How can you quickly and fully understand the relative merits of futures vs forwards for hedging? I suggest using an experience many people are familiar with, buying a diamond engagement ring, as a guide. What could buying a diamond engagement ring have to do with hedging commodities or interest rate risk? Far more than it appears at surface level. Let me explain.

For most engagement ring buyers, the desired outcome is a positive reaction from the intended recipient. The diamond itself isn’t the objective, though it is very important to get it “right”. Getting it right could mean that the recipient finds the diamond’s size, shape, and quality appealing. It could also mean that it fits with their values or socioeconomic status. There are a surprising number of variables. It can take some work on your part to uncover which are important to your future spouse. Equally, which ones matter most.

In many ways, this parallels the process company leaders use to evaluate commodity risk or interest rate hedging. Companies first need to identify the commodities where they have meaningful exposure. They need to quantify the size of these exposures. Critically, they must decide on how much commodity price risk they want to accept. Uncovering the details about the company’s exposures can require cross departmental detective work. Treasurers rarely have a complete view of commodity price exposures without involving colleagues in purchasing or production teams. Companies use a similar approach to evaluate interest rate hedging needs.

Like the diamond ring buyer, once you’ve defined your company’s hedging requirements it is time to “go shopping” for solutions.

The basics of futures and forwards

First let’s look at the basic features of futures and forwards. When we refer to forwards we also include swaps like interest rate swaps. These are the core building blocks used to hedge commodity price and interest rate risks.

Futures are standardized contracts traded on a regulated exchange. Settlement takes place through a clearinghouse. Just like the stock market, the futures prices are available to all users. All users can access the same transparent quoted prices. There are futures contracts for all kinds of commodities and interest rates. For example, there are futures for gold, Libor, coffee, and copper to name just a few. Key aspects like the settlement date, quantity, location and quality of the underlying asset are standardized. 

In contrast, forwards and swaps are privately negotiated, bilateral contracts between two parties. This usually means a company and its bank. A noted benefit of forwards is the ability to tailor the specific terms like payment dates and maturities. 

That being understood, let’s dig into the implications of the differences between futures vs forwards for hedging. 

Transparency vs information asymmetry  

Back to our diamond engagement ring buyer. Other than those who work in the diamond trade, most buyers don’t know much about the product. They don’t have granular, real time price information. They don’t know how specific stones priced. Buyers may not know the extent to which each of the “four c’s” impact the price. While there are many tools online to help educate buyers, it remains a relatively opaque market. 

The diamond dealer on the other hand has deep insight. He knows what he paid for each diamond in his inventory. He knows the price where he can sell each stone to another dealer. The diamond dealer is in the business of buying diamonds and selling them at the highest possible mark-up. That dynamic is opposite to your desired outcome, to buy the right piece at the best price. There is significant information asymmetry between dealer and buyer. The dealer uses that information gap to maximize his profits at your expense. 

So, how does this relate to forwards and swaps?

The diamond business provides an egregious example of how information asymmetry can hurt you. Banks and other swap dealers tend to live by a much higher standard of customer care. However, the same fundamental dynamics of information asymmetry and motivation to increase profit margins at customer expense exist. Typically, the bank or swap dealer has more information than the hedger. They are incentivized to increase their profit on a forward or swap at the hedger’s expense. 

Regulators have taken steps to address this dynamic aiming to balance to the forwards / swap dealer vs hedger relationship. The Dodd-Frank act required forwards/swaps dealers to begin disclosing the pre-trade mark-to-market to their customers. This attempt to add transparency to the forwards market is helpful.

How are futures more transparent?

Futures are traded on regulated, public exchanges. Therefore, hedgers can see current prices where anyone can execute. This information is available in real time, so hedgers can observe market moves and look for opportunities. All participants can trade at the market price, and know in advance of executing where the market is trading. The exchange does not add any spread to the market price, nor does any other intermediary. Instead, hedgers pay exchange fees and broker commissions. These fees and commissions should be fully disclosed in detail in advance. Consequently, a hedger should have a complete understanding of all costs. 

Now imagine if that diamond dealer opened his books to you. His real books. Do you think his pricing on diamond engagement rings would go up or down?

Why did my friend get a better deal than me?

The diamond dealer, in an effort to maximize profit margins, might make judgements about each potential customer. These judgements inform the dealer as to the amount of profit margin he will add to any given piece. He may consider things like how knowledgeable the prospective buyer is. Equally, he may estimate the buyer’s available budget and willingness to negotiate on price. The price range may also impact the margin the dealer will charge. Why? Presumably it takes a similar amount of work to sell a small diamond as it does a large expensive one. Consequently, the dealer might be happy with a smaller margin on a larger sale.

How does this relate to futures vs forwards for hedging?

It may not seem obvious, but forwards and swaps have similar dynamics. Executing a $500 million swap or a $12 million dollar swap both follow a similar process. The bank or swap dealer will need to arrange derivatives trading lines and get approval to deal with the customer. Regardless of size, the bank and hedger will need to negotiate contracts to govern the forwards. All of these activities have a cost for the bank. Provided the foregoing is true, spreading those costs over a large swap makes them rather small as a percentage of the hedge size. However, for smaller commodity or interest rate swaps, these costs can add a greater percentage increase to the hedge.

Equally crucial to the pricing of forwards and swaps is the estimated likelihood that a hedger doesn’t cover potential losses. Remember, the goal of hedging isn’t to profit. The goal is to lock in certain commodity prices or interest rates. A commodity hedger may not be bothered if the forward declines in value because they typically have an offsetting physical position. Equally, an interest rate hedge is likely offset by a floating rate loan obligation. However, a loss on the hedge exposes the bank/swap provider to risk. This risk is that the hedger doesn’t pay for the loss on the hedge. 

In all things banking, the goal is to walk the fine line between risk and return. This means, that the greater the perceived risk that the hedger won’t cover losses, the higher the price. Broadly speaking, swaps for a large corporate enterprise with high credit ratings might be cheap. Conversely, If you’re a privately held mid-market trucking company, the swap is probably going to be more expensive.

Sometimes you need a very specific diamond ring

What if you know that your intended recipient of this diamond ring only wants one from Tiffany’s? At the end of the day, sometimes your situation demands a very specific solution. Like the Tiffany’s ring in it’s iconic baby blue box, you pay a premium for it. 

Companies evaluating commodity hedging occasionally face this same situation. This arises when the specific type or grade of commodity the company needs to hedge isn’t widely quoted. For example, platinum ingot delivered in NY is a widely quoted liquid market. However, if the hedger actually needs platinum sponge delivered to Johnson Matthey in Pennsylvania, the price is different. This price difference is referred to as basis. 

A hedger could accept the basis risk. This means that the hedger may have mitigated price movements of platinum, but not the changes between ingot and sponge forms. If this is an acceptable outcome, the hedger can use futures or forwards to accomplish the hedge. 

This basis risk can get particularly important when looking at energy commodities like natural  gas or gasoline at specific locations. In some cases it is prudent to hedge the specific grade of commodity and delivery location a hedger needs. This is where forwards really shine. This is because forwards are bespoke contracts where the exact form, quantity, and location can be defined. 

Will that be cash or credit?

When evaluating futures vs forwards an important area to understand is credit. What risk are you accepting that your counterparty doesn’t pay you if the hedge is in your favor? With futures the answer is the same for everyone. Since futures are settled through a clearinghouse, every market participant has the same counterparty. To ensure the clearinghouse is always able to honor its obligations, the exchange requires all participants to post margin. All participants, settle mark-to-market changes daily. 

In contrast, forwards and swaps expose counterparties to each other’s credit risk. You may not be particularly concerned that your bank will fail to honor its side of the hedge. Conversely, your bank is very focused on estimating your company’s chances of defaulting on the swap. This estimate will drive the bank’s decisions about margin & collateral requirements it requires your company to secure the swap. Equally, it will also drive the pricing of the forward as higher expected risk requires a higher return. In this context pricing is the spread that the bank adds to the futures price to earn a profit on the forward. 

For many mid-market companies a bank provided forward or swap is secured by all assets of the company. Often, the bank is a secured lender to the company so it already has a collateral charge over the company’s assets. This may mean that the company doesn’t need to post additional cash margin. However, if your company’s bank loans require a borrowing base, be aware. It is customary for the bank to reduce borrowing base availability by a “potential future exposure” estimate for the swap. Under this scenario the company is effectively “borrowing” the margin money from its bank.

Can I borrow against margin money posted on futures hedging?

Most companies don’t have unlimited liquidity. Consequently mid-market companies typically aim to have as much available liquidity under their credit lines as possible. This usually means negotiating the highest advance rates they can against assets like receivables and inventory. Some companies considering futures to hedge may not be aware that your hedge account can be pledged to your bank. Many banks will give hedgers borrowing base credit against the liquidation value of a company’s hedge account. 

The futures industry has developed a standardized security agreement that may be used for this purpose. In fact, this is the sole purpose of the agreement. With this agreement in place, many banks give up to 100% borrowing base credit for hedge account liquidation value.

Futures vs forwards – Conclusion

When considering commodity or interest rate hedging, it’s critical to clearly understand the relative merits of futures vs forwards. Understanding the value of transparency and the motivations of your counterparty can dramatically lower hedging costs. Forwards and swaps can be the most sensible solution for a variety of corporate hedging needs. However, this is not universally the case. A judicious use of futures as part of a company’s hedging structure can reduce costs and possibly streamline workflow.

We hope you’ve found this a practical and useful guide to analyzing futures vs forwards for your hedging needs. Please let us know if you have any suggestions on how we can improve it, or any of our resources. If you would find it helpful to explore your company’s hedging requirements please contact us. We would be grateful for the chance to help.

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