Sunday, 1 December 2019

Unit 7: Application of Futures Contracts Futures contracts have linear payoffs.

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Unit 7: Application of Futures Contracts     Futures contracts have linear payoffs.

It means that the losses as well as profits for the buyer and the seller of a futures contract are unlimited.

A long hedge is appropriate when a company knows it will have to purchase a certain asset in the future and wants to lock in a price now.

Futures act as a hedge when a position is taken in them, which is just opposite to that taken by the investor in the existing cash position.

Hedgers sell futures (short futures) when they have already a long position on the cash asset, and they buy futures (long futures) in the situation of having a short position (advance sell) on the cash asset.

Primarily there are two kinds of hedge positions using futures namely, short hedge and long hedge.

Financial Derivatives     The unit discusses four types of hedging strategies namely, going long, going short, long hedging and short hedging.

When an investor goes long, he enters a contract by agreeing to buy and receive delivery of the underlying at a pre-determined price.

The investor going long is trying to profit from an anticipated future price increase.

A speculator who goes short—that is, enters into a futures contract by agreeing to sell and deliver the underlying at a set price—is looking to make a profit from declining price levels.

The methodology of hedging using futures is elaborately explained using illustrations.

The hedge ratio is the number of futures contacts one should use to hedge a particular exposure in the spot market.

Speculators can also benefit from trading in futures contracts.

When the underlying asset is expected to be bullish (rising prices), the speculator opts for buying futures; whereas when the underlying asset is expected to be bearish (falling prices), the speculator opts for buying futures.

The unit concludes by illustrating two of the primary benefits that an arbitrager can obtain using futures contracts.

Arbitrage: Arbitrage refers to riskless profit earned by taking positions in spot/futures markets.

Beta: Beta is a measure of the systematic risk of a security that cannot be avoided through diversification.

Carry cost (CC): Carry cost is the interest cost of holding the underlying asset (purchased in spot market) until the maturity of futures contract.

Carry return (CR): Carry return is the income (e.g., dividend) derived from underlying asset during the holding period.

Hedge Ratio: The hedge ratio (HR) is the number of futures contacts one should use to hedge a particular exposure in the spot market.

Index Futures: Index Futures are futures contracts with indexes as their underlying asset.

Short hedge: A short hedge is one that involves a short position in futures contracts.

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