Hedging Strategies Using Futures
Hedging Strategies using Futures
Introduction to Hedging
Hedging refers to reducing risk. Let us take a simple example to understand hedging. A farmer expects to produce ‘X’ quantity of a commodity by the end of the cropping season say, October. He has to invest a certain amount of money today from his savings or maybe take a loan in expectation of returns he will get in October. But, he cannot accurately predict the prices he will get for his produce. A dip in prices could result in a loss. To deal with this uncertainty, the farmer would like to lock in a price for his produce so that he is assured of a reasonable return. In this case, he would enter into a futures contract from the short side. Now, the efficiency of the hedge depends on 2 things: the underlying asset and the time to maturity for the futures contract and these should correspond to the farmer’s produce and the harvesting period. What we have discussed here is a short hedge. Similarly, a long hedge will be used when the party intends to buy a certain asset in the future and wants to reduce risk of rising prices.
Basis Risk
Hedging is not as easy as it appears to be. Some of the issues are listed below:
1. The asset whose price has to be hedged may not be the same as the underlying asset in futures contract
2. The exact date on which the asset is to be bought or sold may be unclear
3. The hedge may require the futures contract to be closed out before the delivery period
Essentially, the price at the time of delivery known as the spot price may not be the same as the price of the futures contract which was used to hedge the risk. The difference between these prices gives rise to Basis Risk.
Basis = Spot Price of asset to be hedged – Futures Price of contract used
During the term of the contract, both the spot price and the futures price change resulting in changing value of basis. In general, an increase in basis is called strengthening of basis and a decrease in basis is called weakening of basis.
Introduction to Hedging
Hedging refers to reducing risk. Let us take a simple example to understand hedging. A farmer expects to produce ‘X’ quantity of a commodity by the end of the cropping season say, October. He has to invest a certain amount of money today from his savings or maybe take a loan in expectation of returns he will get in October. But, he cannot accurately predict the prices he will get for his produce. A dip in prices could result in a loss. To deal with this uncertainty, the farmer would like to lock in a price for his produce so that he is assured of a reasonable return. In this case, he would enter into a futures contract from the short side. Now, the efficiency of the hedge depends on 2 things: the underlying asset and the time to maturity for the futures contract and these should correspond to the farmer’s produce and the harvesting period. What we have discussed here is a short hedge. Similarly, a long hedge will be used when the party intends to buy a certain asset in the future and wants to reduce risk of rising prices.
Basis Risk
Hedging is not as easy as it appears to be. Some of the issues are listed below:
1. The asset whose price has to be hedged may not be the same as the underlying asset in futures contract
2. The exact date on which the asset is to be bought or sold may be unclear
3. The hedge may require the futures contract to be closed out before the delivery period
Essentially, the price at the time of delivery known as the spot price may not be the same as the price of the futures contract which was used to hedge the risk. The difference between these prices gives rise to Basis Risk.
Basis = Spot Price of asset to be hedged – Futures Price of contract used
During the term of the contract, both the spot price and the futures price change resulting in changing value of basis. In general, an increase in basis is called strengthening of basis and a decrease in basis is called weakening of basis.