The Hindu Business Line : Futures, sans uncertainty

We now know the distinguishing features of forward and futures contracts. We also know that futures contracts are standardised forward contracts traded on regulated exchanges.

In sum, a futures contract is an agreement between two parties to buy or sell an asset of a specified quantity and quality at a specified time in future, at a specified price, through the exchange.

Why do we need futures trading? There are risks inherent in every economic activity. It is said that there is no worthwhile reward without risk. If the economic activity or business process is longer, greater is the uncertainty and the risk.

For instance, if exporter A wants to sell a commodity today for delivery, say, 10 days hence, his risk of adverse price changes is limited to that period. But if he wants to sell today for delivery, say, four months hence, he runs the risk of adverse price changes over a longer time frame.

Dramatic changes can happen in four months. Therefore, the longer the process, the greater the uncertainty and risk associated with the transaction. Someone must manage this risk scientifically. Futures market does that.

Two major functions

There are two major functions of futures trading — price discovery and price risk management.

Price Discovery: It is one of the principal benefits of futures trading. Market participants constantly look for information relating to transactions and, importantly, prices at which deals happen.

Not many traders are equipped in terms of product and market knowledge to take informed decisions to trade in forward positions. Traders usually look for price signals and reports from peers. Ready delivery contracts and forward contracts are customised and the transaction details are usually not in public domain.

On the other hand, a futures contract has necessarily to be registered with a recognised commodity futures exchange, and the price at which it takes place has to be disseminated. This helps every market participant discover forward prices. Anyone who wants to take a view on a commodity price, say, three months from now is able to discover that price based on transactions at the exchange for that forward month.

Price discovery is of great significance to market participants. Whether primary producers, processors, traders, exporters, importers or consumers, they can find out the price at which market participants trade, something that will give them an indication of the expectation of market participants about the likely price behaviour of a commodity at a future point of time.

Indeed, policymakers, governments and researchers can use it to obtain price signals. This would help players plan their strategies or take informed decisions about their own forward pricing. Knowledge of forward prices helps producers and consumers plan their business operations, including management of raw material and finished goods inventory, marketing, pricing, cash flow, etc.

For instance, price discovery helps producers plan production, inventory, marketing and pricing, while consumers can plan their purchases and other activities. Traders benefit, as the price discovery creates flexibility in business and helps them switch from one commodity to another. Investors or speculators, of course, profit from being able to manage their risks better.

Price Risk Management: It is the most vital function of commodity futures trading. It helps market participants insure against adverse price movements in future. When players in the physical market make forward commitment for purchase/sale of commodities, they run the risk of adverse price changes. They can manage the risk better by hedging in the futures market.

What is hedging? Hedging involves off-setting an existing or anticipated risk in the business by taking an opposite position on the futures exchange in order to mitigate the price risk. Hedge transactions on the exchanges are designed to protect the normal business profits from adverse price fluctuations.

In other words, players can lock-in their normal business profits by resorting to hedging. Put simply, hedging is nothing but transferring the risk you carry to someone else willing to assume the risk.

Example: Assume A, a trader, wants to enter into a contract in June for delivery of, say, groundnut in October. Groundnut crop is in the making and no one knows how the crop will shape up and what the prices will be at the time of harvest. To get a market view of prices in October, A will go to a futures exchange and look at prices at which October Groundnut Contract is traded. That will give him an indication of how others in the market view groundnut prices in October.

After discovering prices for October, A takes a view, based on his judgment and experience, about pricing his contract for supply of groundnut in October.

Having entered into the export contract, A surely runs the risk of prices going against him (similarly, the buyer too runs the risk of adverse price changes) in October depending on progress of monsoon, acreage, crop size, quality, and so on. So, A would go to a futures exchange to hedge his price risk and protect his profit margin.

Next week, we shall see how A would hedge his price risk.

Please send suggestions and queries to younginvestor@thehindu.co.in, or

The Research Bureau,

The Hindu Business Line,

859-860, Anna Salai, Chennai-600002.

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