchasing futures to negate previous sales
of future contracts, or selling futures to negative
previous purchases of futures contracts

Hedging with Futures

FUTURES Contracts Margins
Brokers/ traders place a good faith deposit with the clearing house/
exchange in return for the benefit of novation
This is the initial margin deposit
Objective is to minimize possibility of loss due to default
Investors provide cash or other acceptable security to the broker
Initial margins may be charged as a fixed amount per contract, or as a
percentage of the market value of the contract, this varies as per rules of
the clearing house/ exchange
Mark-to-market gains/ losses increase/ decrease the balance in the margin
account
When the balance falls to the level of the specified maintenance margin,
the holder of the positions is required to top-up the balance back to initial
margin level

Hedging with Futures

FUTURES Contracts Margins

Financial gain or loss on a futures trade depends on the

difference between the initial price and the price when the
position is closed. When futures are used to hedge exposure of
physicals traded any losses or gains should be mostly offset by
the losses or gains on the physicals

An initial margin deposit (usually 10% of the futures contract

value) is required, and daily profits and losses are credited to
this margin account.
Because unlimited additional margin calls can be made
whenever a traders futures position experiences continued
losses, trading futures requires significant reserves of cash
and/or credit
Brokerage fees are an additional cost when utilizing futures

Hedging with Futures

FUTURES Contracts Advantages & Limitations to their use
Advantages of using Futures:
1. Common platform for all traders
2. Price transparency
3. Lower transaction costs
4. Absence of counterparty credit risk
5. Market prices available to wider world
6. Liquid Market
7. Standardized contract size
8. Thus, futures contracts can be a cost-effective solution as compared to
over-the-counter contracts
Limitations of using Futures:
1. Basis Risk
2. Physical volume risk
3. Imperfect gains and losses in futures markets wont exactly match
gains and losses from the physical market

Hedging with Futures

FUTURES Contracts - Summary
Futures can be used to assist traders in hedging their exposure to
coffee price movements
Futures can be useful when a trade can not rely solely on physical
trading to control their exposure
Futures enable traders to take financial positions which are equal and
opposite to their physical positions, hence protecting their businesses
from coffee price volatility
Futures are not perfect and traders must take account of basis when
using futures to manage their risk exposure
We shall now consider the use of options contracts for hedging
operations