CFM11074a - Understanding derivative contracts: types of derivative contracts
Futures: examples
Example 1 – a commodity future
Datchlow plc, a UK manufacturing company, is a major user of
natural gas in its factories. It has a contract with a gas supplier
under which it pays monthly for the gas it uses, on the last day of
each month, at the market price on that day.
At the end of October 2003, the company anticipates that
natural gas prices may rise in November. It decides to hedge its
position by buying 1-month natural gas futures on the London
Petroleum Exchange.
On 1 November, it buys five contracts or ‘lots’
for the month of November. Each lot is for the notional delivery of
1,000 therms of natural gas on each of the 30 days of the contract
period, so the contracts are over 150,000 (1,000 x 30 x 5) therms
of natural gas. On 1 November 2003, natural gas futures are trading
at £11.90 per therm, so the contracts will cost Datchlow plc
£1,785,000 (£11.90 x 150,000).
On 28 November 2003, Datchlow plc decides to close out the
position by selling five natural gas futures contracts. (The
company could opt to take delivery of natural gas, but has no
reason to do so – it is already locked into a contract for
the supply of gas.) At that date, the contracts are trading
at £12.15 per therm, so the company’s position is worth
£12.15 x 150,000 = £1,822,500.
The company has made a profit of £1,822,500 –
£1,785,000 = £37,500.
This profit will wholly or partly offset the additional
amount the company has to pay on its November gas bill.
Datchlow plc does not actually have to pay out
£1,785,000 when it buys the contracts. Instead, it has to put
up margin, equal to the maximum amount which the clearing house
feels it might lose on the contract in one day (see CFM11031a).
Suppose that on 1 November the company puts up initial margin
of £5,000 per lot, or £250,000. At the end of the
day’s trading, the position is marked to market. Suppose that
the price of natural gas has fallen by 2p per therm. The company
has made a loss on the day’s trading of £3,000 (150,000
therms x 2p). The minimum amount of margin which the company must
maintain is increased by £3,000 to £253,000. It must pay
the additional £3,000, or the clearing house will
automatically close out its position.
Further suppose that on 2 November the price of natural gas
rises by 3p per therm. Datchlow plc therefore makes a profit on the
day’s trading of £4,500 (150,000 x 3p). The minimum
amount of margin it must maintain is reduced by £4,500 to
£248,500.
The company is thus able to realise its profits or losses on
a daily basis.
