Price Uncertainty, Hedging and Financial Derivatives

Basics | Short vs. Long | Futures Markets | Options Markets | Option Plays | Credit Default Swaps


Optimal management of any resource requires that the owner sell when the price is right. Any long-term resource investment involves future price uncertainty. Fortunately, there are various financial market "derivatives" that allow investors to "hedge" their positions by transferring price risk to speculators.


Let's begin with a couple of standard strategies for hedging against future price risk. The classic examples involve agricultural commodities. Large producers and buyers of energy and mineral resources use the same strategies in very similar markets.

Suppose that in May, just after her cornfields are planted, a farmer in Pootville, Iowa, might want to hedge against the risk of a big drop in corn prices by September, when she intends to harvest and sell her corn, so she enters into a forward contract with the local grain elevator, specifying a set price and minimum delivery quantity. The farmer avoids the risk of a price decline; the elevator avoids the risk of a price increase. Obviously the farmer also gives up the chance of a bigger profit if prices rise, and the elevator gives up the chance of a bigger profit if prices fall.

Direct forward contracting is the simplest type of hedging, but like barter, it typically requires direct negotiation between the two parties with complementary (opposite) risks. Forward contracting still involves significant risk of non-performance. For example, there might be a drought, so that the farmer can't deliver the corn, or a bumper crop that reduces prices, so the elevator is unwilling to pay the higher price they had agreed on.

Various commodities, categories of government or corporate bonds, and even stock market indices, support futures markets. Instead of forward-contracting with the local grain elevator, our farmer could call up her broker in May and have him sell some September corn futures contracts at the Chicago Board of Trade (CBT) for her.

Since prices of corn futures move pretty much in parallel with cash prices for corn, taking a "short" position in May in corn futures would complement her "long" position in her corn crop and offset her price risk. Before the futures contracts expire in September, she harvests and sells her corn, and buys back the futures. Here's how the hedge strategy would protect her profit if the local and futures prices fell:

  May (now)September gain/loss
cash position: plant at $4.25/bu sell at $3.72/bu -$0.53/bu
futures position: sell (short) at $4.15/bu buy back $3.60/bu +$0.55/bu
net result: $4.27/bu

The price difference between the Pootville cash market and the Chicago futures market is called the local "basis." When the CBT and local prices don't move exactly in parallel, the basis changes. In this example, the basis rose two cents, in favor of our farmer. She was trying to lock in a price of about $4.25/bu and realized a net price of $4.27/bu in September.

Before explaining the details of futures markets, we need to explain short-selling.


Short-selling involves selling a "borrowed" asset with the expectation of buying it back later at a lower price. A short position profits from a price decline, just as a long position profits from a price increase.

Most investors in the stock market are bullish "longs" who buy stocks, betting that their prices will rise. If you buy 100 shares of Megabux Inc. (MBUX) at $50/share, there is no limit on the upside: it could possibly go to $80,000/share like Berkshire-Hathaway and your $5,000 investment would now be worth $8 million. And your downside risk is limited: the worst that can happen is MBUX goes to zero and you lose your $5,000.

In contrast, a "short" is bearish on the stock, and bets that its price will fall. If you thought MBUX was going to tank, you could short 100 shares at $50/share through your brokerage. The broker borrows some other investor's shares, sells them for you, and holds the proceeds for you. The upside of this position is limited: the best outcome for you would be if MBUX goes to zero, and the $5,000 from the short sale is all yours; the unknown long whose shares you borrowed is out $5,000. But your downside risk is unlimited: if MBUX soars to $80,000/share, you would be on the hook for the additional $7,995,000 needed to buy back those shares!

In practice, your broker will require you to maintain a "margin" account with sufficient assets to cover losses in your short position. If your loss exceeds your margin account, your broker gives you a "margin call" requiring you to put up more money; otherwise the broker will use your margin account to close out your short position by buying back the shorted shares at the higher price. Margin requirements minimize the credit risk in short-selling.

Short-sellers are often viewed with suspicion: they want companies to fail! In the movie Casino Royale the evil dude took a huge short position on a jet manufacturer, and then tried to make their new jet crash so their stock price would tank. Fortunately James Bond saved the jet and the company's stock price too, so the evil dude organized the poker tournament to try to win back the money he'd lost in his margin account, etc., etc.


While futures markets look like legalized gambling, they serve a valuable economic function by transferring risk from hedgers to speculators. In the bad old days, farmers across the midwest would be harvesting and shipping their crops to Chicago by train at the same time, prices would plummet as the glut of commodities arrived, and late shipments might find no buyers at all.

The Chicago Board of Trade began in 1848 as a venue for forward-contracting, and established secondary trading in standardized futures contracts in 1864. The Chicago Mercantile Exchange (CME) started as a spin-off of the CBT in 1898. The CBT and CME merged in 2007, and the combined CME Group merged with the New York Mercantile Exchange in 2008.

A standardized futures contract specifies the particular grade, quantity, delivery date and delivery location, etc. for the underlying asset. For example, a CBT September corn contract is 5,000 bushels of #2 yellow corn, at a specified minimum cleanness and dryness, to be delivered in Chicago two days after contract expiration on the last business day prior to September 15th. There are equivalent corn contracts for March, May, July and December deliveries. A NY Mercantile Exchange crude oil future is 1,000 barrels of "light sweet" crude, for delivery in Cushing, Oklahoma. There are crude oil contracts for every month.

Contracts are "created" when a buyer (long) and a seller (short) agree on an initial price. The "open interest" represents the number of such contracts in active trading at a particular time. Contracts are "destroyed" whenever corresponding long and short positions are closed out. Trading is traditionally conducted by open outcry in one of the trading "pits" (like little round amphitheaters) on the exchange floor, or nowadays more often by computerized trading.

To take a short or long position in a futures market, you simply establish a margin account with a brokerage that handles trading in those contracts, and then send in your buy and sell orders. Each trade costs you a small brokerage commission which is deducted from your account. Futures trading is risky because it is so highly leveraged. Each one-cent price change means a $50 gain or loss on each contract. A single big price move can quadruple your money (assuming you can close out your position in time!), or wipe out your margin in a matter of minutes. Corn futures prices can move up to 30 cents in a single day.

Most of the players in commodity futures markets are speculators--aka gamblers. But our Pootville corn farmer isn't gambling with futures, she's hedging. For her, facing the price risk without the offsetting short futures position would be a much bigger gamble. It doesn't matter that she's not growing the type of corn the CBT contract specifies, and that she has no intention of delivering her corn to Chicago. The hedging simply depends on parallel price movements in her local corn market and the CTB corn futures market. Most futures contracts are simply canceled out rather than executed. She will harvest and sell her corn locally, and close out her short futures position before the contracts expire.

In the example above, the hedge strategy paid off handsomely; without it, she would have received $3.72/bu instead of $4.27. On a farm with 500 acres of cropland yielding 160 bushels/acre, or 80,000 bushels total, that's $44,000 of revenue achieved by shorting 16 contracts.

On the other hand, suppose local corn prices rose to, say, $4.80/bu between May and September. Closing out the short futures position would now cost her the extra revenue she gained in the cash market, e.g.:

  May (now)September gain/loss
cash position: plant at $4.25/bu sell at $4.75/bu +$0.50/bu
futures position: sell at $4.15/bu buy back $4.68/bu -$0.53/bu
net result: $4.22/bu

The futures position effectively locks in her price either way. She got $4.22, which is pretty much what she wanted, but she may envy neighboring farmers who didn't hedge and got 50 cents more per bushel. Fortunately there is another hedging strategy that would guarantee her a minimum price near $4.25/bu if the cash price falls, and give her the cash price if it rises. Instead of shorting corn futures, she could buy a "put" option on corn futures.


A futures contract is a "derivative" of the actual commodity market. Commodity options are derivatives of the commodity futures market. There are two types of options--puts and calls--and two parties in any options market--the writer (seller) of the option, and the buyer of the option.

The buyer of a "call" option acquires the right, but not the obligation, to buy the underlying asset from the option writer (seller) at a specified "strike price" on or before a specified expiration date. The buyer of a "put" option acquires the right, but not the obligation, to sell the underlying asset to the option writer (seller) at a specified "strike price" on or before the specified expiration date of the option.

Our farmer could buy put options on September corn futures (one option per futures contract) at a $4.20/bu strike price. She would pay the writer of these options a "premium" to compensate him for assuming her price risk.

Here's how the farmer's option strategy performs under the same two price change scenarios:

Price falls:May (now)September gain/loss
cash position: plant at $4.25/bu sell at $3.72/bu -$0.53/bu
put options: buy puts at $4.20 strike price
for $0.10/bu premium		 exercise puts: short futures at $4.20;
close out position at $3.60		+$0.50/bu
(net of premium)
net result: $4.22/bu
 
Price rises:May (now)September gain/loss
cash position: plant at $4.25/bu sell at $4.75/bu +$0.50/bu
put options: buy puts at $4.20 strike price
for $0.10/bu premium		 let puts expire -$0.10/bu
(lost premium)
net result: $4.65/bu!

Since the current (May) cash price is $4.25/bu, a September put option with a $4.20/bu strike price is "out of the money" because it has no intrinsic value. You wouldn't exercise an option to sell for less than the current market price, neither would you exercise an option to buy for more than the current market price. Our farmer could buy "in-the-money" September puts with a $4.40 strike price. These puts would have $0.15/bu "intrinsic value" (the current price minus the strike price) which would be included in the premium paid to the option-writer.

An in-the-money call option has a strike price lower than the current cash price, and its premium will include its current intrinsic value plus the seller's expected risk cost. An out-of-the-money call has a strike price higher than the current price, and has zero intrinsic value, so it's premium is just the expected risk cost, which is based on estimated probabilities that the cash price will exceed the strike price before the contract expires.

In contrast, an in-the-money put has a strike price higher than the current cash price, and a correspondingly higher premium, while an out-of-the-money put has a strike price lower than the cash price, zero intrinsic value, and a premium reflecting just its expected risk cost to the seller.


As the term "premium" suggests, options are basically insurance policies against adverse price movements, but they are also highly leveraged speculative instruments. The maximum potential profit from buying a put is the full strike price, realized if price of the underlying asset falls to zero; the maximum loss is the premium. The maximum potential profit from selling a put is the premium received; the maximum loss is the full strike price if the underlying asset price goes to zero. The maximum potential profit from buying a call is theoretically unlimited, and a small premium payment could conceivably earn the buyer a multiple of the strike price! The maximum buyer loss is the premium paid. The maximum potential profit from selling a call is just the premium received; the maximum potential loss is theoretically unlimited.

Before you get excited about the enormous potential profits you could make from buying options, consider this: the vast majority of options expire unused, with the option writers pocketing the premiums. Option writers are typically expert traders with highly diversified risks and very large margin accounts to cushion occasional big payouts, and just like big insurance companies (and casinos!), they win in the long run.

Suppose you get some reliable insider information that Megabux Inc. is about to announce that it will be bought out for double its current stock price. You might buy $1000 worth of MBUX and double your money. Better yet, you could put up your $1000 for a margin purchase of $2000 worth, and quadruple your money. Or better still, you could spend $1000 to buy a lot of out-of-the-money (cheap premium) calls. Say MBUX is currently trading at $50/share, and you pay a $1/share premium to buy cheap, out-of-the-money short-term calls on 1,000 shares at a $60 strike price. Then when MBUX goes to $100, your calls are worth $40,000! (Of course insider trading is illegal, and a small-time player hitting an options jackpot like this would almost certainly attract the attention of the SEC.)

Brokerages sometimes let ordinary customers write "covered" call options on shares of widely-traded stocks in their portfolios. For example, you might own 100 shares of Megabux, currently trading at $50/share, and sell a July call option on them at a $60/share strike price, collecting a premium of $2/share, or $200. You would not be able to sell the shares until the option was exercised or expired, or you bought back an equivalent call. MBUX might fall to $30/share, but you'd still be $2/share ahead of other MBUX shareholders. MBUX might soar to $100, and your option buyer would exercise his option, taking your shares for the $60/share strike price and selling them for $40/share profit, but you'd have received a total of $62/share, the first $10 of the price increase plus the option premium.

Apart from writing covered calls, option-writing is for sophisticated, large-scale traders. Like insurance companies, successful option writers diversify their risks by writing large numbers of different options so that the total revenue from premiums typically exceeds the cost of settling the minority of options that get exercised.

There are countless strategies involving multiple options for exploiting specific expectations regarding price direction and volatility. Suppose MBUX shares are currently trading at $50. Here are some examples;

To bet on a price decline you might try...

To bet on a price increase, you might try...

  • a bull call spread: buy an at-the-money $50 call for $5 and sell an out-of-the-money $60 call for $2, for a net premium cost of $3. A price increase to $53 earns this back. A price increase to $60 or higher earns you $7.
  • a bull put spread: buy an out-of-the-money $40 put for $2 and sell an in-the-money $60 put for $13 for a net premium received of $9. Your maximum profit is when the price rises to $60 or higher and both puts expire.

To profit from high price volatility either way, you might try a long straddle, buying both puts and calls at the same strike price. The most you lose is both premiums if the price remains flat.   To profit from low price volatility, you might try a short straddle, selling both puts and calls at the same strike price. Now your maximum profit is the two premiums, but a big price move can cost you a lot.

There are many other complex strategies such as butterflies, condors, collars, strangles, etc. that you can research on your own time. If you are really interested in derivatives, I recommend Dr. Toensmeyer's FREC/ECON 471 "Futures & Options Markets" course.


The derivatives markets discussed so far are fairly well regulated to maintain market confidence. But there are other derivatives markets that function outside the conventional regulatory framework. A well-known example is credit default swaps. Failures in this market are blamed for triggering the recent recession.

Here's how the trouble started. A steady run-up in housing prices beginning in the 1990's made it profitable for people to buy houses with big mortgages and little down-payment, and mortgage lenders were happy to finance these purchases. Mortgage lenders don't simply sit on the mortgages they issue and collect the payments; instead, they sell the mortgages in a secondary for cash that they can recycle into more mortgages. Mortgage service companies are hired to send homeowners their monthly bills, and remit their payments to whoever holds the mortgage.

In this secondary market, large numbers of mortgages vare bundled and traded as "mortgage-backed securities" (MBS). In a big bundle of diversified mortages, the risk of mortgage defaults is fairly predictable and stable. Hedge funds and investment banks buy MBS's and receive the stream of mortgage payments from them.

These large investors can then insure these payment streams by buying "credit default swaps" (CDS). The buyer of a CDS pays the seller a portion of the monthly payment stream from the security for the seller's guarantee to pay off the value of the security if its payment stream is interrupted or some other defined adverse "credit event" occurs. This tertiary CDS market facilitated the rapid growth of the mortgage-backed securities market.

While the CDS market looks like an insurance market and has insurance company participants like AIG, there were no regulations regarding standardized accounting methods, minimum loss reserves for sellers, restrictions on insider trading, etc. Speculators could buy CDS's on securities they didn't own. (Gosh, if I bought a fire insurance policy on your house, and some gasoline and matches....)

This was a recipe for trouble. With the CDS market making the MBS market "safe" for everybody, mortgage lenders could issue lots of sub-prime mortgages that were likely to default, bundling and reselling these in the MBS market. The smart players sold junk MBS's and even bought CDS's on them as a short strategy; the suckers bought the junk MBS's, and perhaps CDS's as insurance.

In the housing market slowdown beginning in 2008, a lot of homeowners suddenly found themselves unable to sell and "underwater," owing more on their mortgages than their houses could sell for. When you are underwater, your obvious incentive is to stop paying the mortgage, let the bank foreclose, and enjoy many months of free housing until whoever owns the MBS containing your mortgage can finish foreclosure and get you evicted. And if you're lucky, some messy record-keeping might make it impossible to prove the MBS really has your particular mortgage; then it's your house free and clear! There are various websites that explain how such homeowners can "walk away" very profitably.

The hiccup in the housing market caused a jump in sub-prime mortgage defaults, which caused the MBS market to freeze up and triggered a huge volume of payouts from CDS's. AIG and other sellers of CDS's were suddenly insolvent. MBS prices plummeted, and the MBS market could no longer recycle money back to mortgage lenders. The credit freeze extended through the entire financial system and the economy went into recession. To get the credit markets working properly again, the taxpayers are bailing out the fat cats who got suckered. Congress has yet to find the political courage to reform this system; most politicians simply don't understand it.