Page 113 - DCOM510_FINANCIAL_DERIVATIVES

Financial Derivatives

Notes security. Selling security futures without previously owning them simply obligates the trader
to selling a certain amount of the underlying security at some point in the future. It can be done
just as easily as buying futures, which obligates the trader to buying a certain amount of the
underlying security at some point in the future.

Self Assessment

Fill in the blanks:
5. ……………………… are equities or debentures of publicly traded companies that are
bought and sold through brokerage firms.
6. ……………………… is the purchase or sale of a specific security.
7. ……………………… require all transactions to be paid for in full by the settlement date
three days after the trade execution.
8. Trading securities are timed by investors to buy ……………….and sell ……………..in
short time frames.
9. Selling securities involves buying the security before ………………….it.

7.3 Use of Futures (Only Simple Strategies of Hedging, Speculation
and Arbitrage)

There are three major categories of people who use futures: hedgers, speculators and arbitrager.
The hedger uses the futures market to manage price risk for products they have or expect to
have. Risk is transferred to the speculator. The speculator accepts the risk with the anticipation
of earning a profit. Speculators have no intentions of buying or selling actual commodities. The
arbitrager does not actively participate in the futures market (doesn’t buy or sell futures) but
uses the information provided in the futures market. Possible uses include establishing price
outlook and evaluating other pricing alternatives. Let us discuss some simple strategies of
hedging, speculation and arbitrage.

7.3.1 Process of Hedging through Futures

To hedge something is to construct a protective fence around it. Applied to financial markets,
hedging implies eliminating the risk in an asset or a liability. Applied to stock market, hedging
implies eliminating the risk in an investment portfolio. Hedging is the process of reducing
exposure to risk. Thus, a hedge is any act that reduces the price risk of a certain position in the
cash market. Futures contracts are the primary tools of effective hedging and they enable the
market participants to change their risk exposure from unexpected adverse price fluctuations.
Futures act as a hedge when a position is taken in them which are just opposite to that taken by
the investor in the existing cash position.

Notes Hedgers sell futures (short futures) when they have already a long position on the
cash asset, and they buy futures (long futures) in the situation of having a short position
(advance sell) on the cash asset.
Hedging is one of the three principal ways to manage risk, the others being diversification and
insurance (i.e., insurance as applied to investments). Let us bring out the distinction between the
three. Diversification minimises risk for a given amount of return (or, alternatively, maximises
return for a given amount of risk). Hedging eliminates both sides of risk: the potential profit

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