In our last installment, we discussed forward contracting agreements in the cash market along with some of the considerations that go along with this type of contracting. For this month’s article, we will turn our attention to the futures market and focus on contracting with futures. A futures contract is a standardized agreement between a buyer and seller that establishes a price for an underlying asset such as a commodity or financial instrument for a future period. The terms of the contract such as the size or quantity of the instrument, the quality and the specific settlement procedures between the buyer and seller are pre-established by the exchange at which the contract trades. In addition, the exchange performs the role of clearing the contract which helps to guarantee the performance of the agreement by both parties to the contract. In this way, a futures contract differs from a forward marketing agreement where the terms of that contract are negotiated directly between a buyer and seller, with each party at risk to the other for potential non-performance of the agreement reached between them.
While the features of a forward agreement and futures contract differ from one another, in many respects they are similar. They both establish a price between a buyer and seller for a future period, and in this way allow a producer to set a purchase or sale in advance to help protect forward margins in their business. Where they differ primarily concerns their settlement procedure and how the contract performance is executed. In the case of a forward agreement as we reviewed last month, there will be a single settlement upon delivery of the underlying asset. As an example, let’s assume the two parties in this hypothetical agreement are a crop producer who grows corn and a neighbor in the local area who raises hogs. In the springtime, the two agree to a forward contract where the crop producer will sell their corn to the hog farmer at harvest time for a fixed price, and deliver this corn in the first half of November upon completion of their harvest. The price they establish in the spring will be a function of the forward futures contract that will represent the spot market during the delivery window. In this case, the December Corn futures contract would represent that spot period in the first half of November.
Let’s say that in April the December Corn futures price is $4.50/bushel. We will also assume that in this particular local market, a normal basis for the first half of November would be 25 cents under December futures. As a result, the crop farmer agrees to sell his corn to the neighbor who finishes hogs for $4.25/bushel – the $4.50 December Corn futures prices minus the basis of 25 cents under futures. At this point in time, no funds are exchanged between the two parties although there are provisions in the agreement that lay out how each will have to perform on the contract to fulfill the agreement. The main stipulation for the crop farmer is that he is obligated to deliver the corn to the hog producer during the first half of November. In turn, the hog farmer will be obligated to pay the crop producer in full upon receipt of the grain. This is how the contract gets “settled” and each party performs on their end of the agreement. A forward contract has a single settlement upon delivery.
Now let’s examine the futures market by contrast. As an alternative to contracting with each other, the hog producer may elect to secure his feed input cost by purchasing a corn futures contract on the exchange. Likewise, the farmer may choose to protect the value of his corn crop by selling a corn futures contract through the exchange. Using the same example as before, let’s assume that each is protecting their risk for the forward harvest period in November and therefore decides to contract using December Corn futures. In order to trade a futures contract, each party will need to post a performance bond to initiate the position. The performance bond represents collateral that is deposited with the exchange through an intermediary which is the brokerage firm that will clear the trade with the exchange. We will assume for this example that the performance bond requirement to trade corn futures in April is $1,500 per contract. This will require both the corn farmer and the hog finisher to each deposit a minimum of $1,500 into a brokerage account for each contract they will need to execute in order to protect their individual risks.
With December Corn futures trading at $4.50/bushel, the notional value of the contract is $22,500 which is the size of the contract at 5,000 bushels times the current market price of $4.50. Therefore, with a performance bond or initial margin requirement of $1,500/contract, both the hog farmer and crop producer each have deposited the equivalent of just under 7% of the contract’s notional value as collateral to guarantee performance of their separate agreements. In terms of what they have agreed to, this also differs from the forward contract we discussed previously. In that arrangement, they have a commitment to each other that involves physical delivery of and payment for the corn at the agreed upon settlement date – the delivery period in the first half of November. With a futures contract, each party will instead have a financial commitment to the exchange that will have to be maintained over the life of the contract until it is closed out or offset. While some futures contracts such as corn have a physical delivery settlement procedure as part of the specifications of how they are standardized by the exchange, the reality is that only a very small minority of futures contracts are settled through physical delivery. The vast majority are simply closed out or offset ahead of the contract’s expiration.
Now let’s examine how each party will have to perform on their separate agreements in the futures contracts they buy and sell. Unlike having a direct obligation to one another as stipulated in the forward contract, each party will have a financial commitment to maintain with the exchange to guarantee the performance of their contract. How this works in practice is that there is a daily settlement procedure for the futures contract. With the close of the futures market each day, a closing or settlement price is posted for each futures contract that trades on the exchange. Open positions are then “marked” to this price, and each brokerage account is credited or debited on a daily basis with the accrued gains or losses from the previous day’s closing price.
As an example, we will assume that both the crop producer and the hog farmer execute their futures contract at a price of $4.50/bushel in April when they open their separate positions. The crop producer sells December Corn futures at $4.50 to establish a sale price for their crop while the hog farmer purchases the December Corn futures contract at $4.50 to establish a purchase price for their feed needs. Each of them deposits $1,500 into a brokerage account to initiate their performance bond requirement, as stipulated by the exchange. Now let’s say that on the day they execute their trades, the December Corn futures contract closes or settles at $4.50/bushel. At this point, neither party is ahead or behind on their position as the market price that is being marked is the same at which they executed their separate contracts. (See table below)
On day 2, let’s say that December Corn futures close 10 cents higher at $4.60/bushel. The hog producer will therefore have a gain in their brokerage account of $500 or $0.10/bushel x 5,000 bushels/contract. Another way of looking at this is to think about what each party would need to do in order to close out their position in determining whether there is a gain or loss. Because the hog producer bought the contract to establish a long position in the market, he would need to sell the contract back in order to close it out. If he now can sell the contract he purchased at $4.50 back to the market at $4.60, he would realize a 10 cent gain on the position. Even though he is not yet closing out his position, his account is nonetheless credited for this unrealized gain based on where the contract is marked to the new market price. As such, the value of his account will increase to $2,000 ($1,500 initial performance bond requirement + $500 unrealized gain).
The crop farmer on the other hand will see a debit posted to their brokerage account. With the market now trading at $4.60, in order to close out of his sale obligation at $4.50, he would need to buy the contract back at $4.60 realizing a 10 cent loss. As a result, the value of his brokerage account will drop from $1,500 at the end of day 1 to $1,000 at the close on day 2 ($1,500 initial performance bond requirement – $500 unrealized loss). One stipulation of the exchange is that the initial performance bond requirement must be maintained for as long as the contract and the corresponding obligation on the position remains open. Because of this, the current value of the farmer’s account at $1,000 will require him to post additional or “maintenance” margin in the account in order to maintain the minimum performance bond requirement. As such, a margin call will be issued by the farmer’s brokerage firm at the end of day 2, requiring him to deposit additional collateral to the account in order to maintain the position in the market. In this example, the farmer will receive a $500 margin call at the end of day 2 to bring the value of his account back up to the initial performance bond requirement.
Now let’s say on day 3 the market declines and December Corn closes 20 cents lower at $4.40/bushel. Each open position is marked to the new settlement price, resulting in a loss of equity for the hog producer but a gain for the crop farmer. The 20 cents represents a $1,000 change in value on a 5,000 bushel contract, meaning that the value of the hog producer’s account will decline from $2,000 at the end of day 2 to $1,000 on the close of day 3. This means that the hog producer will be in the same position the crop farmer was the day before, with deficient equity in their brokerage account in order to maintain the open position in the market. As such, the hog producer’s brokerage firm will issue a $500 margin call to address the difference in the current value of the account and the minimum amount necessary to be maintained in order to keep the position open.
The crop producer on the other hand will see a $1,000 credit posted to their account resulting from the 20 cent drop in the futures price. Assuming they met the margin call from the day before, this means that the value of the account will increase from $1,500 at the end of day 2 to $2,500 at the end of day 3. Another way of thinking about this is while the hog producer has a margin deficit in their account, the crop farmer now has a margin excess of $1,000 ($2,500 account value – $1,500 performance bond requirement). Just as the exchange will require any margin deficit to be covered on a daily basis to maintain performance on the contract, any margin excess is likewise free to be withdrawn from the account.
This is an important distinction between a single settlement procedure in the forward contract versus a daily settlement procedure in a futures contract. While the thought of meeting margin calls may be unsettling to some and the idea of maintaining capital requirements on a daily basis might seem arduous, it is a two-way street in that unrealized gains can also be drawn upon so that cash flow can go both ways. If the market is moving against the hedge, this will present a negative cash flow situation relative to using a forward contract; however, if the market is moving in favor of the hedge there will be a positive cash flow development which would not be available through use of a forward contract.
Moreover, the mechanics of a daily settlement procedure help ensure that the performance of all open interest in the market is maintained to the benefit of every position. Because all accounts have to be settled on a daily basis, no debt is built up that would present a systemic risk. The mechanics of a single settlement procedure in a forward contract by contrast necessitate that one party will be in debt to the other party depending on how the market moves, with counterparty risk present until the settlement occurs. Because of this, it is important when using a forward contract that you know your counterparty and have faith and confidence that they will honor the terms of the agreement. Non-performance can be an issue if one of the parties runs into financial hardship before the forward contract is settled.
Another distinction that is worth highlighting is the difference between how a forward contract stipulates the requirement of physical delivery as part of the settlement procedure while the futures contract does not. This may present an added risk for the seller, who is required to make delivery. If for example the corn farmer suffers a drought whereby his crop is decimated and he is unable to physically deliver the bushels of corn to his neighbor, the forward contract may stipulate that these bushels must be replaced in the open market at prevailing costs. With a futures contract, the farmer would simply be able to offset their financial obligation to the exchange by buying back the futures contract without having the added burden of having to physically supply the lost grain.
In our next installment, we will examine another type of contracting alternative called a swap. As we will see, a swap will have features of both the forward contract as well as the futures contract and can be an attractive alternative for some producers depending on their situation.