Question

Explain using examples where futures contracts have been used to hedge against both current and new types of risk faced by financial institutions and individuals in 2020.

Answer 1

Derivative instruments like Futures and Forwards have been used extensively over the years for hedging purposes. Their usage has even more significance in a time like this (i.e. 2020), when lockdown and shutting up of commercial activities have created a situation of a recession in the offing.

A very good and recent example of hedging to protect against current risk and to lock a profit by taking advantage of the lower crude oil prices can be seen in the Oil Futures market. The Oil Futures have gone into Contango which essentially means that the futures prices have gone above the spot prices of oil. This has happened mainly due to the lower prices of oil. People know that the current oil prices below $20 per barrel are too good to remain at this position. Hence, they have bought futures contracts in oil to ensure that they get the required oil in one or two years at the same reduced price. This has ensured that the futures price are more than the spot price. Hence, people have hedged against the price risk of crude oil.

An example of a new type of risk faced by individuals and financial institutions is an epidemic risk. No institution worried about the possibility of an epidemic taking over the whole world and ceasing all commercial activities. But 2020 has shown that there can be a risk due to this also and it has to be taken into account while making decisions about investments. Many investors tried hedging their equity portfolios by anticipating that their would be a large scale impact due to COVID-19. They took short positions in Futures of their equity shares so that when the prices of equities goes down, they will be able to compensate it by the gain in the futures position.