Why are profit/loss constantly adjusted in futures contracts if the goal is to protect against volatility?

Question

In this article: http://www.investopedia.com/university/futures/futures2.asp?header_alt=g In the chapter "Profit and Losses-Cash Settlement", the author describes that profit and loss are governed by changes in market prices.

I guess I'm confused as to why there would even be profit and loss in a futures market. The way it was explained, I thought the whole point of a futures contract was to guarantee against the effects of volatility. In other words, you'd enter a contract to be fulfilled for a certain quantity of a commodity at a certain price in advance of a specific fixed date.

So for example, a banana producer agrees to sell 100kg of bananas for $5/kg 3 months from today and the buyer agrees to pay $500 at that date.

If all of those factors are fixed, why do the participants gain and lose money as the price changes in the market?

Is the idea that those changes reflect the price you would get if you want to close your contract by transfering it to someone else? But then, why wouldn't you get the price you paid for initially?

If you were to wait until the date of delivery, would you get the price you agreed to initially, unaffected by price movements?

Answer 1

You are correct that the price fixed when the contract is made is set and maybe there are a few institutions that don't actually bother to track the future after they initiate the contract. But most parties likely track the contracts fairly carefully for a number of reasons. The big deal is that while the price the contract is set, and if you did a perfect hedge maybe the value of the contract and the thing you are hedging is then fixed, the value of that futures contract by itself changes and this is important.

The biggest reason is as JB mentions above most futures contracts settle up on a daily basis as the price of the underlying changes. This happens to limit the losses when for large price changes and one party owes a bunch of money on a futures contract and (for that reason or a different one) goes bankrupt. If the other party is using the contract to hedge a sale or asset maybe this risk is minimal but maybe that expected sale doesn't happen or maybe the party is using futures for speculation. There is no way to know built into the contract if a party is really hedging or not so people naturally want to limit this default risk.

There are many other reasons to track profit and loss as well:

• reporting and taxes
• Tracking how well the hedge is working if the hedge is "approximate" in some way which it usually is
• understanding how much risk you are hedging away or how much risk you are adding in the case of speculation
• Sometimes the hedge is no longer necessary and one wants to sell the contract
• A clearing corporation usually requires futures contracts to have some margin posted and when certain amounts are exceeded (too much loss by one party) the losing client must put up more margin

There are likely even more reasons as well that I'm missing but hopefully that gives you an idea.

Answer 2

From the question:

Is the idea that those changes reflect the price you would get if you want to close your contract by transfering it to someone else? But then, why wouldn't you get the price you paid for initially?

Before we even go into this, we need to understand that there are two types of contracts:

1. Futures: Trade in exchanges, marked to market on a daily basis (MTM) and usually don't have a fixed strike price. e.g. USDINR Futures (US Dollar Indian Rupee contract). In futures you will see different duration contracts (weekly, monthly etc.) like USDINR Dec23 contract, USDINR Jan24 contract, USDINR Feb24 contract. Here we don't have a fixed future strike price as mentioned in your banana example in the question. We only have contract specifications (lot size, expiry date, settlement price etc)
2. Forwards: These contracts are traded over the counter (OTC) and are not marked to market (MTM) on a daily basis. Here the profit and loss settlement usually happens at the contract expiry date. Needless to say the counterparty risk in these contracts is very high compared to the futures as they are not standardized, not market to market and have a low liquidity. These contracts have a fixes future strike price along with a contract expiry date. The banana contract mentioned in the question is a forward contract only.

Now coming back to the original question, after three months the buyer has to pay only $500 for the commodity as per the contract. Let's say if the spot is $600 after the three months, he can book a $100 gain as he got the commodity for $500 (forward contract) and can now sell it to other buyer.

Hope this answers the question.

Answer 3

Here is I think the root of your misunderstanding:

"I guess I'm confused as to why there would even be profit and loss in a futures market. The way it was explained, I thought the whole point of a futures contract was to guarantee against the effects of volatility. "

No, that is how some people use futures contracts, but it is not what they naturally are. A futures contract is an agreement to buy or sell something at a known price, on a future date.

Take yourself out of the financial mindset for a moment and apply this to your personal life. Assume you sign a contract to buy a new car for $30,000, but the dealer has to wait 6 months for the car to be shipped to you, which you agree to in the contract. This is the 'futures contract' [note that many futures contracts actually contain terms for physical delivery - meaning they are not just financial concepts, they truly are orders to buy or sell x amount of pork bellies and drop them off at your doorstep].

In this simplest form, the price you will pay is exactly fixed - you will not pay more or less based on the price of steel, or transportation costs, or anything else, you know exactly how much you will pay. However keep in mind that even in this simplest format, someone has risk here, just not you - perhaps the dealer has to pay whatever transportation costs end up being [oops, rail strike means the car is taken by semi-trailer, increasing fuel costs by $500], or perhaps the manufacturer has to pay whatever the paint costs end up being [hooray, new method of creating yellow paint have dropped by $200!].

Now in that same example, imagine you sign the contract, and then fail your drivers' license, meaning that you will not be able to drive your car when you get it. So, when it arrives, you will have to sell it to someone. If the value of your model of car rises, then you might make a profit! If the value of your car drops, you might have a loss. This is because you have a fixed cost to purchase the car, but your sale price is yet-unknown. This is how many people use futures contracts - as a way to financially peg their sale or purchase price to a known thing in advance.

This could be done as a way to gamble on the future price of that thing, or the opposite - for example, if you are a manufacturer of bananas and know you will make about 10,000 kg's next month, you could lock in your sale price today by selling a futures contract guaranteeing their delivery at a known price. Whether you are doing it to speculate on future price, or hedge against your other assets & liabilities, the inherent 'value' of your futures contract would have an implicit gain or loss based on the value of that item in the open market that day.

To go back to your example, if a banana producer agrees to sell 100kg of bananas for $5/kg 3 months from today, then if the price of bananas rises 2 months from now, the producer has inherently lost value by fixing their price - because if they had simply waited 3 months to sell them, they would have gotten more money. This is the cost of mitigating risk - the producer has eliminated both their upside [because they gain nothing if the price of bananas rises], and their downside [because they lose nothing if the price of bananas falls]. If this is done purely to reduce risk, then any gain on the futures contract itself, should offset a loss on the underlying asset [or vice versa], but it is still true to say that in that case, the futures contract has a gain or a loss.

Answer 4

Daily variation margin is paid to reduce counterparty default risk on PnL. It has nothing to do with the volatility that you might or might not be exposed to via holding a speculative or hedging position in futures contracts.

If anything it reduces the actual real volatility of returns streams as random counterparty defaults are much less likely.