Page 170 - DMGT513_DERIVATIVES_AND_RISK_MANAGEMENT

Unit 12: Risk Management with Derivatives I

long hedge in comparison to the future cash market investment occurs only if the Notes
financial manager is a superior forecaster of future interest rates. However, long
hedge does lock-in the currently available long-term futures rate, thereby reducing
the risk of unanticipated changes in this rate.
(d) Financial institutions are prohibited from employing long hedges, since their
regulatory agencies believe that long hedges are similar to speculation, and these
agencies do not want financial institutions to be tempted into affecting the
institution's return with highly leveraged "speculative" futures positions.
Stock futures can be used as an effective risk-management tool. Take the case of an investor
who holds the shares of a company and gets uncomfortable with market movements in
the short run. He sees the value of his security falling from ` 450 to ` 390. In the absence of
stock futures, he would either suffer the discomfort of a price fall or sell the security in
anticipation of a market upheaval. With security futures, he can minimize his price risk.
All he needs do is enter into an offsetting stock futures position; in this case, take on a short
futures position. Assume that the spot price of the security he holds is ` 390. Two-month
futures cost him ` 402. For this he pays an initial margin. Now if the price of the security
falls any further, he will suffer losses on the security he holds. However, the losses he
suffers on the security, will be offset by the profits he makes on his short futures position.
Take for instance that the price of his security falls to ` 350. The fall in the price of the
security will result in a fall in the price of futures.

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Caution Futures will now trade at a price lower than the price at which he entered into a
short futures position. Hence his short futures position will start making profits. The loss
of ` 40 incurred on the security he holds, will be made up by the profits made on his short
futures position.
4. Short Hedging – Long Spot and Short Futures: A short hedge is one that involves a short
position in futures contracts. A short hedge is appropriate when a hedger already owns an
asset and expects to sell it at some time in future. It can also be used when a hedger does
not own an asset right now, but knows that the asset will be owned at some time in the
future. A hedger who holds the commodity and is concerned about a decrease in its price
might consider hedging it with a short position in futures. If the spot price and futures
price move together, the hedge will reduce some of the risk. This is called short hedge
because the hedger has a short position. A company that knows it is due to sell an asset at
a particular time in the future can hedge by taking short futures position. This is known as
a short hedge. The pay-off profile of long hedging is depicted in Figure 12.4.
Figure 12.4: Pay-off Profile of Short Hedging

Hedging
Profit

Stock Price

Loss Short Futures

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