By Bryan Rafie, Fall 2015 Student Intern
The future is to some extent unpredictable. Unpredictability brings risk. Businesses do not like risk. In an effort to manage their risk, businesses establish future contracts. Futures contracts are standardized forward contracts. Forward contracts are agreements to buy or sell a good (Commodity or Financial Instrument) at a specific price at some point in the future. Businesses commonly use forward contracts to minimize the risk of the prices on items vital to their business going up or down.
An example of this would be an oil company and an airline. An airline needs gas to fuel their airplanes. Without gas, the airplanes do not fly, and the airline does not make money. Therefore, when an airline sets the price of a ticket they take into account the price of oil. Oil companies drill for oil. After spending a lot of money finding and extracting the oil from the ground, the oil company then has to sell the oil. Therefore, before an oil company will decide to drill for oil in a certain site, it takes into account the price of oil. The two companies have an interest in the price of oil remaining constant over a period of time. If the price of oil goes up, the airline will not make as much money per ticket. If the price of oil goes down, the oil company will not be able to recoup as much of the money they invested when drilling for oil. In order to avoid this problem, both companies will agree to a forward contract. This helps assure businesses that the plans they make based on the price of oil today are not undermined by fluctuations in its price.
Say the price of oil goes up 200%. The oil company decides not to sell to the airline because it can sell the oil to someone else and make a lot more money. The airline’s options are limited. It has to buy oil to operate, so it now has to pay the increased price of oil, and sue the oil company to recover damages. The problem with lawsuit is they take time and cost money. This risk if called counterparty risk. To reduce this risk, companies use future contracts.
Futures contacts are standardized forward contracts that are overseen by a party called a clearinghouse. The clearinghouse acts as an intermediary. Each party establishes an account with the clearinghouse. The clearinghouse then requires the parties to deposit a specific amount of money into the account to initiate the contract. This deposit is called the initial margin. After the futures contract is established, the clearinghouse requires both parties to maintain a certain balance in the account. This balance is called the maintenance margin. The clearinghouse then determines the value of the contract daily. As the value changes, the clearinghouse transfers funds from one parties account to the other. The clearinghouse then guarantees the performance of futures contract, essentially eliminating the counterparty risk.
The dangers futures contracts present are what also make them so effective. The standardized nature of a futures transaction allow many investors access to these contracts. The margins required by the clearinghouse are normally only a fraction of the actual value of the contract. In some cases these margins can be as low as 5-10%. This means that an investor can promise to deliver $500,000 worth of oil for only $25,000 up front. The problem here is that an investor can make big bets on the price of a commodity relatively cheaply. This ability therefore increases the risk relating to relatively small price fluctuations. If an investor makes a bet that goes bad, the clearinghouse is able to manage and minimize the risk to the other party of the transaction. Unfortunately this does not reduce the risk to parties who may have given money to the investor who lost money on the investment.
Ultimately, futures contracts help business mitigate real risk associated with their businesses. It also allows investors to take big risks in exchange for potential big returns. Therefore, individuals considering investment in this area should be careful to understand the details and risk involved.