Futures Contracts and Hedging Strategies

Futures Contracts

• Futures contracts are standardized forward contracts.
• They are traded on organized exchanges like the CME (North America), MFE (Canada), WCE (Canada), PBOT, MidAmerica Commodities Exchange, Tokyo International Financial Futures Exchange, and London International Financial Futures Exchange.
• Standardizations include quantity, quality (not always required in financial futures), delivery dates/procedures, and delivery prices of underlying assets.
• Types include commodity (gold, oil, wheat), stock, and index futures.

Hedging with Futures

• Hedging allows counterparties with offsetting risks to eliminate risk (e.g., farmer and cereal manufacturer).
• Hedgers can transfer risk to speculators.
• Speculators absorb price risk from hedgers.

Speculation in Futures

• Speculators don't need to meet; terms are standardized.

• Speculation involves going long (expecting price increase) or short (expecting price decrease).

• Example: Speculating on copper futures: Buying 10 contracts of 25,000 pounds of copper, at USD$0.70/pound delivers profit or loss of USD$12,500 per 5 cent price movement.

Interest Rate Swaps

• Interest rate swaps exchange fixed-rate payments for floating-rate payments on similar loans (e.g., Company A with fixed 7% and Company B with adjustable rate).
• They are common in multinational corporations.
• Two main types: Fixed-for-floating interest rate swaps, and currency swaps (one currency/rate for another).
• Companies borrow where they have a comparative advantage, then swap to match needs.
• No standardized market for swaps.

Credit Default Swaps

• Credit default swaps are insurance-like instruments, not swaps.
• Buyers bet against a financial product (e.g., bond), hoping it will default, similar to an insurance premium.
• Example: The Big Short movie illustrates the 2007-2008 housing bubble crisis, showing the role of credit default swaps in the crisis.
• No regulation for derivatives.

Hedge Funds

• Hedge funds are private investment funds for wealthy investors, managed by professional managers.
• They are called "hedge funds" because their investment performance isn't always closely tied to the overall stock market.
• They can invest in virtually anything: stocks, bonds, government securities, currencies, derivatives, commodities, tangible assets, closely held companies, and can use leverage by borrowing funds or shorting stock.