Hedging Strategies using Futures

Hedging is a process adopted by the investor to reduce the risk involved due to the exposure in financial market due to fluctuations of the price. The investor usually hedge their fund in an asset that primarily goes against the portfolio i.e. if the portfolio goes up in value the hedged asset goes down, whereas if the portfolio goes down in value the hedged asset goes up in value. This way of hedging reduces the loss to the investor. The investors adopt many techniques for hedging some of them are,

Hedging technique adopted by investors are,

• Insurance polices
• Forward contract
• Swap options
• Over-the-counter
• Derivative contract and finally
• Futures

Futures contract is a standardized contract between two parties to buy or sell specified asset (either commodity or securities) at a future cost in a future date. They are kind of derived contract as they are not direct securities. The party who assume to sell the asset in the future goes short in the asset whereas the part who assumes to buy the asset in the future goes long in the asset.

The prime factors that must be considered while signing a future contract are,

• The implementation date
• The expiry date
• The implementation cost
• The holder and buyer details
• The asset which is being bought or sold.

The futures contracts are sold in market just like securities. The above mentioned factors determine the price movement of the futures in the market. The price fluctuations of these futures mainly depend on the price movement of the asset in the market. In financial market futures are primarily used for Indexes, stocks, currency and commodity.

Hedging process using futures are done as given below.

If the portfolio contains asset that have a very high beta asset and moves along with the market movement the investor hedges the portfolio with a futures which moves in value opposite to that of market movement. In general the investor goes for short in case of high beta portfolios.

If the portfolio contains asset that have a very high negative beta asset and the portfolio value moves against the market then the investor hedges the portfolio with futures which moves in value along with the market movement. In general the investor goes for long position in this case.

Question:

• Define Hedging
• List some of the uses of Hedging