Page 171 - DMGT513_DERIVATIVES_AND_RISK_MANAGEMENT

Derivatives & Risk Management

Notes The salient features of short hedging strategy in futures are:
(a) Situation: Bearish outlook. Prices expected to fall. Protection needed against risk of
falling prices.

(b) Risk: No downside risk. Strategy meant to protect against falling markets.
(c) Profit: No profits, no loss. In case of price increase, loss on the spot position is offset
by gain on futures position. In case of price increase, gain on the spot position is
offset by loss on futures position.

Example: Consider for example, an exporter knows that he will receive U.S. dollars in
two months. The exporter will realize a gain if the U.S. dollar increases in value relative to the
rupee and loss if the dollar decreases in value to the rupee. A short futures position leads to a loss
if dollar appreciates and a gain if it depreciates in value. It has the effect of offsetting the
exporter's risk.
If the spot price decreases, the futures price also will decrease since the hedger is short the
futures contract. The futures transaction produces a profit that at least partially offsets the loss on
the spot position. This is called a short hedge. Another type of short hedge can be used in
anticipation of the future sale of an asset. It is taken out in anticipation of a future transaction in
the spot market. This type of hedge is known as an anticipatory hedge.

Self Assessment

State the following are true or false:
8. A short 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.
9. A short hedge is also known as an anticipatory hedge, because it is effectively a substitute
position for a future cash transaction.
10. 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.

11. 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.
12. Futures will now trade at a price lower than the price at which he entered into a short
futures position.

12.4 Speculation and Arbitrage

The following are the key benefits of speculation and arbitrage in future contracts:

12.4.1 Speculation using Future Contracts

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 selling futures.
Both of these are described below using suitable illustrations.
Case 1: Bullish Sentiment and Buying of Futures
Take the case of a speculator who has a view on the direction of the market. He would like to
trade based on this view. He believes that a particular security that trades at 1,000 is undervalued

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