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L3-4 Ch3 Hedging Futures - L ectu re 3-4(Ch3 Hedging W ith...

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Lecture 3-4: (Ch3) Hedging With Futures Basic Principles A perfect hedge is one that completely eliminates risk A short hedge is a hedge that involves a short position in futures contracts used when an investor already owns an asset and expects to sell it sometime in the future. A long hedge involves a long position in a futures contract used when a company wants to purchase a certain asset in the future and wants to lock in prices now. You take a long hedge to close an open position in a short hedge. Vice versa. Hedgers with any long positions usually avoid any possibility of having to take delivery by closing out their positions before the delivery period . Arguments for and Against Hedging Most companies should hedge risks such as; interest rates and exchange rates, and focus on their core activities which they presumably have skills in. One argument is that shareholders can, if they wish, do the hedging themselves. Competitive pressures within the industry may be such that the prices of the goods and services produced by the industry fluctuate to reflect raw material costs, interest rates, exchange rates and so on.
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o A company that does not hedge can expect its profit margin to be roughly constant . o A company that does hedge can expect its profit margin to fluctuate! o Should look at the big picture when hedging. Important to realize that hedging using futures contracts can result in a decrease or an increase in a company’s profits relative to the position it would be in with no hedging. o Treasure could be congratulated in cases where company is better off, but in trouble when hedging offsets “should be” profits. Basis Risk In practice, hedging is often not quite as straightforward. Some reasons include: 1. The asset whose price is to be hedged may not be exactly the same as the asset underlying the futures contract. 2. The hedger may be uncertain as to the exact date when the asset will be bought or sole. 3. The hedge may require the futures contract to be closer out before its deliver month. The Basis The basis in a hedging situation is as follows: Basis = Spot price of asset to be hedged – Futures price of contract used If the asset hedged and the assets underlying the futures contract are the same, the basis should be zero at the expiration of the futures contract. Prior to expiration, the basis may be positive or negative. As time passes, the spot price and the futures price do not necessarily change by the same amount. As a result, the basis changes.
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Increase in the basis strengthening of the basis Decease in the basis weakening of the basis Basis Risk Basis risk is the risk due to basis changes over time.
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