Latest / How Canadian Markets Work / Forwards and Futures Explained: How Can Leverage Wipe You Out? | Canadian Investing

Transcript

Forwards and Futures Explained: How Can Leverage Wipe You Out? | Canadian Investing · How Canadian Markets Work

• 0:00
  Imagine making, you know, an economically perfect
• 0:03
  investment decision. Right, like you do all the
• 0:05
  math correctly. Exactly. You correctly identify
• 0:08
  your exact risk exposure. You hedge it flawlessly,
• 0:12
  taking all the mathematically sound steps to
• 0:14
  insulate your portfolio. Your logic is impeccable.
• 0:17
  The market ultimately moves exactly as you anticipated.
• 0:21
  And yet it bankrupts you anyway. Yeah, before
• 0:23
  you could ever even prove you were right. It's
• 0:26
  terrifying. It really is. It sounds like, well...
• 0:28
  A structural paradox, right? The financial system
• 0:31
  penalizing you for being correct. But this scenario
• 0:34
  actually plays out constantly across markets.
• 0:37
  It happens because being right about a long -term
• 0:40
  outcome is entirely irrelevant if the architecture
• 0:43
  of your financial instruments won't let you survive
• 0:46
  the path to get there. And that structural trap
• 0:48
  is our focus for this deep dive. Welcome in.
• 0:51
  We are looking through a really fascinating stack
• 0:53
  of notes and research on financial derivatives
• 0:56
  to uncover the hidden traps of cash flow timing.
• 0:59
  Yeah, specifically looking at the journey of
• 1:01
  comparing forwards and futures. Okay, let's unpack
• 1:04
  this because we are going to see why an airtight
• 1:08
  economic hedge can become a fatal liability simply
• 1:12
  because of how and when cash is demanded. And
• 1:15
  you know, for the listener, even if you have
• 1:17
  never directly traded a derivative in your life,
• 1:20
  you probably own them indirectly. Right, like
• 1:22
  through ETFs or managed products in your retirement
• 1:25
  account. Exactly. Understanding this mechanism
• 1:27
  is, I mean, it's the ultimate shortcut to understanding
• 1:30
  how financial crises actually happen. So to understand
• 1:33
  how things go wrong, we first have to look at
• 1:35
  the simplest way to make an agreement. Let's
• 1:38
  start with the baseline, the forward contract.
• 1:41
  Right, the classic forward. The sources outline
• 1:43
  this really classic scenario. Think of a farmer
• 1:46
  who will have, say, 10 ,000 bushels of wheat
• 1:49
  to sell in September. And there's a bakery that
• 1:52
  knows they will need wheat in September. A perfect
• 1:54
  match. Right. So they agree in March on a price
• 1:57
  of $8 per bushel for delivery when September
• 2:00
  rolls around. And that right there is a forward
• 2:02
  contract. It is bilateral, meaning it's just
• 2:05
  the two of them. Just a handshake, basically.
• 2:07
  Exactly. And it's totally customized. Any quantity,
• 2:10
  any date, any grade of wheat you want. And it
• 2:13
  is settled completely at delivery. So no money
• 2:16
  changes hands until the wheat shows up. Right.
• 2:19
  And the huge advantage here is that it minimizes
• 2:22
  what we call basis risk. Because it matches the
• 2:25
  farmer's real -world exposure perfectly. Exactly.
• 2:29
  You are hedging the exact thing you are growing.
• 2:31
  But, okay, let me play devil's advocate for a
• 2:33
  second. If this is so perfect, why did the financial
• 2:37
  world need to invent anything else? Like, what's
• 2:39
  the catch? Well, there are three... Pretty fatal
• 2:43
  flaws with forwards, actually. OK, laying them
• 2:44
  on me. First is counterparty risk. If that bakery
• 2:47
  goes bankrupt in July, the farmer's hedge just
• 2:51
  vanishes. Oh, wow. So you're totally reliant
• 2:53
  on the other guy's business sting afloat. Exactly.
• 2:55
  The second flaw is illiquidity. It is a private
• 2:58
  contract, right? Right. So you can't just easily
• 3:00
  sell it to someone else if you change your mind
• 3:01
  or want out early. Because who wants a contract
• 3:04
  for your exact specific grade of wheat on your
• 3:06
  exact timeline? Which brings us to the third
• 3:09
  flaw matching. It is incredibly hard to find
• 3:12
  someone who wants the exact mirror of your specific
• 3:16
  size and schedule in the first place. Yeah, that
• 3:18
  makes sense. Because finding a perfect customized
• 3:20
  match is hard, the market essentially created
• 3:23
  a mass -produced solution. Right, which is the
• 3:25
  futures contract. So futures are the solution
• 3:28
  to the forward's flaws. Yeah, futures are standardized
• 3:30
  by an exchange. So you get fixed quantities,
• 3:33
  fixed grades, fixed delivery dates. It's off
• 3:36
  the rack instead of custom tailored. Exactly.
• 3:38
  And the trade -off there is that by standardizing,
• 3:41
  you accept basis risk. Because the contract won't
• 3:44
  perfectly match your exact exposure anymore.
• 3:46
  Right. But you gain a really deep liquid market
• 3:48
  where you can enter and exit easily. Which is
• 3:51
  huge. It is. And if we connect this to the bigger
• 3:53
  picture, This leads to the most crucial innovation
• 3:56
  of all. The central clearinghouse. Yes. The clearinghouse
• 4:00
  completely changes the game. It steps between
• 4:02
  every single buyer and seller. So your counterparty
• 4:05
  is no longer that random bakery down the street.
• 4:08
  Right. Your counterparty is now a heavily capitalized,
• 4:12
  heavily regulated clearinghouse. Meaning counterparty
• 4:15
  risk is largely removed. Essentially, yes. Yeah.
• 4:17
  They guarantee the trade. But wait, that begs
• 4:20
  a really logical next question. If the clearinghouse
• 4:23
  takes on all the risk of everyone failing, how
• 4:26
  does it protect itself from going bankrupt? And
• 4:28
  that is the secret sauce. The clearinghouse protects
• 4:31
  itself through a mechanism called marking to
• 4:34
  market. The daily repening. Yes, every single
• 4:37
  day. Gains and losses are calculated daily, and
• 4:40
  cash actually moves between accounts every single
• 4:44
  evening. Okay, to put this in perspective for
• 4:46
  the listener, it's like paying rent. But instead
• 4:49
  of signing a lease and paying at the end of the
• 4:51
  year, your landlord recalculates the value of
• 4:53
  the apartment every single night. Oh, that sounds
• 4:56
  incredibly stressful. Right. And they make you
• 4:58
  settle up the difference in cash before you go
• 4:59
  to sleep. That is a perfect analogy. And the
• 5:02
  mechanics of this margin are intense. You have
• 5:04
  to post what's called initial margin. just to
• 5:07
  open the position like a down payment or a security
• 5:10
  deposit. Yeah, exactly. But if your daily losses
• 5:13
  erode your cash below a certain maintenance level,
• 5:16
  you get hit with a margin call, which means you
• 5:18
  have to wire more cash immediately or they close
• 5:20
  your position immediately. Yeah. And we have
• 5:22
  to stress the massive leverage involved here.
• 5:25
  The margin is just a tiny percentage of the contract's
• 5:28
  actual notional value. So you're controlling
• 5:30
  a huge asset with a tiny bit of cash. Right.
• 5:34
  Meaning a really modest price move in the market.
• 5:36
  causes a massive percentage swing in the cash
• 5:39
  you've posted. Which brings us to the ruinous
• 5:41
  path, the cash flow timing risk. Now we see exactly
• 5:45
  how this daily settlement turns our perfectly
• 5:47
  safe farmer into a bankrupt one. It's a really
• 5:50
  brutal sequence of events. Here's where it gets
• 5:52
  really interesting. Let's set up the math for
• 5:54
  the listener, just based on the sources. The
• 5:56
  farmer uses futures to hedge his 10 ,000 bushels
• 5:59
  at $8. Right, so he is short the futures contract,
• 6:03
  blocking in that $8. OK, but in April, the global
• 6:05
  price of wheat unexpectedly rises to $9 a bushel.
• 6:09
  A huge spike. Right. And because the farmer sold
• 6:12
  futures to lock in $8, his short futures position
• 6:16
  loses $1 per bushel. Which is a $10 ,000 paper
• 6:20
  loss. But because of daily settlement, it's not
• 6:22
  on paper. That's a $10 ,000 loss collected instantly
• 6:26
  via a margin call. Yes. But wait, I have to push
• 6:28
  back hard on this logic. The farmer has 10 ,000
• 6:31
  bushels of real wheat growing in the field. If
• 6:34
  the price went up to $9, his physical crop is
• 6:37
  literally worth $10 ,000 more. Yes, it is. Economically,
• 6:41
  he is perfectly flat. The physical gain offsets
• 6:44
  the futures loss. Why is this a crisis? Because,
• 6:48
  and this is the core insight from the research
• 6:50
  we've done, the field doesn't pay margin calls.
• 6:53
  Oh, wow. Right? The farmer has these... amazing
• 6:56
  unrealized gains sitting out in the soil, but
• 6:58
  he needs cold hard cash today to satisfy the
• 7:02
  clearinghouse. And if his money is all tied up
• 7:04
  in tractors and fertilizer. Exactly. If he lacks
• 7:07
  the liquidity, he is forced to close his position.
• 7:09
  He realizes a massive $10 ,000 loss and he ruins
• 7:13
  the hedge entirely. He gets wiped out before
• 7:15
  the harvest even happens. Yes. But what's tragic
• 7:18
  is that if the farmer could somehow survive those
• 7:21
  daily margin calls until September. If he had
• 7:24
  a giant line of credit to just float the cash.
• 7:27
  Right. He would sell his physical wheat for $90
• 7:30
  ,000, subtract the $10 ,000 in margin he paid
• 7:33
  along the way, and he is left with $80 ,000.
• 7:37
  Which is exactly $8 a bushel. Exactly. The final
• 7:41
  outcome is mathematically identical to the forward
• 7:43
  contract. It's the exact same destination, but
• 7:46
  a totally different road. The path required an
• 7:48
  interim cash flow that completely destroyed him.
• 7:51
  Yes. Liquidity is what killed him, not solvency.
• 7:54
  So what does this all mean? Like, how does the
• 7:56
  listener avoid these hidden traps when managing
• 7:59
  their own wealth? What's fascinating here is
• 8:01
  that even if you aren't a farmer, these rules
• 8:03
  totally apply to you. Rule number one from the
• 8:06
  sources is understanding incorrect exposure.
• 8:09
  Because retail investors rarely trade futures
• 8:11
  directly. Right, but they are absolutely exposed
• 8:13
  to them inside commodity ETFs and managed products.
• 8:17
  Like an oil ETF. Exactly. If you buy a crude
• 8:20
  oil ETF, you have to know what is under the hood.
• 8:23
  You aren't buying barrels of oil. You are buying
• 8:26
  a fund that holds futures contracts. And those
• 8:29
  funds have to pay those daily market to market
• 8:31
  margins. Yes. And they have to constantly roll
• 8:34
  expiring contracts, which can create a massive
• 8:37
  structural drag if the market is in contango.
• 8:40
  Contango meaning the future price is higher than
• 8:43
  the spot price. Right, so the fund is structurally
• 8:45
  forced to buy expensive contracts and sell cheap
• 8:47
  ones, bleeding your returns. That is a huge hidden
• 8:50
  cost. Okay, what's rule number two? Rule two
• 8:53
  is about position sizing. The biggest mistake
• 8:56
  traders make is sizing their positions based
• 8:58
  on the margin requirement rather than the full
• 9:01
  notional value. Mistaking the down payment for
• 9:03
  the actual risk. Exactly. If you post $5 ,000
• 9:06
  to control a contract worth $100 ,000, your true
• 9:10
  exposure is $100 ,000. Because if the market
• 9:12
  gaps against you, you are on the hook for that
• 9:15
  whole amount. Right. You must size your position
• 9:19
  against the full notional value, never just the
• 9:22
  margin posted. Otherwise, you end up owing your
• 9:25
  broker more than your net worth. And that leads
• 9:27
  perfectly into the final rule from the sources,
• 9:30
  which is understanding your settlement types.
• 9:32
  The difference between physical and cash settlement.
• 9:35
  This one is crucial. Yeah. Because financial
• 9:38
  instruments, like an S &P 500 index future, they
• 9:41
  settle in cash. You just get a credit or a debit.
• 9:44
  But commodity futures can actually settle physically.
• 9:48
  Meaning you are legally obligated to take delivery
• 9:51
  of the physical asset. Right. You really need
• 9:53
  to make sure you know your contract type or,
• 9:55
  you know, you might end up legally obligated
• 9:57
  to take delivery of a literal truckload of physical
• 10:00
  wheat in your driveway. I mean, we laugh, but
• 10:02
  that kind of logistical nightmare actually happens.
• 10:05
  It's why oil went negative back in April 2020.
• 10:07
  Right. Traders couldn't take physical delivery
• 10:09
  of the oil because storage was full. So they
• 10:11
  were paying people to take the contracts off
• 10:13
  their hands. Exactly. They were trapped by the
• 10:15
  settlement terms. Unbelievable. OK, so to briefly
• 10:19
  recap for everyone listening. Forwards are customized,
• 10:22
  but they are illiquid and carry massive counterparty
• 10:24
  risk. Futures are standardized and safe from
• 10:27
  that counterparty risk thanks to the clearinghouse,
• 10:30
  but the daily cash demands the market to market
• 10:33
  can ruin you before you ever reach the finish
• 10:35
  line. The cash flow timing mismatch. Exactly.
• 10:38
  But I want to leave a listener with a final thought
• 10:40
  tomorrow over. We've been talking about this
• 10:42
  on an individual level. But if one farmer going
• 10:45
  bankrupt because of a cash flow timing mismatch
• 10:48
  is a personal tragedy, think about the macro
• 10:51
  scale. Right. What happens to the global financial
• 10:53
  system when thousands of massive institutions,
• 10:57
  pension funds, banks are all using the exact
• 11:00
  same futures contracts to hedge the same macro
• 11:02
  risks? And then a market shock hits and they
• 11:06
  all get hit with billions of dollars in margin.
• 11:08
  calls on the exact same afternoon. They all have
• 11:11
  to sell off assets to get the cash at the exact
• 11:13
  same time. Exactly. It creates a systemic liquidity
• 11:16
  crunch. The mechanism built to protect the system
• 11:19
  can actually pull all the liquidity right out
• 11:21
  of it. It's an automated centrifuge for cash.
• 11:24
  That is an incredibly provocative thought to
• 11:26
  end on. Thank you all for joining us on this
• 11:28
  deep dive. Keep questioning the mechanics behind
• 11:30
  your money. Read the fine print on your ETFs,
• 11:33
  and we'll see you next time.