Question

Describe how to use futures contracts to hedge. Calculate the profit or loss of using futures contract.

Answer 1

A futures contract can be used for hedging against any adverse price movements. A futures contract is a contract in which a buyer agrees to buy a commodity or security at a point in the future at a pre-determined price. A buyer hedges his/her risk by buying a futures contract because he/she might need the delivery of the commodity or the security after a certain time. Because the value of such underlying can adversely change to hurt the buyer, he/she can be certain that such underlying is available at a pre-determined fixed price. The profit or loss is determined by the price at which futures contract as executed and the price of the commodity or the security at maturity time.

Let's consider an example of a person who needs wheat delivery in September. He buys a futures contract in May for purchasing 1kg wheat at a price of $0.2. The current price of wheat is $0.18. Let's say in September, the price of wheat suddenly increases to $0.25 due to certain factors. However, since the person has already entered a futures contract to buy wheat at $0.2 per kg, he/she will pay only 0.2$ per kg to take delivery. In this case, he/she gains (0.25-0.2) = $0.05 per kg ( Since the spot price of wheat in September becomes $0.25. Conversely, if the spot price of wheat in September decreases to $0.15, the buyer of the futures contract will incur a loss of $(0.2-0.15) = $0.05 loss.

The opposite is true for a future contract seller who would benefit if the spot price in September drops below $0.2 (ie. the future price). He/She would have incurred a loss if the spot price in September increases above $0.2. This is because had he not entered a future contract he could have sold his wheat in the market at a price of $0.25. But since he has entered a future contract, he/she is forced to sell his/her wheat at $0.2. In this case, the future seller has agreed to deliver wheat at a price of $0.2 in September.