A tool for reducing price risk

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Presentation transcript:

A tool for reducing price risk Forward Contracting A tool for reducing price risk

Definitions Forward Contract: Futures Contract: A customized contract between two parties guaranteeing delivery by one party and acceptance of delivery from the other party for a specified amount, quality, and price of a commodity at a specified future date. Futures Contract: A standardized contract between two parties regarding delivery by one party and acceptance of delivery from the other party for a specified amount, quality, and price of a commodity at a specified future date.

Comparison A Forward Contract is highly customizable between the buyer and the seller and delivery (and acceptance) of the product is always expected. A Futures Contract is standardized with pre-fixed quantities and qualities stated. Every buyer and seller of a futures contract faces the same standards. Actual delivery on futures contracts is rare (< 1%).

MARKETS Cash Market: a market in which commodities and services are bought and sold with an immediate settlement of the transaction. Hence, a forward contract is a mechanism for managing risk within a cash market. Futures Market: a market in which contracts for the delivery of certain commodities at a future date are bought and sold. Hence, contracts are sold, not the actual commodity. Primarily a tool for price risk management (i.e., hedging) and for speculators.

Forward Contract Risks Price movement By agreeing to a forward contract, the buyer and seller eliminate their exposure to price movement (favorable and unfavorable) and engage in trade at an agreed price. Sellers have the risk that the cash market price will be higher than the contract’s agreed upon price. Buyers have the risk that the cash market price will be lower than the contract’s agreed upon price. Counterparty Risk The risk that one party in a contract will be unable to uphold their side of the contract. With forward contracts, counterparty risk falls unto the contract signees whereas with futures contracts the exchange facilitator (i.e., the trading house) absorbs most of the risk.

Forward Contract Risks Price risk exists for both forward contracts and future contracts But, counterparty risk is higher with forward contracts The trading house (e.g., the Chicago Mercantile Exchange) provides enough traders that it is almost always possible to find an offsetting buyer, thus limiting counterparty risk. However, future contracts require more upfront financial commitment (e.g., margins, etc.) than forward contracts.

Forward Contract Example A forward contract for feed (an input for dairy): Farmer Jones forward contracts with Feed Supply, Inc. for the delivery of 500 tons of feed grain at a price of $170.00/ton on November 15, 2015. Farmer Jones obligated to pay Feed Supply, Inc. $85,000 on November 15, 2015. Feed Supply, Inc. obligated to deliver 500 tons of feed grain on November 15, 2015. What are the risks each face?

Forward Contract Example Suppose, price rises above $170/ton to $180/ton: Farmer Jones benefits in this case, saving $10/ton or $5,000. Feed Supply, Inc. “loses” $10/ton or $5,000 on the contract. Suppose, price fell below $170/ton to $155/ton Farmer Jones “loses” $15/ton (or $7,500) in this case as he has to pay a higher price than is available on the cash market on November 15, 2015. Feed Supply, Inc. benefits by $7,500, because they are receiving $15/ton more than they would have by selling on the cash market.

Forward Contract Example What is the counterparty risk in this scenario? For Farmer Jones, it is the risk that Feed Supply, Inc. will renege (willingly or unwillingly) on the contract. Hence, if price rises, not only will Farmer Jones have to pay a higher price, they now have to scramble and find a different supplier for their feed grain. Even if price falls, they still have to find a new supplier, plus deal with the legal ramifications of the unfulfilled contract. Failing to uphold (i.e., defaulting) your part on a forward contract is usually handled in the language of the forward contract itself but defaulting, quite understandably, is highly undesirable and can lead to a multitude of legal and financial issues.