A futures contract is an agreement between two parties to buy or sell a specified asset at a future time and price. The quantity and quality of the asset and the future price and time of the transaction are all agreed upon when the futures contract is made. To complete the contract, the seller must deliver the asset at the future time and the buyer must accept the asset and pay the seller the previously agreed upon price. A majority of the time, futures contracts are never completed. Rather, the buyer and/or seller purchase the opposite position of a different futures contract, allowing them to reverse out of their original position.
Futures contracts can be made on different types of assets, including commodities such as metals, fuels, crops, and livestock. Producers of commodities commonly use futures contracts to reduce their risks from fluctuating commodity prices. They hedge against the price risk by purchasing futures contracts in a position opposite to their current position. A long position benefits from a price increase, and a short position benefits from a price decrease. Producers have a long position in the product they are selling, so they may enter into a short hedge if they want to reduce the price risk of a product they are selling. Producers have a short position in any product they need for production, so they may enter into a long hedge if they want to reduce the price risk of a raw material they use in production. Let’s cover a couple of examples to show how futures contracts can be used as a hedge. For the sake of simplicity, these examples ignore transaction costs and taxes.
Long Position, Short Hedge: The price of cattle is currently 90 cents per pound. Mr. Rancher needs to sell his cattle six months from now but is unsure what the future price of cattle will be. He wants to lock-in a future price, so he looks for someone who will buy his cattle six months from now at 90 cents per pound. Mr. Butcher offers to buy Mr. Rancher’s cattle six months from now at a price of 90 cents per pound, so they agree to a futures contract. After six months pass, the price of cattle may be either higher or lower than 90 cents per pound. Let’s evaluate what happens under each scenario.
Price Increase: Six months pass, and the price of cattle increases to 95 cents per pound. To complete the contract, Mr. Rancher would deliver the cattle to Mr. Butcher for 90 cents per pound, thereby selling for 5 cents less than the market rate but still getting the 90 cents per pound previously locked-in. However, Mr. Rancher could reverse out of his futures contract position by purchasing a contract to buy cattle currently at 95 cents per pound and using that contract to cover his obligation to sell cattle at 90 cents per pound. Mr. Rancher incurs a 5 cent loss on his futures contract and then sells his cattle at the current market price of 95 cents per pound, so his net revenue would be 90 cents per pound, his previously locked-in price.
Price Decrease: Six months pass, and the price of cattle decreases to 85 cents per pound. To complete the contract, Mr. Rancher would deliver the cattle to Mr. Butcher for 90 cents per pound, thereby selling for 5 cents more than the market rate but still getting the 90 cents per pound previously locked-in. However, Mr. Rancher could reverse out of his futures contract position by purchasing a contract to buy cattle currently at 85 cents per pound and using that contract to cover his obligation to sell cattle at 90 cents per pound. Mr. Rancher earns a 5 cent gain on his futures contract and then sells his cattle at the current market price of 85 cents per pound, so his net revenue would be 90 cents per pound, his previously locked-in price.
Short Position, Long Hedge: The price of hay feed is currently 15 cents per pound. Mr. Rancher needs to buy hay to feed his cattle over the next several months but is unsure what the future price of hay will be. He wants to lock-in a future price, so he looks for someone who will sell him hay three months from now at 15 cents per pound. Mr. Farmer offers to sell Mr. Rancher hay three months from now at a price of 15 cents per pound, so they agree to a futures contract. After three months pass, the price of hay may be either higher or lower than the 15 cents per pound. Let’s evaluate what happens under each scenario.
Price Increase: Three months pass, and the price of hay increases to 20 cents per pound. To complete the contract, Mr. Farmer would deliver the hay to Mr. Rancher for 15 cents per pound, and Mr. Rancher would buy for 5 cents less than the market rate, paying just the 15 cents per pound previously locked-in. However, Mr. Rancher could reverse out of his futures contract by selling to someone else his contract to buy hay at 15 cents per pound and then purchasing hay at the current market rate of 20 cents per pound. Mr. Rancher earns a 5 cent gain on his futures contract and then buys hay at the current market price of 20 cents per pound, so his net cost would be 15 cents per pound, his previously locked-in price.
Price Decrease: Three months pass, and the price of hay decreases to 10 cents per pound. To complete the contract, Mr. Farmer would deliver the hay to Mr. Rancher for 15 cents per pound, and Mr. Rancher would buy for 5 cents more than the market rate, paying the 15 cents per pound previously locked-in. However, Mr. Rancher could reverse out of his futures contract by selling to someone else his contract to buy hay at 15 cents per pound and then purchasing hay at the current market rate of 10 cents per pound. Mr. Rancher incurs a 5 cent loss on his futures contract and then buys hay at the current market price of 10 cents per pound, so his net cost would be 15 cents per pound, his previously locked-in price.
As you can see, in both the long position and the short position, the use of a futures contract can lock-in a price. The hedge can reduce price risk, but it may not eliminate price risk. Mr. Rancher needs to accurately predict the quantity, quality, and timing of the cattle he will sell and the hay feed he will need in order to achieve a perfect hedge. It should be noted that Mr. Rancher has locked-in a price only because he has hedged opposite to his current position. Futures investors who are not producers or users of the underlying assets are not trying to reduce price risk; they are trying to realize an investment gain. Futures contracts are still subject to gains and losses even if the futures investor owns or uses the underlying assets. Futures contracts are complex financial products subject to investment risk. However, futures contracts can be very a useful tool for commodity producers and consumers who are completely exposed to price risk.
