In this first session on risk management together, we're going to consider probably the most straight forward category of risk management instruments, the forward contract, or simply the forward. We will then demonstrate some of the limitations of the forwards and discuss how the establishment of futures markets has helped address many of these issues. So let's get into it. To motivate this session and the sessions to follow, let's fictitiously assume the role of chief operating officer of the Kellogg's Group, Judy. On New Year's Day, 2014, Judy wakes up to a corn price of $7.50 a bushel. This is what we call a spot market price. That is, the price of corn for immediate delivery. Now Judy looks up Kellogg's inventory of corn and quickly realizes that the company is going to have to go into the spot markets at the end of March, so as to replenish supplies. In terms of their March exposure, Kellogg's has a short position in corn. That is, they'll need it in the future, but they don't yet have it. The risk that Kellogg's faces is that the price of corn may be much higher at the end of March. That same morning, a corn farmer in Nebraska, let's call him Frank, also wakes up and starts thinking about the crop that he expects will be ready to go to market at the end of March. In terms of his exposure, Frank has a long position in corn. In that he will own corn, but will want to sell it at the end of March. The risk Frank faces is that the price of corn will decrease significantly by the end of March. So what's the solution? Well, what if Judy and Frank got together and entered into a contractual agreement relating to the exchange of corn at the end of March? This agreement is what we call a forward contract. And we'll typically specify the following details. Firstly, the price, which is known as the forward price as it relates to a feature or forward delivery date. The price will be expressed on a standardized unit basis such as per bushel. Next up, the contract will specify the quantity to be exchanged. Then the precise quality of the corn, and finally any details relating to precisely where and when the corn may be delivered. Now for the sake of our example, let's assume that Frank and Judy negotiate a price of $8 per bushel. So let's firstly consider the impact of the forward contract from Judy's point of view. If she did not have the contract in place, then Kellogg's would have to pay whatever the prevailing spot price is at the end of March, in order to secure its corn. But think about what happens if Judy is able to lock in a purchase price of $8 per bushel? If the price on March 31 was $6 a bushel, then she would regret her decision to lock in at $8 if she could have purchased for $2 a bushel less. If the spot price of corn at the end of March was $12, though, then Judy is high-fiving everyone in the office because she has saved the company significant amounts of cash by securing a purchase price $4 below the prevailing spot market price. The key is, the gains and losses on forward contracts are measured against what would have happened if the contract had not been entered into. So this diagram reflects the potential gains and losses that could be enjoyed or incurred depending on what the prevailing prices of the commodity underlying the forward contract is at the contract's delivery date. Note that the price that Kellogg's will pay, the horizontal line at $8, is unaffected by the price of corn as at March 31. Note also that even though Judy did not have to pay Frank upfront to enter the contract, there may be a cost to the contract in the form of potential losses incurred, by not being able to take advantage of lower corn prices on the delivery date. More specifically, the difference between the price that Judy has locked in and the price she would have paid, if she were unhedged, is the payoff from the forward contract. And do you recall that we said earlier that Judy was short in the spot market? Because she did not currently own, but wanted to own corn in the future. To hedge this position, she agreed to buy via the forward contract. And so we say that Judy has a long position in the forward contract. But what about Farmer Frank? For Farmer Frank, the vertical axis represents the price received for corn. As it was for Judy, the unhedged price that Frank would have traded at on 31 March is simply the prevailing spot price on that date. Recall that Frank was long in the underlying asset. To hedge these, he has gone short in a forward contract on corn. That is, he has agreed to sell corn in the future at a pre-specified sale price of $8. The payoff to Frank's short forward position is the opposite to the payoff to Judy's long forward position, which makes sense as they are counterparties to each other on the contract. So let's assume that Judy and Frank enter into the forward contract at 11:00 am on January the 1st. Over the next couple of months prices rise steadily owing to the unexpected demand in Europe. By 18th of March 2014, the price of corn has risen to $20 a bushel. How is Judy sleeping? Well, on the one hand, you might think she's sleeping fine as she's covered all of Kellogg's price risk by entering into the forward contract with Frank, and probably about a thousand other corn farmers. But there's still risk present. Because as the price of corn continues to increase, Frank has a stronger and stronger incentive to default on the forward contract and sell his corn on market. You see, the problems is that while initially Judy and Frank might both agree to exchange corn at $8 a bushel, when they each start thinking about the risk of default, they might build into their reservation prices. A risk premium. So back on January 1, instead of being willing to pay $8, Judy offers Frank a forward price of say, only $7. For his part, Frank builds in his own premium, demanding a forward price of $9 for future delivery, instead of only $8. As a result, the two parties won't enter into a forward contract. And participants more generally will find it hard to hedge their price risk. Here's where we introduce the futures market. Once a buyer and seller agrees to a futures price, the futures market intervenes and guarantees the performance of both sides of the transaction. So effectively, the futures exchange is acting as buyer to every seller and seller to every buyer of the underlying contracts. It is assumed all of the default risk so that those that are concerned about price rises, like judy and Kellogg's, know that if prices do rise, there's no concern about default. Similarly, Frank is reassured that irrespective of how low prices go in corn, his contract will still be honored. Now let's pause for a moment and get a bit of terminology straight. In futures markets, the person that enters the agreement to buy the underlying asset is said to buy a futures contract. Conversely, the party that agrees to sell the asset underlying the contract is said to sell the futures contract. So how does the futures exchange protect itself against either Judy or Frank defaulting on their obligations? Well they do so via a system of deposits and margin calls. The initial deposit represents cash or cash equivalents that are lodged in an account with the features exchanged at the inception of the contract. As the values of the features contract changes, funds are deducted from one of party's account and deposited into the other party's account. In a system known as marking to market. This generally occurs at the end of each day. If the cash account for one of the traders falls below a certain level, the exchange will contact the trader to let them know that additional funds need to be deposited. This is known as a margin call. So let's demonstrate this using our March 31 futures contract, which represents an agreement to trade one bushel of corn for $8. The contract was entered into at 11:00 AM on the 1st of January and both Judy and Frank were required to deposit $1 into their margin accounts. At the close of trade on the first day that the positions were open, the market price of that contract had fallen to $7.90. That is, the last trading corn for delivery on 31st of March took place at a price of $7.90. Now recall that Judy had locked in a buying price of $8 and Frank a selling price of $8. So at the end of this first day, the contract that Judy has bought has fallen in value by $0.10. While Frank is $0.10 better off because he locked in a selling price of $8 and it has now fallen to $7.90. Consequently, $0.10 is deducted from Judy's account and deposited into Frank's account. In the process of marking to market, all gains and losses are credited or debited to each trader's account on a daily basis. Over the next three days the price of the March contract rises from $7.90 to $8.70, an $0.80 price change, which also flows through to Judy and Frank's accounts. In summary, forward contracts provide traders with the ability to lock in buying and selling prices for future delivery. Although it's no real up front cost with the forward contract, there is the potential opportunity cost in that a trader may give up the ability to take advantage of price movements that would benefit them if they had not entered into the forward contract. Futures contracts are standardized forward contracts that are traded on an exchange. To protect itself against losses through default by traders, exchanges enforce a system involving deposits, margin calls and marking positions to market on a daily basis.
