Why is hedging important?
Let’s assume you are the CEO of a company that manufactures copper pipes. Obviously, your monthly profits highly depend on the price of copper which in the last 15 years fluctuated from roughly $1.30 to almost $4.50 per pound (COMEX). In order to smoothen your expenses (and thus your profits), you would like to predetermine copper prices for the future.
How to hedge price movements
Two of the most common vehicles to achieve this goal are Forwards and Futures. While both mark an agreement to buy or sell an asset (e.g. copper) at a specified future point in time (e.g. in 3 months) and in a specific quantity (e.g. 25,000 pounds), there are still several distinctions.
- Forwards are non-standardized, individually negotiated contracts between two counterpaties and only traded over-the-counter (i.e. they are not available via exchanges).
- Contract terms are not made public and include the underlying (e.g. copper), the expiration or delivery date (e.g. in 1 month), the corresponding amount of units (e.g. 25,000 pounds) and the price at which the underlying will be bought or sold at maturity. Moreover, the contract specifies who is the buyer (long) and who is the seller (short).
- Contract terms are private and highly customizable.
- Forwards ensure that delivery (or settlement) of the underlying will surely take place (for a pre-specified price).
- As settlement is solely conducted at the end of the contract, forwards are not subject to price changes.
- Due to being traded over-the-counter, forwards display a high probability of default (counterparty risk).
- Hardly available for retail investors.
- In contrast to forwards, futures are standardized contracts with fixed maturities (delivery dates), units and underlyings. They are traded on exchanges and settled on a daily basis (marked-to-market) until the contract ends. Instead of a private counterparty, transactions are settled by central clearing houses (e.g. NYSE).
- Clearing houses guarantee transactions and reduce the probability of default.
- Futures are also suitable for retail investors and speculators that do not want to hold shares until maturity (to prevent delivery).
- As futures markets are highly liquid, shares can be bought and sold quickly.
- In consequence of standardized contracts: less flexibility.
- Investors have to deposit an initial margin to compensate adverse price movements. Moreover, they have to fear the risk of margin calls (if the initial margin is depleted).
- Due to daily settlement, futures are not suitable to secure certain price levels. However, our company could hedge spot prices by a simultaneous investment in copper futures. Increases of raw material costs are then set off by investment revenues.
All in all, both vehicles are appropriate to smoothen monthly expenses, and thus profits. While forwards directly secure certain price levels, futures can be used in order hedge price increases. However, both also involve drawbacks. Forwards are hardly available for retail investors and display a higher probability of default, whereas futures bear the risk of margin calls.