In: Finance
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?
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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