Derivatives

CHAPTER 4Futures: Hedging and Speculation

Aims

• To examine how futures can be used for hedging.
• To explain basis risk, cross hedge and rolling hedge.
• To examine some novel types of futures contracts.
• To show how futures are used for speculation.

4.1 HEDGING USING FUTURES

Futures contracts can be used for hedging an existing position in a spot (cash-market) asset. For example, an oil producer might have a large amount of oil coming ‘on stream’ in 3 months' time and may fear a fall in the spot oil price over the next 3 months, so will have to sell their oil at a low spot price. Or, a US exporter who is receiving sterling from the sale of goods in the UK in 3 months, may fear a fall in the spot FX rate for sterling – which implies they will receive fewer dollars when they exchange sterling for dollars.

In the above cases the seller (of oil or sterling) does not know what the spot/cash market price will be in 3 months' time and their future (dollar) receipts are therefore subject to price-risk. Hedging with futures can be used to reduce such risk to a minimum. In practice, using futures contracts cannot reduce price-risk to zero so a ‘perfect hedge’ is usually not possible.

4.1.1 Short Hedge

The basic idea behind hedging is very simple. If you are holding (i.e. long) the underlying asset (e.g. stock-ABC) then you need to take a futures position (on stock-ABC) such that the monetary gain, after closing out the futures contract, largely offsets any monetary losses in the spot market, ...