CFA Level 1
Derivatives - End Users and Dealers
End users of forward contracts vary across a broad range of sectors. In general, end-users have specific risk management concerns that can be mitigated by an appropriate forward contract. However, because forward contracts are not found on a formal exchange, end-users must find a counterparty to their contracts. A dealer is used find a complimentary counterparty that can provide a financial transaction to solve the problem. The problem could be that the end user wants to reduce or eliminate risk or just wants to take a position on the way the market may move in the future. End users are typically corporations, nonprofit organizations and governments. Below are two examples of situations in which end-users can mitigate risk with forward contracts.
An engineering firm based in Rome, Italy, has a contract with an American company for six months of work. The Italian company is being paid in two installments: the first payment at the start of the contract and the final payment on the closing date of the contract. The Italian company arranges a closed forward contract for the final payment. This protects the company against currency fluctuations and establishes how much the company will receive in euros for its final payment. This allows the company to avoid losing revenue unexpectedly as a result of rate fluctuations.
An importer in Chicago is bringing in a line of ceramics from Spain. The stock is due to arrive in the U.S. in three shipments over the next two months. Because the importer will pay for each shipment on arrival, the importing company arranges for an open forward contract equal to the value of the entire order in euros. The open contract allows the importing company to make a series of payments by drawing down on the contract amount throughout the contract period. Thanks to the forward contract, the importer knows exactly how much it needs to pay for the shipment in U.S. dollars, rather than having this amount change due to rate fluctuations between the time it books the order and when the shipment arrives.
Farmers, manufacturers, importers and exporters are typical end-users who hedge their positions by buying or selling in the futures market to secure the future price of a commodity intended to be sold at a later date in the cash market.
Other market participants, however, do not aim to minimize risk but rather to benefit from the inherently risky nature of the futures market. These are the speculators, and they aim to profit from the very price change that hedgers are protecting themselves against. Hedgers want to minimize their risk no matter what they're investing in, while speculators want to increase their risk and maximize their profits. Unlike the hedger, the speculator does not actually seek to own the commodity in question. Rather, he or she will enter the market seeking profits by offsetting rising and declining prices through the buying and selling of contracts.
A dealer helps facilitate the trading and structure of these transactions based on the end user's specific needs and goals. Dealers may take the other side of the trade for the end user or a dealer may find another counterparty that has the exact opposite needs of the end user. A dealer differs from an agent in that it takes ownership of the asset, and thereby is exposed to some risk. A dealer has ownership, even if only for an instant, between a purchase from one party and a sale to another party, and is thus compensated by the spread between the price paid and the price received.
Individuals or firms may act as either a broker or a dealer in separate transactions. This helps the dealer reduce the end user's risk from derivatives and may allow the dealer to earn additional revenue by buying and selling these contracts with his clientele. Dealers tend to be broker/dealers and/or large global banking institutions such as JP Morgan Chase, Citigroup and UBS Warburg to name a few of them.
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