Types of Hedging In The Financial Futures Market

There are basically three types of hedges used in the financial futures market today: (1) the long hedge, (2) the short hedge, and (3) the cross hedge. Cross hedges, as we will see, may be either long or short. Each types of hedge meets the unique trading needs of a particular group of investors. All three types have become increasingly popular as interest rates and security prices have become more volatile in recent years.
The long (or buying) Hedge
A long hedge involves the purchase of futures contracts today, before the investor must buy the actual securities desired at a later date. The purpose of the long hedge is to guarantee ("lock in") a desired yield in case interest rates decline before securities are actually purchased in the cash market.
As an example of a typical long-hedge transaction, suppose that a commercial bank, Life Insurance Company, pension funds, or other institutional investor anticipates receiving $ 1 million 90 days from today. Assume that today is April 1 and the funds are expected on July 2. The current yield to maturity on securities the investor hopes to purchase in July is 12.26 percent. We might imagine that these securities are long-term U.S. Treasury bonds, which appeal to this investor because of their high liquidity and zero default risk. Suppose, however, that interest rates are expected to decline over the next three months due to a recession. If the investor waits until the $1 million in cash is available 90 days from now, the yield on Treasury bonds may well be lower than 12.26 percent. Is there a way to lock in the yield available now even though funds will not be available for another three months?
Yes, if a suitable long hedge can be negotiated with another investor or trader. In this case the investor can purchase ("go long") 10 September Treasury bond futures contracts at their current market price. (Recall that Treasury bond futures are sold in $100,000 denominations.) Cash payment on these contracts will not be due until September. Suppose their price currently is 68-10, or $68,312.50 on a $100,000 face-value contract. Assume too that, as expected, bond prices rise and interest rates fall. At some later point the investor may be able sell the bond futures contracts at a profit, since prices on these contracts tend to rise along with rising bond prices in the cash market. Selling the bond futures contracts at a profit will help this investor offset the lower yields on Treasury bonds that will prevail in the cash market once the 1 million actually becomes available on July 2.
We note that on July 2 the investor goes into the spot market and buys $1 million in 8 percent, 20-year U.S. Treasury bonds at a price of 82-13. At the same time, the investor sells 10 September Treasury bonds futures contracts at 80-07. Due to higher bond prices (lower yields) in July, the investor loses $139,687.50, because the market price of treasury bonds has risen from 68-14 to 82-13. This represents an opportunity loss because the $1 million in investable funds was not available in April when interest rates were high and bond prices low. However, this loss is at least partially offset by a given in the futures market of $119,062.50, because the 10 September bond futures purchased on April 1st were sold at a profit on July 2. Over this period, bond futures contracts rose in price from 68-10 to 80-07. In effect, the investor will pay only $705,000 for treasury bonds bought in the cash market on July2. The market price of these bonds will be $824,062.50 (or 82-13) per bond, but the investor's net cost is lower by $119,062.25 due to a gain in the futures market.
The short (or selling) hedge
A financial device of growing popularity is the short hedge. This hedge involves the immediate sale of financial futures contracts until the actual securities must be sold in the cash market at some later point. Short hedges are especially useful to investors who may hold a large portfolio of securities which they plan to sell in the future but, in the meantime, must be protected against the risk of declining security prices. We examine a typical situation where a securities dealer might employ the short hedge.
Suppose the dealer holds $1 million in U.S. Treasury bonds, carrying an 8¾percent coupon and a maturity of 20 years. The current price of these bonds is 94-26 (or $948.125 per $1,000 par value), which amounts to a yield of 9.25 percent. However, the dealer is concerned because higher interest rates appear to be in the offing. Any upward climb in rates would bring about lower bond prices and therefore reduce the value of the dealer's portfolio. A possible remedy in this case is simply to sell bond futures contracts in order to counteract the anticipated decline in bond prices. For example, suppose the dealer decides to sell 10 Treasury bond futures contracts at 86-28, and 30 days later is able to sell $1 million of 20-year, 8¾ percent Treasury bonds at a price of 86-16 for yield of 10.29 percent. At the same time the dealer goes into the futures market and buys 10 Treasury bond futures contracts at 79-26 to offset the previous forward sale of bond futures.
The financial consequences of these combined trades in the spot and futures markets are offsetting. The dealer as lost $83,125 in the cash market due to the price decline in the bonds held. However, a gain of about $70,625 (fewer fees, commissions, and any tax liability) has resulted from the gain in the futures price. This dealer has helped to insulate the value of the portfolio from the risk of price fluctuations through a short hedge.
Cross hedging
Another approach to minimizing risk is the cross hedge- a combined transaction between the spot market and the futures market using different types of securities in each market. This device rests upon the assumption that the prices of most financial instruments tend to move in the same direction and by the same direction and by roughly the same proportion. Because this is only approximately true is any real-world situation, cross hedging does not usually result in forming a perfect hedge. Profits or losses in the cash market will not exactly offset losses or profits in the futures market. Nevertheless, if the investor's goal is to minimum risk, cross hedging is often preferable to a completely unhedged position.
As an example, consider the case of a commercial bank which holds good-quality corporate bonds carrying a face value of $5 million with an average maturity of 20 years. The bank's portfolio manager anticipates a rise in interest rates, which will reduce the value of the corporate bonds. Unfortunately, there is no futures market for corporate bonds, and therefore the portfolio manager cannot construct a prefect hedge involving these securities. However, futures contracts can be negotiated in U.S. Treasury bonds or even in Ginnie Mae passthroughs , providing either a long or a short hedge to offset the risk of a decline in the value of the corporate bonds.
To illustrate how such a cross-hedge transaction might take place, suppose that on January 2 the market value of the bank's corporate bonds is $3,673,437.50. This means that each $1,000 par value bond currently carries a market price of $734.6875 (or 73-15 on a $100 basis).the portfolio manager decides to 50 sell Treasury bond futures contracts at 81-20 (or $816.25 per $1,000 face value). About two and half months later, on March 14, interest rates have risen significantly. The value of each corporate bond has fallen to 64-13 (or $644.0625 per $1000 bond). At this point the Bank's portfolio manager decides to sell the bonds, receiving $3,220,312.50 from the buyer. This represents a loss on the bonds of $453,125.00. At the same time, however, the portfolio manager buys back 50 U.S. Treasury bond futures contracts at 69-20. The result is a gain from futures trading of 600,000. In this particular transaction the gain from futures trading more than offsets the loss in the cash market. Of course, this example of a cross hedge and the preceding example of long and short hedges are simplified considerably to make the fundamental principal of futures trading easier to understand. In the real world the placing and removal of hedges is an exercise requiring detailed study of the futures market and, in most cases, a substantial amount of trading experience.

Social consequences of the futures market

Not all observers agree that the futures market results in a net gain for society by helping financial institutions reduce risk and use scare resources more efficiently. Some analysts believe that the futures markets are largely speculative and not really geared for the hedging of risks per se. they see these markets as aimed principally at providing wealthy investors with a speculative outlet for their funds, and resulting in unnecessary risks due to excessive speculation. Some have argued that the futures markets increase the price volatility of those securities whose contracts are actively traded. If this is true, it would tend to make the impact of government economic policy, aimed at promoting high employment and low inflation, more difficult to predict. There is evidence from the commodities field that trading in futures tends to smooth out seasonal fluctuations, but only limited evidence exists to date as to the overall impact on the securities markets of contracts trading.
Certainly the more existence of the futures market and its continuing growth creates additional problems for regulatory authorities, especially those concerned with the regulation of financial institutions. Another market must be supervised and additional regulations prepared to cover new forms of risk and new fiduciary relationships. Some observers have expressed the fear that the futures markets substitute "gambling" with securities for "investing" in securities. If this view correct, it suggests a withdrawal of some risk-taking activity from the traditional securities markets and a redirection of this activity towards the futures market. To the extent that risk taking by securities investors is curtailed, this limits the flow of funds into venture capital and decreases the aggregate volume of investment in the economy. Other things equal, the economy's rate of growth is reduced.
On balance, the financial futures market probably has resulted in a modest net benefit to the financial system and to the economy. Those who support the development of this market have certainly overdramatized its positive features, alleging, for example, that interest rates tend to be lower and less volatile with a well-functioning futures market. There is little evidence that this is, in fact, the case. Regardless, it seems clear that the futures market has separated the risk of changing security prices and interest rates from the lending of funds, at least for those institutions actively participating in this market. The risk of price and yield changes is transferred to investors quite willing to assume such risks. The futures market has helped to reduce search costs and expand the flow of information on market opportunities for those who seek risk reduction through hedging. In this sense, the market tends to promote greater efficiency in the use of scare financial resources. Moreover, this developing institution has tended to unify many local markets into a national forward market, overcoming geographic and institutional rigities which tend to separate one market from another.
It should not be forgotten that futures trading is not without its own special risks. While the risk of price and yield fluctuations is reduced through negotiating a futures contract, the investor faces the risk of changing interest rates and security prices between the futures and spot markets. It is rare that gains and losses from simultaneous trading in spot and futures markets will exactly offset each other, resulting in a perfect hedge. Moreover, there are substantial brokerage fees for executing futures contracts, and required minimum deposits for margin accounts. To the extent that the futures market encourages speculation, does not fully offset all prices and interest-rates risks, and is characterized by substantial transactions costs, its net benefits to society will remain both limited and a subject of continuing controversy and close regulatory security.

Traders Active in The Future Market

A wide of financial institutions and individuals are active in futures trading today. The principal traders in financial futures are individuals and commodity pools. Commodity pools are like mutual funds, offering shares to the individual investor who regularly purchases futures contracts. Commodity pools offer the advantage of diversifying risk by trading in many contracts with varied maturities; in addition, they are professionally managed. the majority of commodity pools try to limit losses to the investor‘s original investment. Liquidating investor holdings rather than issuing margin calls. Combined, individuals and commodity pools held close to half of total open contract positions in 1979, and their share as been growing over time.
Firms and individual traders representing the future industry run a close second to individual investors and commodity pools, with open positions ranging from a fifth to about 35 percent of contracts outstanding, depending on the instrument being traded. many of these industry personal speculate on interest-rate movements or arbitrage between spot and futures markets, purchasing one contract and selling another in the expectation that interest rates on purchased contracts will decline more than (or rise less than) rates on contract sold. Alternatively, futures firms and industry traders will buy or sell futures contracts simultaneously with a sell or buy move in the spot market.
Financial institutions also play a prominent role in future trading, led by securities dealers, commercial banks, mortgages bankers, and savings and loans associations. Securities dealers appear to be less interested in risk reduction through hedging and more interested in profitable traders arising from correctly guessing the future course of interest rates and contract prices. Savings and loan associations and mortgage bankers, not surprisingly, are most involved in futures trading of GNMA mortgage-backed instruments. Rapid increases in long-term mortgage rates and volatile swings in the demand for new housing over the past two decades have brought substantial risk to the mortgage lending business. Under pressure from rising interest costs and deposit withdrawals, many savings and loan associations today have been forced to deeply discount and sell their old, low-yielding mortgage loans in the secondary market in order to raise funds. Losses incurred in the sale of old mortgages can be at least partially offset by trades executed in GNMA futures contracts. For their part, mortgages bankers frequently sell GNMA futures to hedge against interest-rate changes that may occur between the time mortgage loans are taken into their portfolios and the time they are sold in package to other investors.
The participation of savings and loan associations in futures trading was been a substantial boost in July 1981. The federal home loan bank broad (FHLBB), the industry ´s chief regulator, loosened the old rules, which limited the total volume of futures contracts an S&L could have outstanding at any one time to no more than the association's net worth position (normally about 5 percent of total assets). The new rules permit a savings and loan to hedge all of its assets if it so chooses. Trading may be carried out in any securities which a savings associations is legally entitled to hold. Many savings and loans sell GNMA futures to hedge the fixed-rate mortgages they hold on single-family homes. However, the new rules for futures trading set by the FHLBB allow savings associations to hedge on both the asset and liability side of the balance sheet and especially to offset the rapidly rising cost of deposits and nondeposit borrowings.
Participation by commercial banks in futures trading has been quite limited to date. Banks accounted for no more than 4 percent of all positions in the three most-active futures markets, according to a survey taken in March 1979. the survey, conducted by the Commodity Futures Trading Commission, found that only 24 banks held open positions in Treasury bill futures and only 14 carried positions in bond futures at that time. One major factor limiting commercial bank participation in the futures market is uncertainly over the attitude of the regulatory authorities, especially the Federal Reserve System and the Comptroller of the Currency. Another problem centers on the required accounting treatment of gains and losses from futures trading. Losses must be recognized immediately for tax purposes, while gains can be deferred. The result is volatile fluctuations in reported income for those banks active in futures trading. However, it is anticipated that bank participation in the futures market will expand significantly as the regulatory community becomes more comfortable with the hedging concept.

the future market for U.S. Treasury bonds and notes

the future market for U.S. Treasury bonds and notes is one of the most active markets for the forward delivery of an asset to be found anywhere in the world. Treasury bonds and notes are a popular investment medium for individuals and financial institutions because of their safety and liquidity. Nevertheless, there is substantial market risk involved with longer-term Treasury bonds and notes due to their lengthy maturities and relatively thin market. For example, Treasury bonds, which have original maturities stretching beyond 10 years, totaled only about $85 billion at year-end 1980, less than 10 percent of the total public debt of the United States and much less than half the volume of Treasury bills outstanding. Because the market for Treasury bonds is thinner than for bills, their price is more volatile, creating greater uncertainty for investors. Not surprisingly, then, Treasury bonds were among the first financial instruments for which a future market developed to hedge against the risk of price fluctuations.
Only those Treasury bonds which either have maturities of at least 15 years or cannot be called for at least 15 to 20 years from their date of delivery (depending on the exchange selected) are eligible for futures contracts. Moreover, all Treasury bonds delivered under futures contracts. Moreover, all Treasury bonds delivered under a futures contract must come from the same issue. The basic trading unit is $100,000(measured at par) with a coupon rate of 8 percent. Bonds with coupon rates above or below 8 percent are delivered at a premium or discount from their par values. Delivery of Treasury bonds is accomplished by look entry, and accrued interest is prorated. Price quotes in the market are expressed as a percentage of par values. The minimum price change which is recorded on published lists or in dealer quotations is one thirty-second of a point, or $31.25 per futures contract.
Contracts for U.S. Treasury notes and non-callable bonds with maturities of four to six years also are traded today. Like Treasury bond contracts, T-note contracts are priced as a percentage of their par (or face) value, based on an 8 percent coupon rate. The basic trading unit is $100,000 face value. Trading in Treasury note futures began at the Chicago Board of trade in June 1979, while Treasury bond contracts were first traded in August 1977

GNMA Mortgage pass-Through or Mortgage-backed securities

During the 1970s the federal government increasingly active in the secondary market for mortgages in order to expand the volume of funds available to the housing market. One of the most successful federal government programs in this area is carried out by the government national mortgage association (GNMA or, more commonly, "Ginnie Mae"). Ginnie Mae purchases residential mortgages in the secondary market and adds them to an investment pool. All mortgages in the pool bear the same interest rate, carry similar maturities, and represent loans against similar types of residences. Then , Ginnie Mae issues its own securities (which it guarantees) as claims against the principal and interest earned by the mortgage pool. These Ginnie Mae IOUs-usually called passthroughs or mortgage-backed securities- are standardized, readily marketable instruments with interest rates generally higher than on U.S. Treasury securities.
In October 1975 the Chicago board of trade opened trading activity in futures contracts for GNMA pass-through certificates. The basic trading unit was set at $1000,000 for certificates with a stated interest rate of 8 percent ("Ginnie Mae 8‘s"). if the rate of interest on a Ginnie Mae issue is lower than 8 percent, then the basic trading unit will be greater than $100,000. On the other hand, if the interest rate is above 8 percent, the basic trading unit is scaled down below$100,000. for example, $107,816.70 is the basic trading unit for an interest rate of 9 percent. Prices on Ginnie Mae issues are qouted as a percent of par with minimum quotes in 32nds of a point. Delivery months on GNMA futures contracts are February,March,June,August,September,November,and December.
Two types of GNMA futures are traded today: (1) GNMA CDR (collateralized depository receipt), and (2)GNMA CD (Certificate delivery). The difference between these two contracts hinges on current market interest rates. As we noted above, GNMA certificates with 8 percent coupon rate were chosen as the basis for GNMA futures contracts traded at the Chicago Board of Trade. the 8 percent figure was chosen because it was a common interest rate attached to GNMA certificates when trading first began. When interest rates rise above or fall below 8 percent, one of two types of adjustments are made in GNMA futures contracts. the dollar amount on the contract invoices can be adjust with the principal balance unchanged-a GNMA CD. Alternatively,the amount of GNMA certificates actually delivered (known as the principal balance) can be altered to capture interest-rate changes with the dollar amount of the contract invoice remaining unchanged. this is known as a GNMA CDR contract. Also, a GNMA CD Contract calls for delivery of the actual GNMA certificates, while a CDR contract requires the delivery of a receipt which evidences GNMA Certificates held in safekeeping by an authorized depository.

90-Day commercial paper in the futures market

One of the most important and rapidly growing money market instruments today is the short-term marketable debt obligations issued by major corporations, known as commercial paper ranges in original maturity from nine months to as short as three or four days. However, the Chicago Board of Trade as ruled that commercial paper traded in the futures market must mature either 30or90 day from date of delivery. It must be of the highest quality, rated either A-1 by standard& Poor's Corporation or P-1 by Moody‘s investor‘s Service, and be approved by the Chicago Board of Trade. The basic trading unit for 90-day paper is a face value at maturity of $1 million, while contracts for 30-day paper are based on a $3 million face value. Prices are quoted on an annual discount basis, with minimum price fluctuations of one basis point or $25 per contract.
A futures trading in commercial paper is extremely light compared to the other securities represented on the major contract exchanges. For example, a survey by the Commodity Futures Trading Commission in March 1979 found that daily trading volume in 90-day commercial paper contracts was less than 5 percent of T-bill contract trading volume. One major problem with paper futures is that the contracts do not specify precisely what issue of commercial paper is to be delivered to fulfill each contract. Because paper issued by any numbers of firms may be used to satisfy the contractual agreement, investors face an unusual degree of uncertainty in this market. In addition, a substantial volume of commercial paper is issued in original maturities of less than 90 days; so the supply of 90-day paper is often quite limit

potential benefits to financial institutions from the futures market

Trading in security futures opens up several potential advantages for financial institutions and for individual investors. The prospect of hedging against changes in security prices offers the potential for reducing risk and offsetting losses stemming from adverse movements in interest rates. Financial futures contracts can be especially beneficial for those financial institutions and individual investors heavily leveraged wit debt, which makes their net earning particularly sensitive to changes in interest rates. This is certainly true of major commercial banks, savings and loan associations, mutual savings banks, securities dealers, and mortgage banking institutions. These financial intermediaries experience marked fluctuations in net income with changes in the differential between interest rates on borrowed funds and returns on loans and other assets.
Moreover, if the future market does lead to a reduction of risk, this will enable many financial institutions to extend greater amounts of credit. The result could be a more efficient allocation of scare funds within each financial institution and within the financial system. Moreover, the futures markets provide for a freer flow of information concerning alternative uses and outlets for funds, permitting each financial institution to rapidly adjust its risk position to changes in interest rates and other costs. As noted by Stevens, the existence of a futures market may result in "increased market information, less search time, integration of markets and greater specialization of risk bearing."

U.S. Treasury bills and the financial future market

In January 1976, U.S. Treasury bills were declared eligible for trading in the financial futures market. the international monetary market (IMM), A Division of the Chicago Mercantile Exchange, announced that contracts for future delivery would be written on T-bills contracts are for $1 million each, while single contracts on one-year bills carry denominations of $250,000.
Future trading in the bill market has become extremely popular. For example, during 1979 daily average trading in T-bill contracts on the IMM was about $7.5 billion. This was almost as large as the daily volume of spot market trading in T-bills conducted by U.S. government securities dealers.

securities used in financial future contracts

The number of futures markets and types of securities and contracts traded in those markets have been expanding rapidly in recent years. In 1975 only one type of contract was traded at the Chicago Board of Trade. In 1981 25 different futures contracts were being traded on several different exchanges. however, most trading in financial futures today centers around five types of securities:(1)U.S. Treasury bills,(2)Treasury bonds and notes, (3)GNMA mortgage pass-through (or mortgage-backed) securities, (4)prime-quality commercial paper, and (5)bank certificates of deposit (CDs). The Chicago Board of trade first offered interest-rate futures contracts for GNMA mortgage instruments in October 1975.Soon. Other commodities exchanges-the international monetary market of the Chicago Mercantile exchange (IMM), The Amex Commodities Exchange, Inc. (ACE), and the Commodity Exchange, Inc. (Comex)-began offering futures trading in T-bills and GNMA certificates. Then, in August 1980 the New York Stock Exchange opened its own futures floor. Known as the New York Futures Exchange, it has began to capture a larger share of the contract market, especially for traders in bank CDs.
Each of these exchanges completely controls which security contracts may be offered for sale, acceptable delivery dates, delivery methods, posting of prices, contract par values, and other essential terms of trade.

The purposes of trading in financial futures(2)

Many financial analysts feel that the relationship between prices in the spot securities market and in the financial futures market is more stable and predictable than is true of prices in either market considered separately. This relatively stable relationship between spot and futures prices is what allows investors to reduce risk by hedging in financial futures.
Under a financial futures contract, the seller agrees to deliver a specific security at a specified price at a specific time in the future. Delivery under the shortest contracts is usually in 3 months from today‘s date, while a few contracts stretch out to 18 months or even two years. When the delivery date arrives, the security‘s seller can do one of three things (1) make delivery of the security if he or she holds it; (2) buy security in the spot (cash) market and deliver it as called for in the futures contract; or (3) purchase a futures contract for the same security with a delivery date exactly matching the first contract. This last option would result in a buy and sell order maturing on the same day, which "zero out" and clear the market. In reality, settlement of contracts generally occurs exclusively in the futures market through offsetting buy and sell orders rather than by using spot (cash) transactions.

The purposes of trading in financial futures(1)

The basic principal behind trading in financial futures is the same as in the commodity markets. A securities dealer, commercial bank, or other investor may sell future contracts on selected securities in order to protect against the risk of falling security prices (rising interest rates) and therefore a decline in the rate of return or yield from an investment. If the price of the security in question does fall, the investor can "lock in" the desired yield because a profit on the futures contracts may fully offset the capital loss incurred when selling the security itself. On the other hand, a rise in the market price of a security (fall in interest rates) may be fully offset by a loss in the futures market. Either way, the investor is able to maintain the desired holding-period yield.
Financial futures may also be used by financial institutions and other investors to reduce the risk of interest-rate fluctuations when borrowing money. For example, suppose that a commercial bank is planning to raise funds by issuing certificates of deposit (CDs) and borrowing in the Eurodollar market one year from today. However, the bank‘s economics department forecasts that interest rates are likely to rise significantly by the time the borrowing takes place. The adverse impact of these expected higher borrowing costs on the bank‘s profit position could be reduced by a sale and then a purchase of financial contracts. For example, management could sell one-year Treasury bill futures contracts now and then "zero out" this sale by purchasing a like amount of T-bills contracts when the delivery date arrives. Provided interest rates on Treasury bills, bank CDs, and Eurodollars increase by about the same magnitude, the added CD and Eurodollar borrowing costs would be offset by a profit on the futures position in T-bills. The bank could "lock in" its desired borrowing cost.

Financial futures

Beginning in October 1975, the Chicago board of trade opened active trading in future contracts for GNMA mortgage-backed certificates. In the ensuing months, futures contracts for U.S. Treasury securities and commercial paper appeared on the scene. Important financial instruments traded in the future market today. The development of future markets for these securities was motivated by the extremely volatile interest-rate movements which have characterized the financial markets for the past two decades. Repeatedly, interest rates have risen to record levels under the pressure of tight money policies and inflation, shutting out important groups of borrowers from ready access to credit.
These high and volatile rates have been a source of concern to regulatory authorities in the field of banking and financial institution. Rising interest rates reduce the value of securities held by financial institutions, threatening them with a liquidity crisis and, in some cases, ultimate failure. Some members of the regulatory community have favored the growth of financial futures as a way to reduce the risks associated with security investments. However, as we will soon see, other regulatory authorities feel that the development of the futures markets may have encouraged speculation and increased the riskiness of those financial institutions participating in futures trading. These regulatory agencies have placed tight restrictions on the use of the futures markets, especially by commercial banks.
Overall, the growth of trading in financial futures has been impressive. For example, the volume of trading in the financial futures at the Chicago Board of Trade was less than 1 million contracts in 1977, topped 3 million in 1979, and soared to nearly 9 million in 1980.by august 1980, the third anniversary of trading in U.S. Treasury bond futures, more than 6 million T-bond contracts had exchanged hands, with a total par value of about $600 billion.

The Nature of Future Trading

In the future market, buyers and sellers enter into contract for the delivery of commodities, securities, or cash at specific location and time and at a price which is set when the contract is made. The principal reason for the existence of a future market is hedging-the act of buying or selling a commodity or claim in order to protect against the risk of future price fluctuations. Adverse movements in prices can result in increased costs and lower profits and, in the case of financial instruments, reduced value and yield. Many business firms and investors today find that even modest changes in prices, interest rates, and other costs can lead to magnified changes in their net earnings. Some investors see the futures markets as means to ensure that their profits depend more upon planning and design rather than on the dictates of a treacherous and volatile market.
Hedging may be compared to insurance. Insurance protects an individual or business firm against risks to life and property. Hedging protects against the risk of fluctuations in market price. However, there is an important difference between insurance and hedging. Insurance rests upon the principal of sharing or distributing risk over a large group of policyholders. Through an insurance policy the risk to any one individual or institution is reduced. Moreover, the risks covered by most insurance plans are highly predictable, especially the risk of death.
In contrast, hedging does not reduce risk. it merely transfers that risk from one investor or institution to another. Ultimately, some investor must bear the risk of fluctuations in the prices of commodities or securities. Moreover, tat risk is generally less predictable than would be true of most insurance claims. The hedger who successfully transfers risk through a future contract can protect an acceptable selling price for a commodity or a desired yield on a security weeks or months ahead of the sale or purchase of that item. In the financial futures markets, the length of such contracts normally ranges from three months to two year.

Opening and closing a hedge

Suppose an agricultural firm produces a commodity such as wheat and is anticipating a decline in wheat prices. This unfavorable price movement can be hedged by selling futures contracts equal to the current value of the wheat. Sale of these contracts, which promise the future delivery of wheat days, weeks, or months from now, is called "opening a hedge." when the firm does sell its wheat, it can buy back the same number of futures contracts as it sold originally and "close the hedge."
Of course, the firm could deliver the wheat as specified in the original futures contracts. However, this is not usually done. If the price of wheat does decline as expected, then it costs the firm less to repurchase the futures contracts than it originally sold them for. Thus, the profit on the repurchase of wheat futures offsets the decrease in the price of wheat it self. The firm would have perfectly hedged itself against any adverse change in wheat prices over the life of the futures contract.
What would happen if wheat rose in price instead of declined? A perfect hedge would result in a profit on the sale of the wheat itself, but a loss on the futures contract. This happens because the firm must repurchase its futures contract at a higher price than its original cost due to the higher price for wheat.

risk selection through hedging

In the preceding paragraphs we have described a complete (perfect) hedge. Such a hedge is essentially a profitless hedging position. Many speculators and investors, however, are willing to take on added risk by not fully closing a hedge, believing they can guess correctly which way prices are going. Through the future market, the investor can literally "dial" the degree of risk he or she wishes to accept. If the investor wishes to take on all the risk of price fluctuations in the hope of achieving the maximum return, no hedging will take place. On the other hand, risk can be eliminated completely by using a perfect hedge.

What is a Eurodollar?

Because the dollar is the chief international currency today, the market for Eurodollar dominates the Eurocurrency markets. What are Eurodollars? Eurodollars are deposits of U.S. dollars in banks located outside the United States. The banks in question record the deposits on their books in U.S. dollars, not in the home currency. While the large majority of Eurodollar (and other currency) deposits are held in Europe, these deposits have spread worldwide, and Europe‘s share of the total is actually declining.
Frequently, banks accepting Eurodollar deposits are foreign branches of American banks. For example, in the city of London-the center of the Eurocurrency market today-branches of American banks outnumber British banks and bid aggressively for deposits denominated in U.S. dollars. Many of these funds will then be loaned to the home office in the states to meet reserve requirements and other liquidity needs. The remaining funds will be loaned to private corporations and governments abroad who have need of U.S. dollars.
No one knows exactly how large the Eurodollar market is. One reason is that the market is almost completely unregulated. Moreover, many international banks refuse to disclose publicly their deposit balances in various currencies. Another reasons for the relative lack of information on market activity is that Eurocurrencies are merely bookkeeping entries on a bank ‘S ledger and not really currencies at all. You cannot put Eurodollars in your pocket like bank notes. Moreover, Eurodollar deposits are continually on the move in the form of loans. They are employed to finance the import and export of goods, to supplement government tax revenue, to provide working capital for the foreign operations of U.S. multinational corporations, and, as we noted earlier, to provide liquid reserves to the largest banks headquartered in the United States.
One recent estimate for mid-1980 drawn from figures compiled by Morgan guaranty trust company in New York gave the gross size of the entire Eurocurrency market at $1,470 billion. The term gross in this instance means the sum of all foreign-currency –denominated liabilities outside the country of the currency‘s origin. The net size of the Eurocurrency market, netting out deposits owned by Eurocurrency banks, was estimated at close to $700 billion. Because Eurodollar represent about three quarters of all Eurocurrency liabilities, the gross size of the Eurodollar market would be about $1,100 billion, while the net total is probably close to $500 billion. Figures of this magnitude would make the Eurodollar market the largest of all money markets.

Why hedging can be effective?

The hedging process can be effective in transferring risk because prices in the spot (or cash) market for commodities securities are generally correlated with prices in the futures (or forward) market. Indeed, the price of a future contracts in today‘s market represent an estimate of what the spot (or cash) market price will be on the contract's delivery date. Hedging essentially means adopting equal and apposite positions in the spot and futures markets for the same asset.

Benefits and costs of the Eurodollar market

The development of Eurodollar trading has resulted in substantial benefits to the international community and especially to U.S. banks and multinational corporations. The market ensures a high degree of funds mobility between international capital markets and provides a true international market for bank and non-bank liquidity adjustments.It has provided a mechanism for absorbing huge amounts of U.S. dollars flowing overseas and generally lessened international pressure to forsake the dollar for gold and other currencies.
The market reduces the costs of international trade by providing an efficient method of economizing on transactions balances in the world‘s most heavily traded currency, the dollar. Moreover, it acts as a check on domestic monetary and fiscal policies, especially on the European continent, and encourages international cooperation in economic policies because interest-sensitive traders in the market will quickly spot interest rates that are out of line and move huge a mounts of funds quickly to any point on the global.
Central banks, such as the bank of England, the Bundesbank, and the Federal Reserve System, monitor the Eurodollar market continuously in order to moderate heavy inflows or outflows of funds which may damage their domestic economics.
The capacity of Eurocurrency market to quickly mobilize massive amounts of funds has brought severe criticisms of this market from central bankers in Europe and from certain government officials, economists, and financial analysts in the United States. They see the market as contributing to instability in currency values, particularly when Eurocurrency trading places severe downward pressure on the dollar and other key trading currencies. As noted above, the market can wreak havoc with monetary and fiscal policies designed to cure domestic economic problems. This is especially true if a nation is experiencing severe inflation and massive inflows of Eurocurrency occur at the same time. The net effect of Eurocurrency expansion, other things equal, is to push domestic interest rates down, stimulate credit expansion, and accelerate the rate of inflation. The ability of local authorities to deal with inflationary problems might be completely over whelmed by a Eurocurrency glut. This danger is really the price of freedom, for an unregulated market will not always conform to the plans of government policy makers.
It is not surprising that certain European central banks have for more than a decade called for controls on Eurocurrency trading. One of the most frequently heard proposals is to impose reserve requirements on Eurodollar deposits. For example, during the 1970s France levied a 9.5 percent reserve requirement on Eurodollar loans. But such controls have not really been effective because of unanimity among foreign governments and central banks. Funds tend to flow away from areas employing controls and toward free and open markets. The key to the future of controls in this market probably rests with the bank of England, because London is the heart of the Eurodollar market. And thus far, the Old Lady of Threadneadle Street, as that bank is often called, remains firmly against significant government restraints on Eurocurrency trading.

The supply of Eurodollars

Where does Eurodollar come from? A major factor in market‘s growth has been the enormous balance-of-payments deficits which the United States has run since the late 1950s. American firms building factories and purchasing goods and services abroad have transferred ownership of dollar deposits to foreign companies, banks, and governments. Domestic shortages of oil and natural gas have forced the United States to import from a third to 40 percent of its petroleum needs generating an enormous outflow of dollars to oil-producing nations. The OPEC countries, for example, accept dollars in payment for crude oil and use the dollar as standard for valuing the oil they sell. American tourists visiting Europe, Japan, Singapore, and the middle East frequently use dollar-denominated traveler‘s checks or take U.s. currency with them and convert it into local currency overseas. Dollar loans made by U.S. Corporation and foreign-based firms have added to the vast Eurodollar pool. Many of these dollar deposits have gravitated to foreign central banks, such as the bank of England and the Bundesbank in the Federal Republic of Germany, as these institutions have attempted to support the dollar and their own currencies in international markets.

Eurodollar maturities

Most Eurodollar deposits are short term (ranging from overnight loans to call money loaned for a few days out to one year) and therefore are true money market instruments. However, a small percentage is long-term time deposits, extending in some instances out to about five years. However, most Eurodollar deposits carry one-month maturities to coincide with payments for shipments of goods. Other common maturities are 2, 3, 6, and 12 months.
Even though Eurobanks do not issues demand deposits, funds move rapidly in the Eurocurrency market from bank to bank in response to the demand for short-term liquidity from corporation, government, and Eurobanks themselves. There is no central trading location in the market. Traders may be thousands of miles distant from each other, conducting negotiations by cable, telephone, or telex with written confirmation coming later. Funds normally are transferred on the second business day after an agreement is reached through correspondent banks.
Eurocurrency deposits are known to be volatile and highly sensitive to fluctuations in interest rates. A slight difference in interest rates on currency values between two countries can cause a massive flow of Eurocurrencies across national boundaries. One of the most famous examples of this phenomenon occurred in West Germany in 1971, when speculation that the German mark would be up valued brought an inflow into Germany of more than $5 billion in a few days, forcing the West German government to cut the mark loose from its officials exchange value and allow that currency to float.