Share this page:

Derivative Products


Warning: Invalid argument supplied for foreach() in /home/customer/www/mhderivatives.com/public_html/wp-includes/shortcodes.php on line 587

Market Participants Uses & Applications

Market Participants

Any market we look at, we need to understand who uses the product and why. It’s worth saying at the outset that derivatives contracts, in general, have four participants. Viewing the diagram below, you will see two participants on top labeled HEDGERS. These are your participants needing futures contracts to hedge their actual business risk. A scan to the bottom of the diagram will show you the speculator and arbitrageur. These participants are our leveraged players. They use the derivatives market for the leverage it offers and provides liquidity to the hedgers. Going forward you may want to look at the type of participants in a specific product you’re viewing to see if all four participants are in the market. Without all four participants actively trading the product, the contract is unlikely to provide significant liquidity and transparency.

Uses & Applications

Hedgers a.k.a “Commercials”

Unleveraged players, a.k.a. “commercials” are corporations with market risk of crude or corn or any future contract. We differentiate between their risk and other types of market participants because these corporations are hedging their business risk to the end product they use or produce:

End Users

An end user of grains and sugar such as Kellogg & Co. doesn’t buy & store their corn, wheat & sugar all at once. Rather they make their purchases periodically over the course of the year. This way they don’t bear the risk of spoilage or the cost of storing the raw products. If the price of their commodity goes up, they will have to pay a higher price to make their product. Companies can choose to take this risk or they can choose to hedge it. Companies can hedge their price risk directly with the producers of the products or they can choose to hedge using futures. Futures, cleared through a central clearinghouse provides anonymity, price transparency and the mitigation of counterparty risk. The trade-off of using futures & central clearing is the company doesn’t get the exact product they use, delivered to the exact location they need. They take “basis risk”, which we’ll discuss in a moment.

End Producers

End producers create a product or make a raw product usable. For example, refiners buy crude oil and refine it into gasoline & heating oil. Kellogg’s purchases grains from farm consortiums. The farmers are the End Producers of corn. End producers are at risk to the price going down. To hedge their market risk they could contract directly with the end user when it’s ready for sale, or they can use futures to hedge their price risk. The end producer, such as the farm consortium choosing to sell futures makes the same trade-off as the End User. By using a central clearinghouse, their advantages include anonymity, price transparency and the mitigation of counterparty risk. The trade-off is that the futures contract may not call for delivery of the exact product they create or delivered to the same location where they are located. The producer takes “basis risk”, which we’ll discuss in a moment.

Leveraged Players

“Leveraged players” in any derivative market describe those people who will borrow money to express their trade. Futures contracts are leveraged due to the low margin cost relative to the contract value. Recall our crude oil contract, with crude @ $50 per barrel = $50,000. Yet our initial margin is only $3190.

  • The leverage of the contract =Initial margin $3,190 divided by the contract value $50,000.
  • The buyer & seller are posting 6.38% of the contract’s value as initial margin
  • They have a leverage factor of 15.67 x margin (capital used).

Margin levels can and will change as prices rise or the commodity becomes more volatile. Generally speaking, clearinghouses want initial margin to cover 3 times the average daily move. Or the average volatility of the most recent 3 days, whichever is higher.

Speculators

Speculators love leverage and with good reason. For a relatively small investment, they can reap great returns. Of course, the ever optimist living within us rarely chooses to look at the double edge sword. In a futures contract, you can LOSE MORE THAN YOU INVEST.

Types of Speculators

  • Short-Term Speculators or Day Traders generally make their decision using technical analysis.
  • Medium to longer-term speculators generally make their decisions based on the fundamental supply-demand of the underlying commodity. They may use technical points once they’ve decided to buy or sell in order to get the best price on the trade.
    • Commodity Trading Advisors, structured product desks and commodity hedge funds would fall into this user type as well.

Arbitrageurs

Arbitrageurs take advantage of price anomalies between similar products when the price between the products reaches a level outside of normal range. The arbitrageur enters a trade, looking to reverse the trade when the prices between the products normalize. In effect, a market maker is also an arbitrageur. A market maker is a liquidity provider to the market. Their mandate is to provide a bid and an offer, prices at which market participants can trade. There is a misconception that arbitrage is exploiting an obvious mispricing in the market. There Ain’t No Such Thing As A Free Lunch (TANSTAAFL). Typically arbitrageurs are simultaneously buying and selling similar contracts. For example, an arbitrageur buying US crude oil and selling UK Brent crude oil will profit if US crude rises more or falls less than Brent Crude.

This arbitrageur is still assuming risk on their trade and will lose money if Brent rises more or falls less than US Crude.

Arbitrageurs look for anomalies in relationships between two. assets.

Hedging a Futures Position – Revisited

In the typical futures market, it’s the End User & End Producer that create the need for the futures product. Consider crude oil:

  • The end user of crude oil is the refiner that needs to purchase oil at different points in time to refine the crude oil into gasoline and heating oil.
  • The end producer of crude oil is the oil & exploration company.

In the last section we covered market risk: we learned that end users of a commodity are at risk to the price of the commodity going up if they choose not to hedge. The end producer of a commodity has price risk of the commodity going down.

Why do corporations hedge using futures?

Because they don’t need to purchase or sell the crude oil today, but rather on specific dates in the future. They can hedge directly with the company who buys (sells) the underlying commodity. But the futures contract offers several advantages. Since all futures contracts are cleared at a central clearinghouse the advantages are:

  1. Privacy: no one other than the clearinghouse knows whose position is it
  2. Counterparty risk mitigation: is limited to the clearinghouse
  3. Transparency & Liquidity: provided by the central trading location of futures (electronic bulletin board)

If they hedge directly with the buyer (seller) of their commodity, they will receive (deliver) the exact commodity at the exact location they need. But they lose the advantages of the clearinghouse and the price discovery/liquidity of active futures contracts.

What is Basis Risk?

The contract specifications for crude oil called for delivery of a certain quality of crude oil. Specifically, the crude must have a Sulphur content of .42% of less; and the API gravity between 37-42 degrees. The crude oil must be delivered into Cushing Oklahoma. Basis risk is the differences between the WTI crude oil (“THE DELIVERABLE GRADE”) and the EXACT crude oil our client is hedging. The exact crude oil the client is hedging can be quite different. The hedger will adjust the number of contracts to account for this risk. But they still use the futures contract as their choice for hedging because of the reasons mentioned above:

  1. A clearinghouse offers more anonymity.
  2. A clearinghouse mitigates counterparty risk.
  3. A clearinghouse provides more liquidity and price discovery so the hedger doesn’t need to give up price advantage due to a need to hedge.
    • The hedger may have to get out of their hedge for a variety of reasons. Hedging with another commercial company will limit their ability to do so at a good price.

Volume & open interest statistics show that many hedgers prefer to use futures. For example in crude oil only ~ 3% of contracts are still open & go through the delivery process. Further, as the open interest of the maturing futures contract goes down, the open interest of the next available futures contract rises. This shows the hedgers are “rolling” their positions into the next delivery month to maintain their price hedge.

Share this page: