Page 136 - DMGT515_PERSONAL_FINANCIAL_PLANNING

Unit 7: Investment Strategies-II

seeking to hedge out the risk of price changes; and speculators, who seek to make a profit by Notes
predicting market moves and opening a derivative contract related to the asset “on paper”,
while they have no practical use for or intent to actually take or make delivery of the underlying
asset. In other words, the investor is seeking exposure to the asset in a long futures or the
opposite effect via a short futures contract.

Hedgers

Hedgers typically include producers and consumers of a commodity or the owner of an asset or
assets subject to certain influences such as an interest rate.

Example: In traditional commodity markets, farmers often sell futures contracts for the
crops and livestock they produce to guarantee a certain price, making it easier for them to plan.
Similarly, livestock producers often purchase futures to cover their feed costs, so that they can
plan on a fixed cost for feed. In modern (financial) markets, “producers” of interest rate swaps or
equity derivative products will use financial futures or equity index futures to reduce or remove
the risk on the swap.

Speculators

Speculators typically fall into three categories: position traders, day traders, and swing traders
(swing trading), though many hybrid types and unique styles exist. In general position traders
hold positions for the long term (months to years), day traders (or active traders) enter multiple
trades during the day and will have exited all positions by market close, and swing traders aim
to buy or sell at the bottom or top of price swings. With many investors pouring into the futures
markets in recent years controversy has risen about whether speculators are responsible for
increased volatility in commodities like oil, and experts are divided on the matter.
An example that has both hedge and speculative notions involves a mutual fund or separately
managed account whose investment objective is to track the performance of a stock index such
as the S&P 500 stock index. The Portfolio manager often “equitizes” cash inflows in an easy and
cost effective manner by investing in (opening long) S&P 500 stock index futures. This gains the
portfolio exposure to the index which is consistent with the fund or account investment objective
without having to buy an appropriate proportion of each of the individual 500 stocks just yet.
This also preserves balanced diversification, maintains a higher degree of the percent of assets
invested in the market and helps reduce tracking error in the performance of the fund/account.
When it is economically feasible (an efficient amount of shares of every individual position
within the fund or account can be purchased), the portfolio manager can close the contract and
make purchases of each individual stock.
The social utility of futures markets is considered to be mainly in the transfer of risk, and
increased liquidity between traders with different risk and time preferences, from a hedger to a
speculator, for example.

Options on Futures

In many cases, options are traded on futures, sometimes called simply “futures options”. A put
is the option to sell a futures contract, and a call is the option to buy a futures contract. For both,
the option strike price is the specified futures price at which the future is traded if the option is
exercised. Futures are often used since they are delta one instruments.

Investors can either take on the role of option seller/option writer or the option buyer. Option
sellers are generally seen as taking on more risk because they are contractually obligated to take

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