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By ADMIN
We can be a little bit more precise concerning the relationship between spot and futures prices for financial futures. To illustrate, suppose we had a futures contract on shares of common stock in a single company (actually there are no such contracts in the U.S.). This particular stock does not pay dividends.
For concreteness, suppose the contract calls for delivery of 1,000 shares of stock in one year. The current (i.e., cash or spot) price is $50 per share. Also, 12-month T-bills are yielding 6 percent. What should the futures price be? To answer, notice that you can buy 1,000 shares of stock for $50 per share, or $50,000 total. You can eliminate all of the risk associated with this purchase by selling one futures contract. The net effect of this transaction is that you have created a risk-free asset. Since the risk-free rate is 6 percent, your investment must have a future value of $50,000 × 1.06 = $53,000. In other words, the futures price should be $53 per share.
Suppose the futures price is, in fact, $52 per share. What would you do? To make a great deal of money, you would short 1,000 shares of stock at $50 per share and invest the $50,000 proceeds at 6 percent. Simultaneously, you would buy one futures contract.
At the end of the year, you would have $53,000. You would use $52,000 to buy the stock to fulfill your obligation on the futures contract and then return the stock to close out the short position. You pocket $1,000. This is just another example of cash-futures arbitrage.
More generally, if we let F be the futures price, S be the spot price, and r be the risk-free rate, then our example illustrates that
F = S(1 + r)
In other words, the futures price is simply the future value of the spot price, calculated at the risk-free rate. This is the famous spot-futures parity condition. This condition must hold in the absence of cash-futures arbitrage opportunities.
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By ADMIN
Intuitively, you might think that there is a close relationship between the cash price of a commodity and its futures price. If you do, then your intuition is quite correct. In fact, your intuition is backed up by strong economic argument and more than a century of experience observing the simultaneous operation of cash and futures markets.
As a routine matter, cash and futures prices are closely watched by market professionals. To understand why, suppose you notice that spot gold is trading for $400 per ounce while the two-month futures price is $450 per ounce. Do you see a profit opportunity?
You should, because buying spot gold today at $400 per ounce while simultaneously selling gold futures at $450 per ounce locks in a $50 per ounce profit. True, gold has storage costs (you have to put it somewhere), and a spot gold purchase ties up capital that could be earning interest. However, these costs are small relative to the $50 per ounce gross profit, which works out to be $50 / $400 = 12.5% per two months, or about 100% per year (with compounding). Furthermore, this profit is risk-free! Alas, in reality, such easy profit opportunities are the stuff of dreams.
Earning risk-free profits from an unusual difference between cash and futures prices is called cash-futures arbitrage. In a competitive market, cash-futures arbitrage has very slim profit margins. In fact, the profit margins are almost imperceptible when they exist at all.
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By ADMIN
Many businesses face price risk when their activities require them to hold a working inventory. For example, suppose you own a regional gasoline distributorship and must keep a large operating inventory of gas on hand, say, 5 million gallons. In futures jargon, this gasoline inventory represents a long position in the underlying commodity.
If gas prices go up, your inventory goes up in value; but if gas prices fall, your inventory value goes down. Your risk is not trivial, since even a 5-cent fluctuation in the gallon price of gas will cause your inventory to change in value by $250,000. Because you are in the business of distributing gas, and not speculating on gas prices, you would like to remove this price risk from your business operations. Acting as a hedger, you seek to transfer price risk by taking a futures position opposite to an existing position in the underlying commodity or financial instrument. In this case, the value of your gasoline inventory can be protected by selling gasoline futures contracts.
Gasoline futures are traded on the New York Mercantile exchange (NYM), and the standard contract size for gasoline futures is 42,000 gallons per contract. Since you wish to hedge 5 million gallons, you need to sell 5,000,000 / 42,000 = 119 gasoline contracts. With this hedge in place, any change in the value of your long inventory position is canceled by an approximately equal but opposite change in value of your short futures position. Because you are using this short position for hedging purposes, it is called a short hedge.
By hedging, you have greatly reduced or even eliminated the possibility of a loss from a decline in the price of gasoline. However, you have also eliminated the possibility of a gain from a price increase. This is an important point. If gas prices rise, you would have a substantial loss on your futures position, offsetting the gain on your inventory. Overall, you are long the underlying commodity because you own it; you offset the risk in your long position with a short position in futures.
Of course, your business activities may also include distributing other petroleum products like heating oil and natural gas. Futures contracts are available for these petroleum products also, and therefore they may be used for inventory hedging purposes.
The opposite of a short hedge is a long hedge. In this case, you do not own the underlying commodity, but you need to acquire it in the future. You can lock in the price you will pay in the future by buying, or going long in, futures contracts. In effect, you are short the underlying commodity because you must buy it in the future. You offset your short position with a long position in futures.
