Question

Explain how (not why) a company can use the futures market to hedge against rising interest rates. What would they buy (or sell?)
Explain how (not why) a company can use the futures market to hedge against rising raw materials prices. What would they buy (or sell?)

Answer 1

1. A company can use the future instrument to hedge against rising interest rates. So it will sure about its project value and future obligation. In this case, the company will enter the future contract and agreed to oblige the given interest rate today say at 5% and ensure that it will not cause any higher interest payment if interest rate rise. So company will sell the interest rate future to borrow at a fixed rate determine today say 5%.

suppose he borrows 2million $ after three months and expects the rise in interest rate so he will enter the future contract to sell to borrow at 5% after 3-7 months. If the interest rate rises to 6.5% so he will sell the future and hedge the 1.5 increase in an interest rate at some commission of future. if interest rate decline so he will be benefited with lower interest payment and also can offset the obligation cost to sell. So net effect will be equal to 5% rate.

2. A company can hedge against the risk if rising price of kay raw material, by making a futures markets contact to protect from loss in future. So it will guaranty the company to purchase of materials at fixed today rate and purchase in future time while taking a long position in the commodity derivatives market. Company will buy the future contract at some commission to purchase raw materials at fixed price say 120$/unit delivered after six months.

Suppose material price after six months increases to 130$/unit, the company will settle the net amount with benefit from contract with 10$/unit purchase from the market. Otherwise actual delivery he may get at 120$/unit of raw material. Hence it effectively minimised the risk of rising price.