FINANCIAL DERIVATIVES Ritesh Nandwani

Faculty, NISM
HEDGING STRATEGIES USING FUTURES
Relationship between Futures Prices & Spot prices
CONVERGENCE OF FUTURES TO SPOT

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CONVERGENCE OF MULTIPLE FUTURE CONTRACTS

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RELATIONSHIP BETWEEN FUTURES & SPOT PRICES

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CONVERGENCE OF FUTURES TO SPOT & BASIS RISK

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Hedging
HEDGING
 Hedging means taking a position in the derivatives market that is opposite of a
position in the cash / spot market
 The objective of hedging is to reduce or manage risks associated with the price
changes
 Hedging is based on the principle that the spot prices and derivatives prices tends
to move in tandem
 Therefore, it is possible to mitigate the risk of a loss in the spot market by taking an
opposite position in derivatives market
 Taking opposite positions allows losses in one market to be offset by gains in the
other
Types of Hedgers
TYPES OF HEDGERS
Broadly, there are two types of hedgers: Long hedgers and short hedgers

Short hedgers are those who are long in stock (spot position) and a decline in
stock price is a risk to them They use derivatives to manage risk associated with
bearish movement in stock price

Long hedgers are those who wants to lock-in buying price of the shares for a
forward date An increase in price is a risk to them and they use derivatives to
manage that risk
LONG HEDGE

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LONG HEDGE

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SHORT HEDGE

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EXAMPLE - SHORT HEDGE FOR EQUITY EXPOSURE
Mr X holds 5000 shares of ABC Ltd at present
Though he is optimistic about the long-term prospects of ABC Ltd, but he is concerned about
some of the near-term events in ABC Ltd and their potential adverse impact on share price
These near-term events are expected to be played out in the next three months
Therefore, he decided to manage this risk by going short on futures contracts of three-months
duration on the same underlying
During this three month period, if the stock price goes down, then this adverse movement in
stock price will give losses on his spot position but his futures position will compensate for this loss
However, if the stock price goes up during this period, then the profits in his spot position are
offset by the losses in his futures position
WHY HEDGING?
To eliminate or reduce volatility risk
Enables them to Focus on their Core expertise instead of managing risks

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HEDGING STRATEGIES
Primary Things to consider
Choice of Contract
Underlying
Expiry date
Quantity
Basis Risk

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CHOICE OF CONTRACT

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BASIS RISK

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BASIS RISK - EXAMPLE

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Cross Hedging
CROSS HEDGING

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CROSS HEDGING WITH FUTURES

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CROSS HEDGING WITH FUTURES

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CROSS HEDGING - OPTIMAL HEDGE RATIO

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CROSS HEDGING - OPTIMAL HEDGE RATIO

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Portfolio Hedging
PORTFOLIO HEDGING - USING INDEX FUTURES

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PORTFOLIO HEDGING - USING INDEX FUTURES

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STOCK HEDGING - USING INDEX FUTURES

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Hedging:
Benefits, Limitations & Important Considerations
BENEFITS AND LIMITATIONS OF HEDGING
Benefits of Hedging:
• Price risk is minimized
• Facilitates business planning and cash flow management
BENEFITS AND LIMITATIONS OF HEDGING
Limitations of Hedging:
• Price risk cannot be totally eliminated
• Transaction cost is to be incurred
• Margins are to be maintained leading to cash flow pressures
• Risks in cases where Expiry date is not same as date of Hedge
• Basis Risk
• Stack and Roll Risk
• Metallgesellschaft Case
HEDGING CONSIDERATIONS

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HEDGING CONSIDERATIONS
Do shareholders need it?
Do my competitors also hedge?
Don’t forget the objective of hedge

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ISSUES ON CORPORATE HEDGING

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THANK YOU

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