Page 111 - DCOM510_FINANCIAL_DERIVATIVES

Financial Derivatives

Notes a decrease in its price might consider hedging it with a short position in futures. If the spot price
and futures price move together, the hedge will reduce some of the risk. This is called short
hedge because the hedger has a short position. A company that knows it is due to sell an asset at
a particular time in the future can hedge by taking short futures position. This is known as a
short hedge. The pay-off profile of short hedging is depicted in figure 7.4.
Figure 7.4: Pay-off Profile of Short Hedging

Profit
Hedging

Stock Price

Loss Short Spot

The salient features of short hedging strategy in futures are:
(a) Situation: Bearish outlook. Prices expected to fall. Protection needed against risk of falling
prices.

(b) Risk: No downside risk. Strategy meant to protect against falling markets.
(c) Profit: No profits, no loss. In case of price increase, loss on the spot position is offset by
gain on futures position. In case of price increase, gain on the spot position is offset by loss
on futures position.

Example: Consider for example, an exporter knows that he will receive U.S. dollars in
two months. The exporter will realise a gain if the U.S. dollar increases in value relative to the
rupee and loss if the dollar decreases in value to the rupee. A short futures position leads to a loss
if dollar appreciates and again if it depreciates in value. It has the effect of offsetting the exporter’s
risk.
If the spot price decreases, the futures price also will decrease since the hedger is short the
futures contract. The futures transaction produces a profit that at least partially offsets the loss on
the spot position. This is called a short hedge. Another type of short hedge can be used in
anticipation of the future sale of an asset. It is taken out in anticipation of a future transaction in
the spot market. This type of hedge is known as an anticipatory hedge.

Self Assessment

State whether the following statements are true or false:
1. The losses/profits for the buyer and the seller of a futures contract are limited in futures
contracts.
2. A short 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.
3. A long hedge is also known as an anticipatory hedge.
4. A short hedge is one that involves a short position in futures contracts.

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