Long and short of futures and forward contracts

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SummaryWhile the future fascinates some of us, for others, it is a source of fear. Financial agents can be sub-divided into two categories.

While the future fascinates some of us, for others, it is a source of fear. Financial agents can be sub-divided into two categories. There are some who wish to seek exposure to the uncertainty and risk that the future entails. We term such agents as ‘speculators’. On the other hand, there are others who are already exposed to this uncertainty and seek ways of mitigating, if not eliminating, their exposure to such risk. We term such agents as ‘hedgers’. Irrespective of their goal, economic agents have access to financial tools that facilitate both exposure to risk as well as risk-avoidance.

Futures and forward contracts, which we term as derivative securities, help traders to both speculate on the future as well as minimise, if not eliminate, the risk to which some of them may already be exposed.

Such contracts are what we term as ‘commitment contracts’, for the assumption of a position in such contracts amounts to a binding commitment to perform on a future date. Such contracts require two counter-parties who are termed as the ‘long’ and the ‘short’, respectively.

The long in the case of such contracts has a binding commitment to take delivery of the underlying asset at the date that is specified in the contract. The short, on the other hand, is committed to give delivery of the underlying asset on the same date. In practice, both parties may be speculators, albeit with different price expectations. The long may be acting on the assumption that the price of the underlying asset will increase by the expiration date of the contract. If so, he can take delivery at the price fixed at the outset, and sell the asset at the terminal spot price, which, by assumption, is higher.

However, there is every possibility that he is wrong and the spot price of the underlying asset may decline as the contract expiration date approaches. In such cases, he will have to countenance a loss since, by its very nature, a long futures position makes it mandatory for the party to take delivery at the contract price.

The short in such a deal may be acting on the premise that the price of the underlying asset will fall. If he reads the market correctly he can acquire the asset at the terminal spot price, which, by assumption, is lower, and deliver at the initial contract price. However, he, too, may misread the market and have to face a situation where the spot price increases. If so, he will have to face the spectre of a substantial loss. Quite obviously, both parties cannot read the market movement correctly. Thus, either the long or the short is condemned to accept a loss in the case of speculation using futures and forward contracts.

Such contracts may be used as risk mitigation tools as well. The long may be a party who has a short spot position in the underlying asset, that is, he is under a prior obligation to acquire the underlying asset at a future date. His worry would obviously be that the spot price of the asset will increase and he can lock in a purchase price by going long in a forward or a futures contract.

On the other hand, the short may take the derivatives position because he has a prior long position in the underlying asset. That is, he owns the asset and is concerned about a perceived price decline. Such a party can lock in a sale price by going short in such contracts. By the time contract expiration approaches, the price of the underlying asset would have either increased or decreased. If it were to have increased, the party that has gone long would be perceived as wise and sound.

On the contrary, if the underlying asset were to have declined in value, the party with a short futures position would have credit bestowed on him for his ability to read the market accurately. In practice, only one of them will be right ex-post and, thus, while one will be complimented for his foresight, the other will be castigated for his foolishness. Such criticism is, however, unfair. For, hedgers use such contracts to mitigate their exposure to price uncertainty and not because they are convinced at the outset that their view on the market will be vindicated subsequently.

Hindsight, as someone said, is a ‘perfect science’. Hedgers are not prescient and, hence, there is every possibility that in their quest to mitigate risk, they end up looking foolish to the uninitiated. To hedge or not to hedge is a classic dilemma that is faced by a treasurer or a CFO. The hard part is convincing the CEO that the outcome with hedging will not always be better than the outcome without hedging. In other words, we hedge because we wish to avoid risk, and not because we are assured about our ability to predict the future.

Thus, the counterparties to such contracts may be both hedgers or may be both speculators, with contrasting price expectations. The other possibility, of course, is that one of the two parties is a hedger, while the other is a speculator.

From the standpoint of speculators, there is no upper bound on the futures price while there is a lower bound of zero, as is the case in the spot markets. Thus, bulls who take futures positions face the spectre of finite losses and infinite profits, while bears who tend to go short in futures are confronted with the possibility of finite profits and potentially infinite losses, as is the case with those who short sell in spot markets.

The writer is the author of ‘Fundamentals of Financial Instruments’, published by Wiley, India

Playing on future

* Futures and and forward contracts, which we term as derivative securities, help traders to both speculate on the future as well as minimise, if not eliminate, the risk to which some of them may already be exposed

* Such contracts are what we term as ‘commitment contracts’, for the assumption of a position in such contracts amounts to a binding commitment to perform on a future date. Such contracts require two counter-parties who are termed as the ‘long’ and the ‘short’, respectively

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