Question

 

Tom informs you that he is now contemplating hedging his 10,000 shares of Home Depot inc using futures contracts. Precisely explain and specifically detail the steps involved in hedging this share portfolio using futures contracts.

 

Answer 1

Future Contract:

It is simply defines as exchange traded forward contract.

Forward Contract:

It is a contract where one party agree to buy, another party agree to sell specified asset on some future date but at rate agreed upon today.

Hedging:

It refers to an action in which investor either buy or sell particular commodity as protection against risk of losses.

Process of Hedging through Futures Contract:

Step 1: If you want to hedge using Index future Contract then, first calculate Beta of your stock (i.e. Home Decor Inc.)

Step 2: Say, the Beta of Stock is 2 then you should take opposite action in futures contract with double amount (i.e. if you have long in spot then short in future but since beta is 2 then short with double amount)

Step 3: Whatever action you want to take with Stock at some future date, take that action with futures contract by today

Step 4: One should need to understand contract size and then determine no. of lots that he will long or short in futures market to protect themselves from losses.