Who are the users of futures contracts? The participants in the futures market are hedgers or speculators or arbitrageurs. Since all the groups are important to the futures market we will discuss each in turn.
Hedgers: Hedgers are parties who are exposed to risk because they have a prior position in the commodity or the financial instrument specified in the futures contract. For example, a farmer may be expecting a produce of n tons of wheat from his farm two months hence or an investor may be currently owning a broadly diversified portfolio of equity stocks worth Rs P million now. By taking an opposite position in the futures market, parties who are at risk with an asset can hedge their position. For example, the farmer may sell wheat futures and the investor may sell stock index futures. By doing so they can shield themselves against the risk of unexpected price changes.
Since one can take either a long position or a short position in the futures contract, there are two basic hedge positions.
The short (sell) hedge: A party who has a long cash position, current or potential may sell (short) the futures. For example, a portfolio manager who wants to liquidate his equity portfolio six months from now but who is worried about the stock market level six months hence may sell stock index futures of six months maturity. Should the market fall in six months, the gains from squaring the stock index futures position would substantially offset the erosion in the value of the portfolio. Likewise, a bond portfolio manager who wants to protect his portfolio against interest rate increase may sell Treasury bond futures.
The long (buy) hedge: A party who is not currently in cash but who expects to be in cash in the future may buy a futures contract to eliminate uncertainty about the price. For example, a miller who wants wheat three month emcee may buy a three months wheat futures contract to hedge against the risk of price change. Similarly a portfolio manager who expects cash surpluses in future meant to be invested in bonds may buy treasury bonds so that he can lock in the buying price and seek protection against a fall in interest rate.
Basis Risk and Hedging
The difference between the futures price and the spot price is called the basis. The convergence property implies that on the maturity date of the contract, the basis must be zero. Thus FT – PT = 0. Before maturity however, the futures price often differs from the spot price.
Suppose a person holds an asset as well as a short position to deliver that asset in the future. If he holds the asset as well as the futures contract till maturity he bears no risk because the gains ad losses on his asset portion and futures contract will exactly cancel. However, if he liquidates the asset and the futures contract before the contract maturity date, he bears basis risk, because the spot price and the futures price need not move in perfect unison at all times before the delivery date.
Speculators: While hedgers buy or sell futures contracts to protect themselves against the risk of price changes, speculators buy or sell futures contracts in an attempt to earn a profit. Speculators do not have a prior position that they want to hedge against price fluctuations. Rather they are willing to assume the risk of price fluctuation in the hope of profiting from them.
Speculators play a very important role in the proper functioning of the futures market. They absorb the excess demand or supply generated by hedgers and assume the risk of price fluctuations that hedgers want to avoid. Speculators impart liquidity to the market and their actions in general dampen the variability in prices over time.