Page 123 - DCOM510_FINANCIAL_DERIVATIVES

Financial Derivatives

Notes  The unit discusses four types of hedging strategies namely, going long, going short, long
hedging and short hedging.

 When an investor goes long, he enters a contract by agreeing to buy and receive delivery
of the underlying at a pre-determined price. The investor going long is trying to profit
from an anticipated future price increase.

 A speculator who goes short—that is, enters into a futures contract by agreeing to sell and
deliver the underlying at a set price—is looking to make a profit from declining price
levels. The methodology of hedging using futures is elaborately explained using
illustrations.

 The hedge ratio is the number of futures contacts one should use to hedge a particular
exposure in the spot market.
 Speculators can also benefit from trading in futures contracts. When the underlying asset
is expected to be bullish (rising prices), the speculator opts for buying futures; whereas
when the underlying asset is expected to be bearish (falling prices), the speculator opts for
buying futures.
 The unit concludes by illustrating two of the primary benefits that an arbitrager can
obtain using futures contracts.

7.6 Keywords

Arbitrage: Arbitrage refers to riskless profit earned by taking positions in spot/futures markets.
Beta: Beta is a measure of the systematic risk of a security that cannot be avoided through
diversification.
Carry cost (CC): Carry cost is the interest cost of holding the underlying asset (purchased in spot
market) until the maturity of futures contract.

Carry return (CR): Carry return is the income (e.g., dividend) derived from underlying asset
during the holding period.
Hedge Ratio: The hedge ratio (HR) is the number of futures contacts one should use to hedge a
particular exposure in the spot market.
Index Futures: Index Futures are futures contracts with indexes as their underlying asset.
Short hedge: A short hedge is one that involves a short position in futures contracts.

7.7 Review Questions

1. What do you mean by ‘going short’? Take a numerical example to illustrate the usage of
‘going short’ in futures contracts for hedging purpose.
2. Hedging is the basic function of futures market. Discuss the statement in the light of uses
of futures contract.
3. ‘All hedging is not perfect’. Explain this statement in the light of cross hedging.
4. What is a short hedge? List its features and present its profit-loss pattern, by taking an
example.
5. Write down the salient features of short hedging strategy, long hedging strategy going
long strategy, and going short strategy in futures.

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