Page 169 - DMGT513_DERIVATIVES_AND_RISK_MANAGEMENT

Derivatives & Risk Management

Notes The salient features ofLong Hedging strategy in futures are:
(a) Situation: Bullish outlook. Prices expected to rise.
(b) Risk: No upside risk. Strategy meant to protect against rising markets.
(c) Profit: No profits, no loss. In case of price increase, loss on the spot position offset by
gain on futures position. In case of price fall, gain on the spot position offset by loss
on futures position.

Example: Suppose that a tyre manufacturing company knows it will require 1,000 quintals
of rubber on May 15. It is, say, January 15 today. The spot price of rubber is ` 5350 per quintal and
the May futures price is ` 5210 per quintal. The company can hedge its position by taking a long
position in 10 May futures contracts and closing its position on May 15. The strategy has the
effect of locking in the price of the rubber that is required at close to ` 5,210 per quintal.
Suppose the price of rubber on May 15 proves to be ` 5,260 per quintal. Since May is the delivery
month for the futures contract, this should be very close to the futures price. The company gains
on the futures contracts = 1000 × (` 5,260 – 5,210) = ` 50,000. It pays 1,000 × ` 5,260 = ` 52,60,000
for the rubber. The total cost is therefore ` 52,60,000 – ` 50,000 = ` 52,10,000 or ` 5,210 per quintal.
For an alternative outcome, suppose the futures price is ` 5,050 per quintal on May 15. The
company loses approximately: 1,000 (` 5,210 – ` 5,050)= ` 1,60,000 on the futures contract and
pays ` 1,000 × ` 5,050 = ` 50,50,000 for the rubber. Again the total cost is ` 52,10,000 or ` 5,210 per
quintal.
Let us take another example. A greeting card company anticipated a large inflow of funds at the
end of January when retail outlets pay for the stock of cards sold during the holiday's season in
December. The management intends to puts ` 1 crore of these funds into a long-term bond
because of the high yields on these investments. The current date is November 1 significantly by
the time the firm receives the funds on February 1. Thus, unless a long hedge is initiated now,
the financial manager believes that the return on investment will be significantly lower (the
cost of the bonds significantly higher) than is currently available via the futures market.

!

Caution The primary objective of the long hedge is to benefit from the high long term
interest rates, even though funds are not currently available for investment.
The disadvantages of a long hedge are as follows:

(a) If the financial manager incorrectly forecasts the direction of future interest rates
and a long hedge is initiated, then the firm still locks in the futures yield rather than
fully participating in the higher returns available because of the higher interest
rates.
(b) If rates increase instead, to fall then bond prices will fall causing an immediate cash
outflow due to margin calls. This cash outflow will be offset only over the life of the
bond via a higher yield on investment. Thus the net investment is the same but the
timing of the accounting profits differs from the investment decision.
(c) If the futures market already anticipates a fall in interest rates similar to the decrease
forecasted by financial manager, then the futures price reflects this lower rate,
negating any return benefit from the long hedge. Specifically, one hedges only
against unanticipated changes that the futures market has not yet forecasted. Hence,
if the eventual cash price increases only to a level below the current futures rice,
then a loss occurs on the long hedge. Consequently, an increase in return from a

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