Page 168 - DMGT513_DERIVATIVES_AND_RISK_MANAGEMENT

Unit 12: Risk Management with Derivatives I

The salient features of going short strategy are: Notes
(a) Situation: Bearish outlook for the market. Price of the underlying expected
to fall.

(b) Risk: Unlimited as the price of the underlying, and hence of futures, increase.
(c) Profit: Unlimited. Depends on the downward price movement until the price of the
underlying reaches zero.

(d) Break-even: The price of the underlying (on maturity) equal to the futures price
contracted.

Example: Let's say that Sonali did some research and came to the conclusion that the
price of oil was going to decline over the next six months. She could sell a contract today, in
November, at the current higher price, and buy it back within the next six months after the price
has declined. This strategy is called going short and is used when speculators take advantage of
a declining market. Suppose that, with an initial margin deposit of ` 3,000, Sonali sold one May
crude oil contract (one contract is equivalent to 1,000 barrels) at ` 25 per barrel, for a total value
of ` 25,000. By March, the price of oil had reached ` 20 per barrel and Sonali felt it was time to
cash in on her profits. As such, she bought back the contract which was valued at ` 20,000. By
going short, Sonali made a profit of ` 5,000! But again, if Sonali's research had not been thorough,
and she had made a different decision, her strategy could have ended in a big loss.

3. Long Hedging – Short Spot and Long Futures: Hedges where long position is taken in a
futures contract are known as long hedges. A long 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.
A company that knows that it is due to buy an asset in the future can hedge by taking a
long futures position. This is known as long hedge. A long hedge is initiated when a
futures contract is purchased in order to reduce the price variability of an anticipated
future long position. Equivalently a long hedge locks in the interest rate of price of a cash
security that will be purchased in the future subject to small adjustment due to the basis
risk.

Did u know? Why long hedge is known as anticipatory hedge?
A long hedge is also known as an anticipatory hedge, because it is effectively a substitute
position for a future cash transaction.

The pay-off profile of long hedging is depicted in Figure 12.3.
Figure 12.3: Pay-off profile of Long Hedging

Long Futures
Profit

Stock Price

Short Spot
Loss

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