Futures for the Hedgers(1)

7/27/2019 Futures for the Hedgers(1)

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FUTURES FOR THE HEDGERS

The primary economic function of the futures market is hedging. Hedging is nothing else

but buying and selling futures contracts to offset the risks of changing spot markets.

Hedgers are those players in the market that own or would own a physical commodity in

the near future. The Hedgers are thus concerned about the future prices of the commodity.

Hedging is thus used as a tool of risk-management by:

Farmers

Producers

Exporters

Bankers

Bond Dealers

Pension fund managers

The market would have primarily two kinds of players: Buyers (actual users of the

commodity) and Sellers (actual producers/manufacturers) of the commodity.

The Buyers are concerned about the RISE in the prices while Sellers are concerned with the

FALL in the prices. The FEARS of these two players makes the futures market for

commodities. The Speculators are players that just want to take positions in the market so

that they can take advantage of the market situations that they “expect”.

The Buyers LONG FUTURES and the Sellers SHORT FUTURES.

Example of LONG FUTURES

Let us say that a wheat miller needs the following quantity of wheat to turn it into flour:

Today is the month of September and he needs 10mt in the month of March of next year. He

observes that the current spot price of Wheat is Rs 10,000 per MT. The miller wants to hedge

his position. He observes that the futures contract for the March of next year is Rs. 10,200.

Since the miller wants to hedge his position against facing a price rise, he will buy a futures

contract for Rs10, 200. He would do a back of the envelope calculation that if he buys now,

he would have to STORE the wheat and has also to consider a notional opportunity cost ofinterest. The miller when he sees that taking all these costs into consideration he would be

better off buying a futures contract he will lock into the futures contract !!!

Can the prices keep on fluctuating after he enters into a contract, sure they will !!!

So what does he do after he has entered into the contract, he will watch the BASIS on a

regular basis. What is the BASIS, the difference between the spot price and the futures price.

Why would he watch the BASIS, because he is LOCKED INTO A POISITION the minute he

buys the FUTURES contract.



Come March and the situation is as follows:

SPOT PRICE of Wheat Contract: Rs 12,000

FUTURES CONTRACT PRICE: Rs 12,000

(this situation is very rare that there will be perfect convergence !!!)

Pay-off table

Spot Futures

September 10000 10200

March 12000 12,000

Buy wheat at 12000he thus makes a

notional loss of Rs1800 because hiscalculation was thatthe price would be10,200

Sell futures for 100profit

Cost to the Miller

Spot Wheat 12,000

Less: Actual profit byselling futures

1,800

Exactly the price he

expected to pay !!!

10,200

The above is an example of a perfect hedge because the Spot and the Futures price

converged !!!

Buying Hedge mechanics:

NOW Enter into contract to supply at afuture date

Buy the futures contract

corresponding to the date of supplyAt the time of starting production Buy input from the spot market

Close out the futures contract byselling the same contract on the sameexchange



Example of a Seller’s Hedge (SHORT FUTURES)

Now let us complicate the situation for a seller’s hedge.

Let’s say there is a farmer and his harvesting season is March with a delivery in April.

Today is in the month of November. The current spot price is Rs 10,000 and the AprilFutures are Rs 10,200. The farmers wants to lock his price, so he SELLS WHEAT FUTURES

at Rs 10,200.

Come April because of a bumper monsoon the price of wheat has actually fallen. He can sell

wheat at Rs 9,200 only but the Wheat Futures have also fallen to Rs 9,200 (perfect

convergence which never happens in the real world !!!)

Spot Futures

September 10,000 10,200

March 9,200 9,200

Sells wheat at 9,200he thus makes anotional loss of Rs1000 because hiscalculation was thatthe price would be10,200

Buy Futures andsquare off hisposition in cashgaining Rs 1000

Revenue to the

farmer:Spot Wheat 9,200

Add: Profit frombuying futures andcash settlement

1,000

Exactly the price heexpected to receive!!!

10,200

HEDGING FOR SELLERS

NOW Start production of a product to sellat a future date

Sell futures contract corresponding tothe date of sale

At the time of getting product ready to sell Sell in spot market

Close out future contract by buyingthe same contract on the sameexchange



The above two examples are fictitious.

WHAT HAPPENS IN THE REAL WORLD, THERE WILL BE FLUCTUATIONS THAT MAY

BE FAVORABLE OR UNFAVOURABLE?

Suppose in our Long Hedge position the ending table looked like this

Spot Futures Basis

September 10000 10200 -200

March 12000 12,150 -150

Non-convergence inthe futures pricewith spot

The basis hasstrengthened

The price that the Miller would pay would be:

Buy wheat in the spot market 12,000

Less: Actual profit from futures 1,950

(12150-10200)= 1,950 10,050

Because of non-convergence he has paid less than he expected to pay if there was perfect

convergence !!!

Spot Futures BasisSeptember 10000 10200 -200

March 12000 12,250 -250

Non-convergence inthe futures pricewith spot

The basis hasweakened

Buy wheat in the spot market 12,000

Less: Actual profit from futures -2,050

(12150-10200)= 1,950 9,950

The Long hedger benefits more if the basis are weakened !!!

Basis Change Strenghten Weaken

Long/Buying Hedge Unfavourable Favourable

Short/Selling Hedge Favourable Unfavourable

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Futures for the Hedgers(1)