Hedging through Forwards / Futures

Hedging through Futures / Forward contracts

With the business environment getting increasing complex, profitability often depends on factors that are beyond the control of an organisation like commodity prices, stock prices, interest rates, exchanges rates, etc.

As a result, modern business has been subjected to more complexity, uncertainty and risk. Futures markets often permit managers to reduce or control risks through hedging strategies.

In other words, futures markets can provide the managers certain tools to reduce and control their risks.  Simply put Hedging means reducing risk. It is the process of investment into securities (usually a derivative) with the objective of reducing or controlling risk.

Examples of Hedging:

E.g. 1. Firm A is a manufacturer of automobile cars in India and they import auto parts from USA. Firm views that parts may increase in future and thereby increase the cost of cars and this may significantly affect the profitability of the firm. So to hedge risk of price increase firm A enters into derivatives futures contract by locking today’s prices for imported parts.

E.g. 2. A farmer expects that there will be 5000 quintals of foodgrain, which he will harvest in coming month. He fears that price of food grain may fluctuate in the coming month. He enters into derivative futures contract by delivering next month at an acceptable price.

E.g. 3. A corporate treasurer intends to borrow money in middle of March for a three-months period. He may fear that interest rates will rise.

In other words, a hedge is position that is taken as a temporary substitute for a later position in another asset (or liability) or to protect the value of existing position in an asset (or liability) until the position is liquidated.

Example

In the month of Sep, 2013 A jute mill anticipate a requirement of 10,000 candies of Jute in the month of Dec, 2013.

Current price of Jute is Rs.1000 per candy. They buy 10,000 candies at Rs.1000 and enter into forward contract (Short) to sell at Rs.1470 per candy.

Profit/Loss profile on Dec, 2013

      Jute purchased                                      = Rs.1000 per candy

      Jute proceeds (forward price)             = Rs.1470 per candy

      Current market price (on Dec 2013)  = Rs.1500

Net cost of candy to mill                             = Rs.1030 (Rs.1000 + Rs.30)

Profit on sale                                                = Rs.440 per candy