CHP 4
1. LONG HEDGE USING FUTURES:
• A long hedge is a futures position that's used to stabilize the price of an asset
that's expected to be purchased in the future.
• The hedger buys futures contracts to cover the anticipated purchase.
• A long hedge is one where a long position is taken on a futures contract.
• A long hedge refers to a futures position that is entered into for the purpose of
price stability on a purchase.
• Long hedges are often used by manufacturers and processors to remove
price volatility from the purchase of required inputs.
• A long hedge represents a smart cost control strategy for a company that knows
it needs to purchase a commodity in the future and wants to lock in the purchase
price.
• A long position means the buyer of the commodity is making a bet that the price
of the commodity will rise in the future.
• If the good rises in price, the profit from the futures position helps to offset the
greater cost of the commodity. By buying a futures contract, they agree to buy a
commodity at some point in the future.
• These contracts are rarely executed, but are mostly offset before their maturity
date.
• Long hedge futures have several features, including:
• Hedging
• Futures can be used to hedge against potential losses. For example, a portfolio
manager can buy index futures to protect their portfolio from a stock market
decline.
• Risk management: Futures can be used as a risk management tool. For example,
borrowers can hedge against interest rate fluctuations by taking an opposite
position in interest rate futures.
• Optimal hedge ratio: The optimal hedge ratio, also called the minimum variance
ratio, is the ratio of the futures position to the spot position. It measures the
correlation between the underlying asset and the futures contract.
• Diversification: Futures contracts can help diversify investment portfolios by
providing exposure to different asset classes, such as commodities, currencies,
and stock market indices.
• Leverage: Leverage allows traders to multiply their investment by borrowing
against the asset being traded. This allows traders to take larger profits without
risking the full value of the trade.
Futures trading also allows you to hedge against your active trading positions and
prevent yourself from incurring high losses due to adverse market movements
2. SHORT HEDGE USING FUTURES:
• A short hedge is one where a short position is taken on a futures contract.
It is typically appropriate for a hedger to use when an asset is expected to
be sold in the future. it can be used by a speculator who anticipates that
the price of a contract will decrease.
• A short hedge is an investment strategy used to protect (hedge) against the risk
of a declining asset price in the future. A short hedge protects investors or
traders against price declines in the future.
• It is a trading strategy that takes a short position in an asset where the investor
or trader is already long.
• A short hedge is the opposite of a long hedge, which protects against
rising prices.
• A long hedge involves purchasing a futures contract (or other long position) to
protect against rising prices It is often used by manufacturers who require certain
inputs and do not want to risk prices rising on those commodities.
FEATURES:
• Hedging: Hedging is a strategy that can help reduce the impact of losses
due to market changes, price fluctuations, and currency fluctuations.
• Leverage: Futures contracts are leveraged, which means that a trader
can receive increased market exposure with a small deposit, or
margin. The trading provider loans the trader the remaining amount
needed to complete the trade.
•Portfolio hedging: Hedgers use futures contracts to protect their
investment portfolio value during volatile times. They often take opposite
positions in different contracts on the same underlying asset to reduce
risk.
3. PERFECT HEDGE USING FUTURES:
• A perfect hedge is a position that eliminates the risk of an existing position or one
that eliminates all market risk from a portfolio.
• Investors commonly attempt to achieve a perfect hedge through options,
futures, and other derivatives for defined periods rather than as ongoing
protection.
• The profit and loss from the underlying asset and the hedge position are equal in a
perfect hedge.
• Hedging requires taking two equal but opposite positions in the cash and futures
markets. In a perfect hedge, gain and loss in one market are offset by loss and
gain in the other market, reducing or eliminating risk exposure.
• perfect hedges using futures:
• Costs: Hedging can be expensive, with fees, commissions, and margin
requirements. These costs can add up quickly, especially for smaller positions.
• Partial hedging: A partial hedge can be a more cost-effective strategy than a
perfect hedge. It offers a balance between risk management and profit-seeking.
• Liquidity risk: A perfect hedge can have liquidity risk.
• Stock without a corresponding future: If a stock doesn't have a corresponding
future traded, it may be exposed to risk.
• Market outlook: The right balance between hedging and profit-seeking depends
on your risk tolerance and market outlook.
• A perfect hedge is achieved when the following conditions are met:
The holding period matches the futures expiration date
The physical characteristics of the hedged commodity match the commodity
underlying the futures contract.
4. IMPERFECT HEDGE USING FUTURES:
• An imperfect hedge is when a hedger's gains and losses in the futures and spot
markets aren't fully offset, resulting in some gain or loss.
• The hedger's gain and loss in the spot and futures market are not fully offset, and
the hedger will end up with some gain or loss. This is called imperfect hedge.
• A partial hedge using index futures is an example of an imperfect hedge
• An imperfect hedge using futures is when a hedge is effective but doesn't
completely eliminate price risk.
REASON FOR IMPERFECT HEDGE (TXTBK)
5. DIFF B/W SPECULATION & ARBITRAGE (TXTBK)
6. CASH AND CARRY ARBITRAGE:
• Cash & carry arbitrage can happen when the price of an asset in the
future is higher than the current cash market.
• In such a scenario, the trader takes a long position on the underlying
asset in the spot or cash market and opens a short position on
the futures contract of the same asset.
• Cash and carry arbitrage is a financial arbitrage strategy that involves
making the best of the anomalies in pricing or mispricing as it is
called.
• This is the relation between an underlying asset and the financial
derivative corresponding to it.
• Using the cash and carry arbitrage strategy, the trader gets a picture of
the ideal cost of carrying for the contract, and based on the futures he
can take a quick decision on whether or not the cash and carry
arbitrage strategy would be profitable.
• For example, the commodity purchased is held until the expiration
date or the delivery date of the corresponding contract. At that point,
the trader delivers the underlying against the corresponding contract
and locks in a riskless profit. The profit earned by the trader is
determined by the purchase price of the underlying plus its total cost
of carrying, which would include insurance, transport, storage, and
notional opportunity cost.
7. REVERSE CASH AND CARRY ARBITRAGE:
• Reverse cash and carry arbitrage occurs when market is in
"Backwardation", which means future contracts are trading at a
discount to the spot price.
• This strategy is “reverse” because it involves selling in the spot
market and buying in the futures market.
• It is different from being short in equities.
• In the reverse cash and carry arbitrage strategy, the trader takes a
short position in the spot price of a commodity and a long position on
its future price.
• Reverse cash and carry arbitrage is the inverse of the cash and carry
arbitrage commodity trading strategy.
• Backwardation refers to a market where there is a downward-sloping
futures curve.
• It is the type of market where reverse cash and carry arbitrage is
heavily utilized.
• Like cash and carry arbitrage, even Reverse cash and carry arbitrage
is a market-neutral strategy.
8. PAYOFF FOR LONG FUTURE CONTRACT: (TXTBK)
• Figure shows that investor makes a profit in long position if spot price at
the expiry is below the future contract price and losses if opposite
happens. Working of commodity futures market Every day, people
engage in activities that require the use of products. The raw materials
that go into making these products are called commodities.
Commodities are bought and sold in what is called the cash market. This
is sometimes called the "spot market" because people pay in full for the
commodity "on the spot." The principle of supply and demand governs
the trading prices of commodities. If supplies are plentiful, prices will be
low. If supplies are scarce, prices will be high. Future traders There are
two types of traders in the futures markets, hedgers and speculators.
9. PAYOFF FOR SHORT FUTURE CONTRACT: (TXTBK)
