Page 166 - DMGT513_DERIVATIVES_AND_RISK_MANAGEMENT

Unit 12: Risk Management with Derivatives I

4. ………..measures the calculated option value's sensitivity to small changes in volatility. Notes
5. Gamma is a measure of the calculated ……….to small changes in share price.

12.2 Hedging with Futures

Future contracts can be used to hedge a company's exposure to a price of a commodity. A
position in the futures markets is taken to offset the effect of the price of the commodity on the
rest of the company business. It is important to recognize that futures' hedging does not
necessarily improve the overall financial outcome.
There are a number of reasons why hedging using futures contracts works less than perfectly in
practice.

1. The asset whose price is to be hedged may not be exactly the same as the asset underlying
the futures contract.
2. The hedger may be uncertain as to the exact date when the asset will be bought or sold.

3. The hedge may require the futures contracts to be closed out well before its expiration
date.

Notes Issues in Hedging Using Futures
The three basic issues in deciding a suitable hedging strategy using futures contracts are as
described below.
(a) When to use a long futures and when to use a short futures?
(b) Which futures contract to use?

(c) What is the appropriate optimal size of the futures position?
Self Assessment

Fill in the blanks:
6. A position in the futures markets is taken to offset the effect of the price of the …………on
the rest of the company business.

7. The asset whose price is to be hedged may not be exactly the same as the asset underlying
the …………..

12.3 Strategies of Hedging

Essentially, futures contracts try to predict what the value of an index or commodity will be at
some date in the future. Speculators in the futures market can use different strategies to take
advantage of rising and declining prices. The most common are known as "going long," and
"going short", also referred to as Long Hedge and Short Hedge respectively.
1. Going Long – Buy Futures: When an investor goes long – that is, enters a contract by
agreeing to buy and receive delivery of the underlying at a pre-determined price – it
means that he or she is trying to get profit from an anticipated increase in future price. The
pay-off profile of 'going long' is depicted in Figure 12.1.

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