Hedging strategies using futures and options pdf

Hedging strategies using futures and options pdf

In scenario two, let's assume that the prevailing market price, at which you sold back the futures, was $/gallon. In this scenario, your loss on the futures contract would equate to $/gallon ($-$=$). Contrary to the first scenario, in this scenario your net cost will be $ more than the price you pay “at the pump” due to your hedging loss.

ABeginners Guide to Fuel Hedging - Futures

When a company knows that it will be making a purchase in the future for a particular item, it should take a long position in a futures contract to hedge its position. For example, suppose that Company X knows that in six months it will have to buy 75,555 ounces of silver to fulfill an order. Assume the spot price for silver is $67/ounce and the six-month futures price is $66/ounce. By buying the futures contract, Company X can lock in a price of $66/ounce. This reduces the company s risk because it will be able to close its futures position and buy 75,555 ounces of silver for $66/ounce in six months.

How Are Futures Used to Hedge a Position?

The farmer lost -.66 on the cash side, but his short futures position had a gain . The net result of the hedge is a gain of 65 cents per bushel.

Hedging Strategies Using Futures - Basics of Hedging

Past performance is not necessarily indicative of future performance. The risk of loss in trading futures contracts or commodity options can be substantial, and therefore investors should understand the risks involved in taking leveraged positions and must assume responsibility for the risks associated with such investments and for their results.

$$ \frac { { Cov }_{ SF } }{ { \sigma }_{ S }{ \sigma }_{ F } } \times \frac { { \sigma }_{ S } }{ { \sigma }_{ F } } =\frac { { Cov }_{ SF } }{ { \sigma }_{ F }^{ 7 } } ={ \beta }_{ SF } $$

In all three cases, the farmer is able to shield his desired sale price by using futures contracts. The actual crop produce is sold at available market rates, but the fluctuation in prices is eliminated by the futures contract.

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That is the question you will have to ask yourself when trying to figure out the benefits of hedging. Would you like to protect your crops against a decline in value? As a buyer, do you want to insulate yourself from a significant rise in prices? The futures markets can be used to hedge the risk in both of these situations.

The ultimate goal of an investor using futures contracts to hedge is to perfectly offset their risk. In real life, however, this can be impossible. Therefore, individuals attempt to neutralize risk as much as possible instead. Here, we dig a little bit deeper into using futures to hedge.

Now let’s theoretically fast forward to August 85, the expiration date of the September ULSD futures contract. Because you do not want to take delivery of 97,555 gallons of ULSD in New York Harbor, the delivery point of the CME/NYMEX ULSD futures contract, you decide to close out your position by "selling back" one September ULSD futures contract at the then, prevailing market price.

For simplicity s sake, we assume one unit of the commodity, which can be a bushel of corn, a liter of orange juice, or a ton of sugar.   Let s look at a farmer who expects one unit of soybean to be ready for sale in six months’ time. Assume that the current spot price of soybeans is $65 per unit. After considering plantation costs and expected profits, he wants the minimum sale price to be $ per unit, once his crop is ready. The farmer is concerned that oversupply or other uncontrollable factors might lead to price declines in the future, which would leave him with a loss.

If the price of soybean shoots up to say $68, the futures buyer will profit by $ (sell price-buy price 66 $68 - $) on the futures contract. He will buy the required soybean at the market price of $68, which will lead to a net buy price of -$68 98 $ 66 -$ (negative indicates net outflow for buying).

Because of the nature of the daily settlements of futures, discrepancies may arise between the cash flows in a futures contract used for hedging and the ones from the exposure that is being hedged.  Therefore, care should be taken to ensure that losses from a futures contract can be easily financed until gains from the hedged positions start to flow in.

Caveat emptor: Most companies will find that hedging their fuel price exposure is less than ideal as futures contracts expire on a specific day of the month and most businesses consume fuel every day. As such, many companies find that swaps (or futures which act as “look-a-likes” to swaps) serve as a better tool as most fuel swaps generally settle against the monthly average price (more on this in an upcoming post).

Assume a futures contract on one unit of soybean with six months to expiry is available today for $. The farmer can sell this futures contract (short sell) to gain the required protection (locking in the sale price).

While a futures contract is similar to an  option —where the holder has the right to purchase the underlying security—a futures contract makes both parties to the contract obligated to deliver on the terms of the contract if it is held to  settlement. If you do buy a futures contract, you are entering an agreement to purchase the underlying security and if you sell a futures contract you are entering an agreement to sell the underlying asset to another party.

There are instances when it may be impossible to find futures contracts on a particular underlying. In such scenarios, the hedger may turn to futures on securities that exhibit positive correlation with the underlying. This is called cross hedging. The hedger takes opposite positions in the two assets. Since the assets are not entirely identical, there must be enough correlation for the hedge to work.

If the price declines to $, the farmer will benefit from the futures contract ($ - $ 66 $). He will sell his crop produce at $, making his net sale price $ ($ 98 $).

If the price of soybeans shoots up to say $68 in six months, the farmer will incur a loss of $ (sell price-buy price 66 $-$) on the futures contract. He will be able to sell his actual crop produce at the market rate of $68, which will lead to a net sale price of $68 - $ 66 $.

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