Question

Provide some specific examples of how firms have chosen to hedge using futures or forward contracts. This could possibly include agricultural operations as well. Be sure to identify the risk the firm is trying to control.

Answer 1

A derivative is a financial asset with a value that is reliant upon or derived from, an underlying asset or group of assets—a benchmark. The derivative itself is a contract between two or more parties, and the derivative derives its price from fluctuations in the underlying asset.

Types of Derivatives

Forwards: Forward contracts are the simplest form of derivatives that are available today. Also, they are the oldest form of derivatives. A forward contract is nothing but an agreement to sell something at a future date. The price at which this transaction will take place is decided in the present.

Futures : A futures contract is very similar to a forwards contract. The similarity lies in the fact that futures contracts also mandate the sale of commodity at a future data but at a price which is decided in the present. They are traded on Exchanges.

Options: An options contract, binds one party whereas it lets the other party decide at a later date i.e. at the expiration of the option. So, one party has the obligation to buy or sell at a later date whereas the other party can make a choice. Obviously the party that makes a choice has to pay a premium for the privilege.

Swaps: A swap is a derivative contract through which two parties exchange the cash flows. currencies or liabilities. Most swaps involve cash flows based on a notional principal amount such as a loan or bond, although the instrument can be almost anything.

Example of hedging through Futures

• Lets say Current Price (as on 01.12.2019) of   Cocoa is $ 78 per KG.
• John has 100 KG of Cocoa and expects that the price may fall in short term as there will be a bulk selling on 25.12.2019. However, he does not want to sell the stock as he has taken a sales contract for January 2020.
• To hedge its short term, position, he takes a position in futures for a month in contract expiring on 31.12.2019.
• Lets say future of Cocoa at NYSE is current traded at 78.3 $
• On 01.12.2019, John will sell 100 KG of Cocoa Future (for contract maturing on 31.12.2019).
• Lets assume that there are no transaction charges in the market

On Maturity Scenario ( on 31.12.2019) there could be 3 scenarios

	units	100 KG
	Stock falls		Stock is constant		stock increase
	Value	70	Value	78	Value	81
stock valuation as on 01/12	7800		7800		7800
stock valuation as on 31/12	7000		7800		8100
Gain/Loss	-800		0		300
valuation of Future position as on 01/12	7830		7830		7830
valuation of Future position as on 31/12	7000		7800		8100
Gain/Loss	830		30		-270
Net Gain / loss	30		30		30

Thus, at a cost of 30 $ he is hedged for any kind of movement in the price.

Risks covered:

• Hedging gives protection against price changes, inflation, currency exchange rate changes, interest rate changes, etc.
• Hedging can also save time and effort as the long-term trader may not be required to monitor/adjust his portfolio with daily market volatility.