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Explain how forwards or futures can be used to manage risk. Provide an example of a...

Explain how forwards or futures can be used to manage risk. Provide an example of a hedge that uses a short futures position.   Why might you chose to use a put option as a hedge instead of a short futures position?

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Expert Solution


Forwards or Futures contracts are one of the most common derivatives used to manage risk. A futures or forward contract is an arrangement between two parties to buy or sell an asset at a particular time in the future for a particular price. The difference between forward and futures contract is - forward contracts are traded Over the Counter and futures contracts are traded on a recognized Exchange like "New York Stock Exchange" (NYSE). The main reason for why companies use Futures contracts is to limit their risk exposure or to limit the fluctuations in price. For example - if a company knows it has to buy 20,000 ounces of gold after 6 months and the spot price of gold/once is $100/Ounce and the futures price for a contract to buy after 6 months is $90/Ounce. By buying the futures Contract at $90/Ounce, the company can manage its risk of getting 20,000 ounces of gold at a particular price of $90/ounce, whatever the price of gold may be in future.

Example of hedge by short futures position :-

A Cotton farmer is planning to plant 100,000 bushels of cotton which will be ready in 2 months. The farmer knows by his experience that the per bushel cost of cotton that he will incur will be $5/bushel. In the spot market at a recognized exchange, cotton/bushel is trading at $6.5/bushel which he thinks is the right amount for him to lock in the profits. He also has the feeling that the prices may fall in future so he can short sell futures contracts consisting of 100,000 bushels of cotton at a price of $6.5/bushel. After 2 months, the situation is - the price of the bushel of cotton has fallen to $6.2/bushel in the local market at an elevator and simultaneously in the spot market at the exchange. So the Farmer can sell his cotton at the local elevator at the current price of $6.2/bushel and buy the futures with the same amount in order to return the futures short sold making him the profits that he anticipated even though the prices of cotton fell in the market.

A put option may be used as a hedge instead of a short futures position because put options are less riskier than short selling futures contracts. With the put option you get a right to sell the asset at a specific price, volume and a date in future. If the price of the contract falls below the strike price, you get the option to sell the contract and if the price of the contract rises over the strike price you don't have to sell it at that price. Else, what you can do it is sell in the spot market and at maximum what you will loss is the premium amount but with short futures position the story is different because you don't have the right but the obligation to deliver the asset in future which you had borrowed and sold in the past. So if the price of the asset rises in the future infinitely you can incur maximum losses.


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