Page 108 - DCOM510_FINANCIAL_DERIVATIVES

Unit 7: Application of Futures Contracts

Case 2: A June Crude Oil futures rises to ` 50: If June Crude Oil futures instead rallies to ` 50 on Notes
delivery date, then the short futures position will suffer a loss of ` 10 x 1000 barrel = ` 10000 in
value.
Figure 7.2: Pay-off profile of ‘Going Short’

Profit Short Futures
or Loss

`0
30 40 50 Futures Price

The salient features of going short strategy are:

1 Situation: Bearish outlook for the market. Price of the underlying expected to fall.
2. Risk: Unlimited as the price of the underlying, and hence of futures, increase.
3. Profit: Unlimited. It depends on the downward price movement until the price of the
underlying reaches zero.
4. Break-even: The price of the underlying (on maturity) equal to the futures price contracted.

Example: Let’s say that Sonali did some research and came to the conclusion that the
price of oil was going to decline over the next six months. She could sell a contract today, in
November, at the current higher price, and buy it back within the next six months after the price
has declined. This strategy is called going short and is used when speculators take advantage of
a declining market. Suppose that, with an initial margin deposit of ` 3,000, Sonali sold one May
crude oil contract (one contract is equivalent to 1,000 barrels) at ` 25 per barrel, for a total value
of ` 25,000. By March, the price of oil had reached ` 20 per barrel and Sonali felt it was time to
cash in on her profits. As such, she bought back the contract which was valued at ` 20,000. By
going short, Sonali made a profit of ` 5,000. But again, if Sonali’s research had not been thorough,
and she had made a different decision, her strategy could have ended in a big loss.

7.1.3 Long Hedging – Short Spot and Long Futures

Hedges where long position is taken in a futures contract are known as long hedges. A long
hedge is appropriate when a company knows it will have to purchase a certain asset in the future
and wants to lock in a price now. A company that knows that it is due to buy an asset in the future
can hedge by taking a long futures position. This is known as long hedge.

!
Caution A long hedge is initiated when a futures contract is purchased in order to reduce
the price variability of an anticipated future long position.

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