632598256894

The ease with which futures facilitate hedging may coax managers to occasionally take speculative
positions. A photographic film manufacturer, for example, might become experienced and
comfortable hedging silver prices by going long in silver futures. Managers at the firm might come to
believe that no one is better able to forecast silver prices than they are. A time may come when they
wholeheartedly believe that silver prices will fall. Not only might they choose not to enter a long silver
futures hedge at this time, but they may choose to go short in silver futures so as to capitalize on the
falling price. If silver prices fall, not only will they benefit from a cheaper raw input, but the short
silver futures will pay off as well. The danger here is that the manufacturer has lost sight of the fact
that it is in the film manufacturing business, not the business of speculating on commodity prices.
Although silver prices might be expected to fall, there is always the possibility that they will rise
instead. The probability of a rise might be small, but the consequences would be catastrophic. Not
only will the firm‟s raw material price rise, but the firm will suffer additionally as it loses on the
futures contract. The lesson here is that firms should stay clearly focused on what their business line is
and what role the use of futures plays in their business. Futures use should generally be authorized
only for hedging and not for speculation. Auditing systems should be in place to oversee that futures
are used appropriately.
Futures and Forwards Summary
As these examples illustrate, futures and forwards are useful tools for hedging a wide variety of
business and financial risks. Futures and forward contracts essentially commit the two parties to a
deferred transaction. No money changes hands initially. As prices subsequently change, however, one
party wins at the other‟s expense. Futures and forwards thus enable businesses to shed or take on
exposure to changing prices. When used to offset an exposure the firm faces naturally, futures and
forwards reduce risk.
Options
Options are another breed of derivatives. They share some similarities with futures and forwards, but
they also differ in many important respects. Like futures and forwards, option prices are a function of
the value of an underlying asset; thus they satisfy the definition of derivative. Unlike futures and
forwards, however, options are assets that must be paid for initially. Recall that no money changes
hands initially as parties enter into forwards and futures. Options, though, are an asset that have to be
bought for a price at the outset.
There are two kinds of options, call and puts.
Call Options