Page 110 - DCOM510_FINANCIAL_DERIVATIVES

Unit 7: Application of Futures Contracts

Notes

Notes The primary objective of the long hedge is to benefit from the high long term
interest rates, even though funds are not currently available for investment.

Disadvantages of Long Hedge

The disadvantages of a long hedge are as follows:
1. If the financial manager incorrectly forecasts the direction of future interest rates and a
long hedge is initiated, then the firm still locks in the futures yield rather than fully
participating in the higher returns available because of the higher interest rates.
2. If rates increase instead, to fall then bond prices will fall causing immediate cash outflow
due to margin calls. This cash outflow will be offset only over the life of the bond via a
higher yield on investment. Thus the net investment is the same but the timing of the
accounting profits differs from the investment decision.
3. If the futures market already anticipates a fall in interest rates similar to the decrease
forecasted by financial manager, then the futures price reflects this lower rate, negating
any return benefit from the long hedge. Specifically, one hedges only against unanticipated
changes that the futures market has not yet forecasted. Hence, if the eventual cash price
increases only to a level below the current futures rice, then a loss occurs on the long
hedge. Consequently, an increase in return from a long hedge in comparison to the future
cash market investment occurs only if the financial manager is a superior forecaster of
future interest rates. However, long hedge does lock in the currently available long-term
futures rate, thereby reducing the risk of unanticipated changes in this rate.
4. Financial institutions are prohibited from employing long hedges, since their regulatory
agencies believe that long hedges are similar to speculation, and these agencies do not
want financial institutions to be tempted into affecting the institution’s return with highly
leveraged “speculative” futures positions.
Stock futures can be used as an effective risk management tool. Take the case of an investor who
holds the shares of a company and gets uncomfortable with market movements in the short run.
He sees the value of his security falling from ` 450 to ` 390. In the absence of stock futures, he
would either suffer the discomfort of a price fall or sell the security in anticipation of a market
upheaval. With security futures, he can minimize his price risk. All he needs do is enter into an
offsetting stock futures position; in this case, take on a short futures position. Assume that the
spot price of the security he holds is ` 390. Two-month futures cost him ` 402. For this he pays an
initial margin. Now if the price of the security falls any further, he will suffer losses on the
security he holds. However, the losses he suffers on the security will be offset by the profits he
makes on his short futures position. Take for instance that the price of his security falls to ` 350.
The fall in the price of the security will result in a fall in the price of futures.
Futures will now trade at a price lower than the price at which he entered into a short futures
position. Hence his short futures position will start making profits. The loss of ` 40 incurred on
the security he holds, will be made up by the profits made on his short futures position.

7.1.4 Short Hedging — Long Spot and Short Futures

A short hedge is one that involves a short position in futures contracts. A short hedge is
appropriate when a hedger already owns an asset and expects to sell it at some time in future. It
can also be used when a hedger does not own an asset right now, but knows that the asset will
be owned at some time in the future. A hedger who holds the commodity and is concerned about

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