Hedging

Futures contracts are efficiently used in ordinary business risk control, in particular for securing (hedging) against potential losses or profit drop entailed by changes in prices for raw materials or ready produce of enterprise, as well as from potential future changes in exchange rates or interest rates if the latter may adversely influence the gains of a particular enterprise.

Hedgers acquire futures contracts to insure themselves against changes in prices for corresponding underlying assets as they deal with them in the course of ordinary business.

Example of Cost Hedging

The management of a power-consuming enterprise, if wishing to protect itselvf against growth in prices for oil or gas during, say, next year, instead of increasing its physical resources (which leads to additional expenses) may acquire the required number of futures contracts for these types of fuel. If the fuel price rises in the future, then the price of the acquired futures contracts will also increase. Upon their sale on the stock market the company will realize the profit that is exactly required to compensate for increasing operational expenditures for purchase of physical resources of fuel at higher prices.

Example of Profit Hedging

To secure itself from a fall in prices for manufactured products, a company may sell futures contracts for the volume of produce expected for realization in the future. Then the short position on the futures will provide the profit not received in consequence of the potential drop in prices for the manufactured products. At present time the biggest companies of the processing industry use futures contracts for wheat, coffee, sugar, saw-timber, cotton, gas, oil, copper, gold etc.

Example of Currency Risk Hedging

By means of hedging the enterprises performing large-scale export-import operations can reduce the risk of unfavourable fluctuations of currency exchange rates. If necessary payments in foreign currency are expected in the future, a company can secure itself beforehand against unforeseen expenses associated with a potential rise in currency price. Acquiring today a futures contract for a given currency with an expiration date near to the payment time, the enterprise thus excludes losses from exchange rates. The conversion costs are balanced with the profit from the futures contract.

Example of Investment Portfolio Hedging

Usage of futures contracts for exchange indices can considerably facilitate investment portfolio management. Imagine a portfolio of US companies’ shares that are considered by the investor as undoubtedly promising. He thinks that the price of these shares will grow faster than the prices of similar securities. However, uncertainty remains regarding large macroeconomic factors influencing generally the whole market. These factors may adversely affect the portfolio, whose price may decrease following the common decline, even if to a lesser degree. To isolate the influence of general market factors, the investor may sell several contracts for the S&P index reflecting the common market index of all US economic sectors. Then the portfolio profitability profile will be:

Realizable profitability = Profitability on investment portfolio – Profitability on the market as the whole.

In other words, an income realized by the investor is adjusted for the market average and the investor will be able to earn on the share portfolio chosen by him regardless of common market trends. Depending on portfolio composition, he may choose the index most suitable for hedging. For example, movement of US equity markets is reflected in the following popular indices: DJIA, NASDAQ 100, NYSE Composite, Russel 2000, S&P 500.