Futures Exchange Notes - Questions
Question 5 (10 Marks)
(1)Distinguish between Hedging and Speculation with respect to future contracts. (2 Marks) The Futures Exchange is used for both Hedging and Speculation. Hedging aims to reduce risk by buying and selling futures contracts. In theory all risk associated with a change in the price of an item can be removed. Hedging will provide a guaranteed price for a future purchase or sale of a commodity or financial asset. The Hedge prevents any losses that might have resulted from a price change. Equally it forgoes any profits that might result from a price change. For example a woolgrower who intends to sell wool in the future could sell a wool futures contract now to hedge against any future price fall. A jeweller who intends to buy gold in the future could buy a gold futures contract to hedge against any future price rise. The speculators, rather than removing risk, increase their exposure to risk. This exposure will result in a profit or loss depending on whether prices rise or fall. Speculators make profits by their ability to predict changes in the futures price. The speculators return can be extremely high or extremely low. This is especially true because the amount invested is not equal to the total value of the contract but only the amount required to be deposited with the Sydney Futures Exchange (SFE). Speculators have no wish to take delivery of the commodity or settle at maturity. Contracts are discontinued (Closed out) before maturity and profits taken or losses minimized.
(2) Explain the “novation process” in relation to the Futures Exchange. (2 Marks) Novation is also used in futures/options trading markets to describe a special situation where the clearing house takes all positions with all the brokers, buying all the brokers sell, and selling all that the brokers buy.
(3) A hedge is required by a wool grazier who will seek to sell wool in 2 months.
The woolgrower sells a future contract immediately at the price of $555. When the date of sale arrives the wool spot price has fallen to $495. The woolgrower reverses (closes) the future contract by buying futures at $498 and the sale of wool takes place at $495.
You are required to answer the following:
1. Total proceeds if hedge did not take place (2 Marks)
2. Total proceeds if hedge did take place. (2 Marks)
3. To what extent was the woolgrower protected from the risk of a price fall. (2 Marks)
1. Proceeds at spot price $495
2. Proceeds of futures contract $555
Less Cost of buying Futures Contract to close out position $498
Gain from hedging 57
Plus sale of wool at actual spot price $495
Total Proceeds $552
3. Value of futures contract less “discount” offered on buy contract to close out position
Sell contract $555
Cost to close out position 3
Value of protection $552
That is prices could drop to zero and the seller would still be covered for $555
In this case the hedge has cost him $3 but has saved him a potential loss of $60.
So the Futures Exchange becomes a clearing house – the buyer for every sell contract and the seller for every buy contract.
They operate a trading account for Contracts eg
WoolGrowers Futures Trading AccountContract to Buy / $ 498.00 / Contract to Sell / $ 555.00
What if price rises – Woolgrower could close out his position early – but remember the whole point of him entering into Futures contracts is to provide protection up until the time he is ready to sell his wool – that is the futures contract is his insurance that he will get a guaranteed price for his wool around the $555 mark. Prices could climb to $600 – he could close out his position at this point with another two weeks to go before he is ready to sell his wool and hope that prices rise further – but what if prices drop back down in the last two weeks below $555 – he has lost his protection.
So what is his position if prices stay at $600 when he is ready to sell
Proceeds at Spot price on sale of wool $600
Proceeds from Sell Contract $555
Less Cost to close out position with Buy Contract at say $602 ($602)
Net position achieved $553
His hedge works if prices rise or if prices fall as low as $1 as long as he closes out his position at the same time he sells the actual commodity.
What is it like from the speculators point of view.
Current price of a commodity $500 – speculator takes out a buy contract for $500 and pays a 10% deposit. – that is $50. The speculator is hoping for a price rise.
Say the price rises to $522 – he will close out his position by taking out a sell contract at $520 (easy to find a buyer at $520 since the spot price is $522.
Return for speculator
Proceeds of Sell Contract $520
Less But Contract 500
Gain on Speculation $20
Return 20/50 = 40%
There is a risk the price could drop to $482 – speculator closes out his position by taking out a Sell Contract at say $480 – since current price is $482 fairly easy to find a buyer
Proceeds of Sell Contract $480
Less But Contract 500
Loss on Speculation $20
If price drops to $450 he loses his deposit and to keep the market liquid Futures exchange will ask Speculator to increase the deposit if it looks like the price will drop below a certain range of the deposit.
Speculator A Futures Trading AccountDeposit on Contract to Buy / $ 50.00
Contract to Buy / $ 500.00 / Proceeds on Sell Contract / $ 520.00
FNSACCT609A Second Term Test 2007 1