Understanding Hedgers and Speculators in Futures Markets: Risks and Opportunities, Study notes of Investment Management and Portfolio Theory

Download Understanding Hedgers and Speculators in Futures Markets: Risks and Opportunities and more Study notes Investment Management and Portfolio Theory in PDF only on Docsity! y g ( ) Lesson # 42 FUTURES Contd… Using Futures Contracts: Who uses futures, and for what purpose? Traditionally, participants in the futures market have been classified as either ledgers or speculators. Because both groups are important in understanding the role and functioning of futures markets, we will consider each in turn. The distinctions between these two groups apply to financial futures as well as to the more traditional commodity futures. Hedgers: Hedgers are parties at risk with a commodity or an asset, which means they are exposed to price changes. They buy or sell futures contracts in order to offset their risk. In other words, hedgers actually deal in the commodity or financial instrument specified in the futures contract. By taking a position opposite to that of one already held, at a price set today, hedgers plan to reduce the risk of adverse price fluctuations—that is, to hedge the risk of unexpected price changes. In effect, this is a form of insurance. In a sense, the real motivation for all futures trading is to reduce price risk. With futures, risk is reduced by having the gain (loss) in the futures position offset the loss (gain) on the cash position. A hedger is willing to forego some profit potential in exchange for having someone else assume part of the risk. How to Hedge with Futures: The key to any hedge is that a futures position is taken opposite to the position in the cash market. That is, the nature of the cash market position determines the hedge futures market. A commodity or financial instrument held (in effect in inventory) represents a long position, because these items could be sold in the cash market. On the other hand, an investor who sells a futures position not owned has created a short position. Since investors can assume two basic positions with futures contracts, long and short, there are two basic hedge positions; 1. The short (sell) hedge: A cash market inventory holder must sell (short) the futures. Investors should think of short hedges as a means of protecting the value of their .portfolios. Since they are holding securities, they are long on the cash position and need to protect themselves against a decline in prices. A short hedge reduces, or possibly eliminates, the risk taken in a long position. 2. The long (buy) hedge: An investor who currently holds no cash inventory (holds no commodities or financial instruments) is, in effect, short on the cash market; therefore, to hedge with futures requires a long position. Someone who is not currently in the cash market but who expects to be in the future and who wants to lock in current prices and yields until cash is available to make the investment can use a long hedge which reduces the risk of a short position. Hedging is not an automatic process. It requires more than simply taking a position. docsity.com y g ( ) Hedgers must make timing decisions as to when to initiate and end the process. As conditions change, hedgers must adjust their hedge strategy. One aspect of hedging that must be considered is "basis" risk. The basis for financial futures often is defined as the difference between the cash price and the futures price of the item being hedged: Basis = Cash price - Futures price The basis must be zero on the maturity date of the contract. In the interim, the basis fluctuates in an unpredictable manner and is not constant during a hedge period. Basis risk, therefore, is the risk hedgers face as a result of unexpected changes in the basis. Although changes in the basis will affect the hedge position during its life, a hedge will reduce risk as long as the variability in the basis is less than the variability in the price of the asset being hedged. At maturity the futures price and the cash price must be equal, resulting in a zero basis. The significance of basis risk to investors is that risk cannot be entirely eliminated. Hedging a cash position will involve basis risk. Speculators: In contrast to hedgers, speculators buy or sell futures contracts in an attempt to earn a return. They are willing to assume the risk of price fluctuations, hoping to profit from them. Unlike hedgers, speculators typically do not transact in the physical commodity or financial instrument underlying the futures contract. In other words, they have no prior market position. Some speculators are professionals who do this for a living; others are amateurs, ranging from the very sophisticated to the novice. Although most speculators are not actually, present at the futures markets, floor traders (or locals) trade for their own accounts as we'll as others and often take very short-term (minutes or hours) positions in attempt to exploit air short-lived market anomalies. Why speculate in futures .markets? After all one could speculate in the underlying instruments. For example, an investor who believed interest rates were going to decline could buy Treasury bonds directly and avoid the Treasury bond futures market. The potential advantages of speculating in futures markets include: 1. Leverage: The magnification of gains (and losses) can easily be 10 to 1. 2. Ease of transacting: An investor who thinks interest rates will rise will have difficulty selling bonds short, but it is very easy to take a short position in a Treasury bond futures contract. 3. Transaction costs: These are often significantly smaller in futures markets. By all accounts, an investor's likelihood of success when speculating in futures is not very good. The small investor is up against stiff odds when it comes to speculating with futures contracts. Futures should be used for hedging purposes. FINANCIAL FUTURES: This section covers financials futures mostly from a speculator’s perspective. The following two chapters, dealing with the management of equity portfolios and fixed income portfolios, show other uses from the hedger’s point of view. The chapters explain how financials futures can logically be used to improve e a portfolio’s characteristics. docsity.com