Introduction

In this chapter, we will explore the concepts of “Marking to Market” and “Hedge Accounting” as they apply to futures contracts. Marking to Market is a crucial process that occurs daily in futures trading, while Hedge Accounting allows businesses to mitigate the impact of price fluctuations on their financial statements. Understanding these practices is essential for market participants to manage risks effectively and gain insight into the financial implications of futures positions.

Marking to Market

Marking to Market is the daily settlement of gains or losses on futures contracts. At the end of each trading day, the settlement price is determined, and all open positions are revalued based on this price. The difference between the new settlement price and the previous day’s settlement price is credited or debited to traders’ accounts.

Example: Suppose a trader holds a long position in a crude oil futures contract. If the settlement price increased from the previous day, the trader would receive a credit to their account. Conversely, if the price decreased, the trader would incur a debit.

Hedge Accounting for Futures

Hedge Accounting is a practice used by businesses to offset the impact of price fluctuations on their financial statements when using futures contracts as hedging instruments. The goal of hedge accounting is to align the recognition of gains or losses on the futures contract with the recognition of gains or losses on the hedged item.

Example: A wheat producer may enter into a futures contract to sell wheat at a predetermined price to hedge against price decreases. With hedge accounting, if the price of wheat declines, resulting in a loss on the futures contract, the loss is recognized as an offset to the reduced value of the physical wheat inventory.

Fair Value Hedge and Cash Flow Hedge

Hedge accounting distinguishes between two main types of hedges: Fair Value Hedge and Cash Flow Hedge.

Fair Value Hedge

This type of hedge is used to offset the exposure to changes in the fair value of recognized assets or liabilities. The gains or losses on both the hedging instrument and the hedged item are recognized in the income statement.

Example: A company holds a fixed-rate debt and expects interest rates to rise. To protect against this risk, the company enters into an interest rate futures contract. Any gains or losses on the futures contract will offset the corresponding changes in the value of the debt.

Cash Flow Hedge

Cash Flow Hedge is used to offset the exposure to variability in cash flows that are attributable to a particular risk associated with a recognized asset or liability. The effective portion of the hedge is recorded in other comprehensive income (OCI).

Example: A company anticipates purchasing raw materials in three months but is uncertain about the cost due to commodity price fluctuations. The company enters into a futures contract to lock in the purchase price, and any changes in the futures contract’s value are recorded in OCI.