Futures Markets function as a tool for producers, traders and manufactures to protect themselves from price fluctuation – hedging.
HEDGING EXAMPLE: SUGAR TRADER
A trader is willing to buy 5 000 tonnes sugar to sell it to a manufacturer six months from now. The trader regards current prices of 300$/tonne as a good price and wishes to secure this price. To that purpose he buys a futures contract for 5 000 tonnes sugar at the current price of 1,500,000$. Six months later when the trader has to buy 5 000 tonnes sugar physically to deliver it to the manufacturer, prices have increased to 350$/tonne. The trader has to actually pay 50$/tonne more, or 1,750,000$ in total instead of 1,500,000$. However, he is able to offset the price increase by selling his future contract bought six months before at 1,500,000$, which is now worth 1,750,000$. By hedging on the future market, the trader has offset the price increase.
HEDGING EXAMPLE: SUGAR PRODUCER
Suppose we’re in May and the current prices for sugar are 400$/tonne. A sugar producer considers this to be a competitive price at which he is willing to sell 20 000 tonnes sugar. However, the sugar will only be produced in November. Therefore, the producer will hedge the price of 400$/tonne by selling 20 000 tonnes sugar on the future market for 8,000,000$. In November, prices have fallen to 320$. The producer sells 20 000 tonnes for 6,400,000$ on the physical market. It compensates the price loses by closing his future contract by buying at 320$ or 6,400,000$ in total.
DEFINITION OF FUTURES
“Futures” or “futures contracts” refer to a standardised contract to sell or buy a determined quality and quantity of sugar at a point of time. Futures are traded on futures market exchange. Many actors on the exchange ensure liquidity of the market. Prices are determined by buyer/demand and sellers/supply. The exchange will publish these prices and market actors will relate the price for physical trade to the future price.