Hedging using Futures

Hedging is a risk management strategy that involves taking an offsetting position in a related asset to reduce the risk of adverse price movements in the primary asset. Futures contracts are commonly used for hedging.

Types of Hedges:

1. Short Hedge (Selling Futures): Used to protect against a decline in the price of an asset that you own or plan to sell in the future.
   • Example: A wheat farmer sells wheat futures contracts to lock in a selling price for their upcoming harvest, protecting against a potential drop in wheat prices.
2. Long Hedge (Buying Futures): Used to protect against an increase in the price of an asset that you plan to buy in the future.
   • Example: An airline buys jet fuel futures contracts to lock in a purchase price for their future fuel needs, protecting against a potential rise in fuel prices.

Example (Short Hedge):

• A coffee grower expects to harvest 100,000 pounds of coffee in three months.
• The current spot price of coffee is $2.00 per pound.
• The grower is concerned that coffee prices might fall before the harvest.
• To hedge, the grower sells coffee futures contracts (assuming a contract size of 37,500 pounds) at a futures price of $1.95 per pound. They sell three contracts to cover most of their expected harvest (3 contracts * 37,500 pounds = 112,500 pounds).

Scenario 1: Coffee prices fall to $1.80 per pound at harvest.

• Loss on physical coffee: The grower sells their 100,000 pounds of coffee in the spot market at $1.80, receiving $180,000. This is $20,000 less than they would have received at the initial spot price of $2.00.
• Gain on futures: The grower buys back the three futures contracts at the lower price (assume $1.80). They make a profit of $0.15 per pound on the futures contracts ($1.95 - $1.80 = $0.15). Total profit on futures: $0.15 * 112,500 = $16,875.
• Net Result: The gain on the futures contracts largely offsets the loss on the physical coffee, effectively locking in a price close to the initial futures price.

Scenario 2: Coffee prices rise to $2.10 per pound at harvest.

• Gain on physical coffee: The grower sells their 100,000 pounds of coffee in the spot market at $2.10, receiving $210,000.
• Loss on futures: The grower buys back the futures contracts at the higher price (assume $2.10). They lose $0.15 per pound on the futures contracts ($2.10 - $1.95 = $0.15). Total loss on futures: $0.15 * 112,500 = $16,875.
• Net Result: The loss on the futures contracts offsets the extra gain on the physical coffee. The grower still effectively locks in a price close to the initial futures price.

Hedging is about reducing risk, not necessarily maximizing profits.