Page 114 - DCOM510_FINANCIAL_DERIVATIVES

Unit 7: Application of Futures Contracts

and the potential loss. Insurance resolves risk into profit and loss, and eliminates the loss while Notes
retaining the profit. Diversification is affected by choosing a group of assets instead of a single
asset (i.e., technically, by adding positively and imperfectly correlated assets). Hedging is
implemented by adding a negatively and perfectly correlated asset to an existing asset. Insurance
for investment is achieved by buying a put option on the investment. Diversification and hedging
do not have cost in cash but may have an opportunity cost. Insurance, on the other hand, has
explicit cost incurred in cash.

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Example: Suppose on June 30 the rice producer predicts that his produce will be 500,000
kgs. after three months. He wants to eliminate the price risk, i.e. he wants to lock in the future
price of his produce. Now, the October futures contracts are trading at ` 3.22/kg., and each
contract consists of 5,000 kgs. This price is acceptable to the producer, so he sells 100 rice futures
contracts at this price. Now on the day of maturity of the contract, if the price goes below ` 3.22,
he is safe. On the other hand if the spot price of the corn goes above ` 3.22, the producer loses the
additional profit. Here the futures eliminate downside risk, but limits upside profit potential.
After selecting the futures commodity and expiration month, the hedger must decide whether to
go long or short.
The basic steps in hedging strategy using futures contracts are:
1. Deciding to use what kind of derivatives and if futures contract, then should it be long
futures or short futures.
2. Deciding the type and nature of Futures contract to be used for hedging the spot position.
Keeping in view that most hedging is cross hedging, this requires deciding the futures
contracts to use whose underlying asset is perfectly correlated with price movement in
original asset.
3. Selection of a contract month. This depends upon such period where the futures and spot
prices are highly correlated. In practice, hedging with the near month futures contract is
preferable because it minimizes the basis variation (basis = spot price – futures price).

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Caselet Case of a Corn Producer

et us consider the following case of a corn producer. A rice producer uses the
futures market to lock in a price for produce. The farmer here is a hedger, he is not
Lconcerned about how the cash price and the futures price move, because both the
futures prices and the cash price tend to move together assuring a gain in one market to
cover the loss in the other market. Futures contract for rice is traded for December, March,
May, July and September delivery at NCDEX (National Commodity Derivative Exchange).
The contracts are for 5,000 kgs. of rice. To begin with, the producer must decide when and
how much to purchase in the futures market. Trading futures requires depositing initial
margin and meeting margin calls if the market moves against the futures position taken by
the hedger. In the case of options, the buyer need not put up margin money, but he will have
to pay an option premium. The minimum loss in this case is the option premium paid.

Source: Mishra Bishnupriya (2007). Financial Derivative. Excel Books.
Concept of Hedge Ratio

The hedge ratio (HR) is the number of futures contacts one should use to hedge a particular
exposure in the spot market. In other words, the hedge ratio is the ratio of the size of the position
taken in futures contracts to the size of the exposure.

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