Interest rate futures assist in hedging interest rate risk exposure. Interest rate changes affect the value of interest-bearing assets including bonds, securities, and loans. By holding such holdings, interest rate futures will assist balance losses by producing corresponding profits in futures positions.
How do futures contracts protect you against risk?
Hedging is the practice of buying or selling futures contracts to safeguard against the risk of losing money due to fluctuating cash market prices. If you’re feeding hogs to market, you’ll want to hedge against dropping cash market prices. If you need to buy feed grain, you’ll want to hedge against rising cash market prices.
How do you protect yourself from rising commodity prices?
Commodity Price Risk Hedging Producers and purchasers can hedge against commodity price changes by acquiring a contract that guarantees a set price for a commodity. They can also lock in a worst-case scenario price to protect themselves from possible losses.
How do you use futures to hedge a portfolio?
Investors who wish to hedge their portfolios must first figure out how much money they want to protect and then pick a representative index. If a $350,000 stock portfolio needs to be hedged, an investor would sell $350,000 worth of a specified futures index. The widest of the indices, the S&P 500, is a strong proxy for large-cap stocks. One S&P 500 futures contract is worth $250 multiplied by the futures contract’s price. An S&P 500 index contract would be worth $350,000 if the index price was nearly $1,400. The E-mini S&P 500 contracts, which trade alongside the main contract, are worth 20% of the standard contract’s value. Each mini-contract is worth $50 more than the S&P 500 futures contract. An investor can sell short one S&P 500 futures contract or five E-mini contracts to hedge $350,000 in equity exposure. Before the futures contract expires, the investor must either purchase it back or roll it over to the following quarterly term. In March, June, September, and December, CME S&P 500 contracts expire.
What is the best way to hedge futures using futures?
We’ll start with hedging a single stock future because it’s the most straightforward and straightforward to accomplish. We’ll also learn about its limitations before moving on to how to hedge a stock portfolio.
Assume you purchased 250 shares of Infosys for Rs.2,284 each. This equates to a Rs.571,000/- investment. In the spot market, you are clearly ‘Long’ on Infosys. You realize the quarterly results are due soon after you start this role. You’re concerned that Infosys will release less-than-optimal financial results, causing the stock price to plummet. You decide to hedge the position to avoid a loss in the spot market.
We merely need to enter a counter position in the futures market to hedge the spot position. We must’short’ in the futures market because our spot position is ‘long.’
Now, on the one hand, you are long Infosys (in the spot market), while we are short Infosys (in the futures market), though at different prices. However, the price fluctuation is unimportant because we are ‘neutral’ in terms of direction. You’ll see what I’m talking about in a minute.
Let’s assume several price points for Infosys after we’ve started this trade and see what the overall impact would be on the positions.
The important thing to remember is that regardless of where the price is headed (up or down), the position will not make or lose money. It’s as if the entire situation has remained static. Indeed, the position becomes agnostic to the market, which is why we say that a hedged position remains ‘neutral’ to the overall market environment. Hedging single stock positions, as I previously stated, is quite simple and straightforward. To hedge the position, we can use the stock’s futures contract. However, in order to trade stocks futures, one must have the same number of shares as the lot size. If they change, the profit and loss statement will change, and the position will no longer be perfectly hedged. This raises a few crucial questions
- What if I hold a position in a stock that isn’t traded on a futures exchange? Does this indicate that I can’t hedge a spot position in South Indian Bank because it doesn’t have a futures contract?
- In the example, the spot position value was Rs.570,000/-, but what if I only had a few tiny holdings, say Rs.50,000/- or Rs.100,000/-? Can I hedge such situations?
In truth, neither of these questions has a straightforward answer. We’ll find out how and why in due time. For the time being, we’ll focus on learning how to hedge numerous spot holdings (usually a portfolio). To do so, we must first comprehend what is referred to as a stock’s “Beta.”
How do you protect yourself against commodities futures?
To hedge, one must take a futures position of approximately the same size as one’s own, but in the opposite price direction. As a result, a commodity producer who is naturally long hedges by selling futures contracts.
How do you protect yourself when buying futures?
When hedging their price risks, end-users hold a long position. They commit to acquire a commodity at some point in the future by purchasing a futures contract. These contracts are rarely fulfilled, and the majority of them are offset before their expiration date. Obtaining an equal opposite in the futures market on your present futures position is how you offset a position. The profit or loss from this transaction is then settled with the spot price, which is the price at which the producer will purchase his commodity.
A wheat delivery is expected in March for a grower. He buys an April Wheat contract in October to hedge against price risk on the spot market in March, when he wants to buy wheat. He forecasts a basis of -$ 0,30, implying that the April futures price will be 30 cents higher than the March cash price. Using the following formula, the producer can now compute the commodity’s estimated purchase price:
The following computation shows how the purchase price will be realized.
This illustrates the impact of effective hedging. The producer would have been obliged to pay the spot price of $ 4,30 if he had chosen not to hedge; instead, he can purchase the commodity for $ 3,21.
How do you protect yourself against cattle futures?
Hedging is one of the marketing methods available to livestock farmers that want to price their animals ahead of time. Hedging safeguards against price changes that are unfavorable.
Two types of hedgers
Hedgers are divided into two types: those who guard against a price drop (short hedge) and those who protect against a price rise (long hedge) (long hedge).
Short hedgers are livestock producers that expect to sell their animals in the future but want to protect themselves from price drops. If a producer sells a futures contract, they become short hedgers (futures contracts that are applicable tothe type of livestock they plan to market).
Short hedgers are the polar opposite of long hedgers.
Long hedgers require a product at some point in the future, don’t want to buy it now, and want to protect themselves from a price increase. If a producer purchases a futures contract, they become long hedgers (futures contract applicable to the type of feed or feederlivestock they plan to purchase).
A cattlefeeder, for example, who plans to put feeder cow in the feedlot in three months but wants to set a price and protect against a price rise in those three months is an example of a long hedger. To hedge against a spike in cash prices, this hedger would purchase feeder cattle futures.
Buying corn futures to fix a price for corn and protect against a price rise is another example of a long hedge by a livestock producer.
Placing a short hedge
Hedging may be appropriate for a producer who is feeding livestock, intending to market them later, and wants to set a price now rather than risk price declines.
The first step is to choose the right futures contract, one that matures around the time the livestock is to be sold. Contracts are not available for every month of the year, unfortunately. In January, for example, a producer might expect to sell hogs or cattle. Contracts for hogs and cattle do not expire in January. In such instances, the producer should choose for the contract that expires one month after the livestock are sold. As a result, if a producer wants to hedge hogs or cattle in January, the February futures price should be used. The reason for choosing a contract that matures after the animals are sold is that the futures contract can be offset when the livestock are sold.
Adjusting the futures price for the expected basis, as illustrated in Example 1, is the most typical way of localizing the futures price. At marketing time, the basis represents the projected difference between the local cash price and the futures price (see Basisfiles under Information Files). Understand the differences between the Livestock Basis, the Lean Hog Basis, and the Live Cattle Basis.)
The hedger can evaluate the possible returns from the hedge once the localized futures price has been determined. To get a net return from the hedge, remove three more components from the localized futuresprice. Example 2 shows how to calculate the estimated return.
If the producer wishes to hedge, he will have to pay the broker’s fee for handling futures trading. This cost fluctuates between $50 and $100 each contract (varies by brokerage firm andnumber of contracts traded, which puts the cost of trading at 15 to 20cents per cwt.).
Every contract that is exchanged requires a deposit. The initial margin deposit size varies depending on the type of livestock futures contract and the price level. Typically, the initial margindeposit will be between 5 and 10% of the contract’s value. Furthermore, if the futures market price goes in the opposite direction of the futures position, the hedger will be required to deposit additional monies.
Because the margin deposit must be paid as the market dictates (as the loss accumulates), an interest charge should be included in the cost of hedging, as illustrated in Example 3. The amount of interest charged will be determined by the direction of the futures price and the length of time the contract is held. The most one can do is make an educated guess on the interest rate.
The expected net return from the hedge is determined by comparing the adjusted futures price with the cost of production and pricing objectives as a third element in determining whether or not to hedge. Individual producers have different levels of targeted profit and price risk that they are willing to take on by not hedging. As a result, each producer must assess if the expected return from hedging is adequate.
Lifting the short hedge
Lifting a short hedge entails buying back (offsetting) your futures position and selling your livestock on the cash market at the same time. Example 4 shows an example of hedging. The hedger can disregard both cash and futures markets from the time the hedge is put until it is pulled since the gain (loss) in one market will offset the loss (gain) in the other. If the price falls after the hedge is put in place, the loss in the cash market is countered by the gain in the futures market. The increase in the cash market is offset by the loss in the futures market if the price rises. In the information file Understanding Livestock Basis, the implications of employing basis to lift a hedge are explained.
1. Purchasing a futures contract (for the same contract month that was previously sold) and simultaneously selling the cattle on the open market.
2. Delivering the livestock in accordance with the contract.
The producer should remove the futures position right before selling the livestock on the cash market when lifting a short livestock hedge. The following is the sequence of events:
1. Get a livestock cash price bid.
2. Get the relevant month’s futures price.
3. Examine the basis and compare it to previous data.
4. Purchase the appropriate month’s futures contract.
5. Sell livestock on the open market for cash.
The basis risk increases as the period between the cash transaction and offsetting the hedge grows.
Hold into contract month
Unlike grain hedgers, who are urged not to keep holdings into the delivery period, livestock producers are allowed to hold hedge positions into the delivery period. During the delivery season, the livestock base is more steady, making it more predictable than during non-delivery periods. It is not essential to lift the hedge with cash settlement contracts (lean hogs and feeder cattle). At the settlement price, the hedge will be closed out.
During the delivery period, a cattle hedger should keep an eye on open interest, or the number of contracts that are still open.
If open interest falls below 1,000 contracts, regardless of the basis, the hedge should be lifted.
Hedging in non-contract months
There aren’t futures contracts available for every month of the year. As a result, the livestock producer may have livestock ready to sell in months when no futures contract is available. Non-contract months are riskier to hedge than contract months. The non-contract months’ base is less stable than the contract months’.
Hedging and quality
Producers who sell livestock that isn’t of the grade stipulated in the futures contract run the risk of incurring additional basis risk. Select grade cattle discounts, as well as carcass premiums and discounts, should be considered into the basis.
When is it advisable to hedge with options rather than futures or forwards?
When you want the flexibility to choose whether or not to utilize the derivative instrument and are ready to pay for it, an option hedge is preferable to a futures or forward hedge. Futures and forward hedges help to limit losses while also limiting profits.
What is the formula for calculating commodity price risk?
Diversification and flexibility are two common strategy efforts for managing commodity risk. One of the most prominent ways for reducing risk and uncertainty is diversification. To control the price and cost risk associated with production, many primary producers, for example, rotate crops and/or livestock.