Investment Analysis & Portfolio Management
Lecture#
18
FUTURES
THE FUTURES MARKET:
A futures contract is a promise; the person who initially sells the contract promises to
deliver a quantity of a standardize commodity to a designated delivery point during a
certain month called a delivery month. The other party to the trade promises to pay a
predetermined price for the goods upon delivery. The person who promises to buy is
said to be long; the person who promises to deliver is short.
UNDERSTANDING FUTURES MARKETS:
Why Futures Markets?
Physical commodities and financial instruments typically are traded in cash markets. A
cash contract calls for immediate delivery and is used by those who need a commodity
now (e.g., food processors). Cash contracts cannot be canceled unless both parties
agree. The current cash prices of commodities and financial instruments can be found
daily in such sources as The Wall Street Journal.
There are two types of cash markets, spot markets and forward markets. Spot markets
are markets for immediate: delivery. The spot price refers to- the current market price
of an item available for immediate delivery.
Forward markets are markets for deferred delivery. The forward price is the price of
an item for deferred delivery.
Futures Contracts:
:
A forward contract is an agreement between two parties that calls for delivery of a
commodity (tangible or financial) as, a specified future time at a price agreed upon
today. Each contract has a buyer and a seller: Forward markets have grown primarily
because of the growth in swaps, which in general are similar to forward contracts.
•
Forward contracts involve credit risk—either party can default on their
obligation. These contracts also involve liquidity risk because of the difficulties
involved in getting out of the contract. On the other hand, forward contracts can
be customized to the specific needs of the, parties involved.
A futures contract is a standardized, transferable agreement providing for the deferred
delivery of either a specified grade or quantity of a designated commodity within a
specified geographical area or of a financial instrument (or its cash value). In simple
language, a futures contract locks in a price for delivery, on a future date.
The futures price at which this exchange will occur at contract maturity is determined
today. The trading of futures contracts means only that commitments have been made
by buyers and sellers; therefore,, "buying" and "selling" do not have the same meaning
in futures transactions as they do in stock and bond transactions. Although these
commitments are binding because futures contracts are legal contracts, a buyer or
seller can eliminate the commitment simply by taking an opposite position in-the same
commodity or financial instrument for the same futures month.
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•
Futures contracts are standardized and easily traded. Credit risk is removed by
the clearinghouse (explained below) which ensures performance on the
contract. On the other hand, they cannot readily be customized to fit particular
needs.
Futures contracts are not securities and are not regulated by the Securities and
Exchange Commission (SEC). The Commodity Futures Trading Commission (CFJC),
a federal regulatory agency, is responsible for regulating trading in all domestic
futures markets. In practice, the National Futures Association, a self- regulating body,
has assumed some of the duties previously performed by the CFTC. In addition, each
futures exchange has a supervisory body to oversee its members.
Futures vs. Options:
Some analogies can be made between futures contracts and options contracts. Both
involved a predetermined price and contract duration. An option, however, is precisely
that. The person holding the option has the right, but not the obligation, to exercise the
put or the call. If an option has no value at its expiration, the option holder will allow it
to expire unexercised. But with futures contract, a trade must occur if the contract is
held until its delivery deadline. Futures contracts do not “expire” unexercised. One
party has promised to deliver a commodity, which another party has promised to buy.
An important concept keep in mind with futures is that the purpose of contracts is not
to provide a means for the transfer of goods. Stated another way, property rights to
real or financial assets cannot be transferred with futures contracts. Futures contracts
do, however, enable people to reduce some of the risks they assume in their business.
People who buy puts or calls do not usually intend to exercise them; valuable options
are sold before expiration day. Similarly, an individual who is long a corn futures
contract usually does not want to take delivery of the 5,000 bushels covered by the
contract. Also, a farmer who has promised to deliver wheat through the futures market
may prefer to sell the crop locally rather than deliver it to an approved delivery point.
In either case the contract obligation can be satisfied by making an offsetting trade, or
trading out of the contract. An individual with a long position sell a contract, canceling
the long position. The farmer with short position would buy. Both individuals would
be out of the market after these trades.
Market Participants:
Two types of participants are required in order for a futures market to be successful:
hedgers and speculators. Without hedgers the market would not exist, and no
economic function would be performed by speculators.
1. Hedgers:
In the context of future market, a hedger is someone who is engaged in some type of
business activity with an unacceptable level of price risk. A farmer must decide what
crop to put in the ground in each spring. The welfare of the farmer’s family or
business depends on the price of the chosen commodity at harvest. If the price is high
the farmer will earn a nice profit in the crop. Should prices be low because of
overabundance or reduced demand, and then prices may fall to such a level that
operating costs cannot even be recovered.
It is important to recognize that the farmer cannot eliminate the risk of a poor crop
through the futures market; only price risk can be eliminated. Crop insurance may help
protect against such an eventuality, but the futures market cannot.
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2. Speculators:
In order for the hedger to eliminate unacceptable price risk, someone must be willing
to assume that risk is the hedger’s place. This person is the speculator. The speculator
has no economic activity requiring use of futures contract, but rather finds attractive
investment opportunities there and takes positions in futures in hopes of making a
profit rather than protecting one. In certain aspects, the speculator performs the same
role that insurance companies perform when they prepare policies. The person who
buys insurance is unwilling to bear the full risk of economic loss an accident occur,
consequently chooses to transfer that risk to the insurance company. The insurance
company is willing to bear the risk because it feels a profit can be made by providing
this coverage in exchange for the insurance premium.
A speculator might promise to deliver 5,000 bushels of wheat at $ 4.00 for September
delivery if he or she feels that wheat will not sell for that much at delivery time.
Speculators cannot conveniently deliver wheat because they are not in the business of
growing it, but this point is not relevant because speculators can easily exit the market
by buying September wheat contracts to cancel out the previous position. The
difference in price on the two trades will be the speculator’s profit or loss.
In considering what makes a futures contract valuable and what makes the price of the
contract fluctuate from day to day, remember that a futures contract is a promise to
exchange certain goods at a future date. You must keep your part of the promise unless
you get someone to take the promise off your hands. In other words, you must make a
closing transaction. The promised goods are valuable now, and their value in the
future may be more or less than their current worth. Prices of commodities change for
many reasons such as new weather forecasts, the availability of substitute
commodities, psychological factors, and changes in storage or insurance costs. These
factors all involve shifts in demand for a commodity, changes in the supply of the
commodity, or both.
3. Marketmakers:
Marketmakers provide liquidity for the marketplace. These people on the floor of the
exchange seek to buy from one person and sell to someone else at a slightly higher
price many times during the day. Marketmakers seldom have the capital to hold large
positions and hope prices move in a particular way. Their bread and butter us earning a
spread between the bid and ask prices prevailing at the moment.
Without marketmarkes, hedgers and speculators would face a less efficient market.
The cost of trading would be higher because the spread between buying and selling
prices would be wider.
THE STRUCTURE OF FUTURES MARKETS:
Futures Exchanges:
As noted, futures contracts are traded on designated futures exchanges, which are
voluntary, nonprofit associations, composed of members. There are several major,
U.S, exchanges.
The exchange provides an organized marketplace where established rules govern the
conduct of the members. The exchange is financed by both membership dues and fees
charged for services rendered.
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All memberships must be owned by individuals, although they may be controlled by
firms. The limited number of memberships, like stock exchange seats, can be traded at
market determined prices. Members can trade for their own accounts or as agents for
others. For example, floor traders trade for their own accounts, whereas floor brokers
(or commission brokers) often act as agents for others. Futures commission merchants
(FCMs) act as agents for the general public, for which they receive commissions.
Thus, a customer can establish an account with an FCM, who in turn may work
through a floor broker at the exchange.
The Clearing House:
The clearinghouse, a corporation separate from, but associated with, each exchange
plays an important role in every futures transaction. Since all futures trades are cleared
through the clearinghouse each business day, exchange members must either be
members of the clearinghouse or pay a member for this service. From a financial
requirement basis, being a member of the clearinghouse is more demanding than being
a member of the associated exchange.
Essentially, the clearinghouse for futures markets operates in the same way as the
clearinghouse for options. Buyers and sellers settle with the clearinghouse, not each
other. Thus, the clearinghouse, and not- another investor, is actually on the other side
of every transaction and ensures that all payments are made as specified. It stands
ready to fulfill a contract if either buyer or seller ^defaults, thereby helping to facilitate
an orderly market in futures. The clearinghouse makes the futures market impersonal,
which is the key to its success, because any buyer or seller can always close out a
position and be assured of payment. The first failure of a clearinghouse member in
modern times occurred in the 1980s, and the system worked perfectly in preventing
any customer from losing money. Finally, as explained below, the clearinghouse
allows participants easily to reverse a position before maturity, because the
clearinghouse keeps trade of each participant's obligations.
THE MECHANICS OF TRADING:
Basic Procedures:
Because the futures contract is a-commitment to buy or sell at a specified future
settlement date, a contract is not really .being solder bought, as in tire case of Treasury
bills, stocks, or Certificate's of Deposit (CDs), because no money is exchanged at the
time the contract is negotiated. Instead, the seller and the buyer simply are agreeing to
make and take delivery, respectively, at some future, time for a price: agreed upon
today. As noted above, the terms buy and sell do not have the same meanings here. It
is more accurate to think in terms of;
1. A short position (seller), which commits a trader to deliver an item at contract
maturity.
2. A long position (buyer), which commits a trader to purchase an item at contract
maturity
Selling short in futures trading means only that a contract not previously purchased is
sold. For every futures contract, some one sold it short and someone else holds it long.
Like options, futures trading are a zero-sum game.
Whereas an options contract involves the right to make or take delivery, a futures
contract
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involves an 'obligation to take or make delivery. However, futures contracts can be
settled by delivery or by offset. Delivery, or settlement of the contract, occurs in
months that are designated by the various exchanges for each of the items traded.
Delivery occurs in less than 2 percent of all transactions.
Offset is the typical method of settling a contract. Indeed, about 95 percent of futures
contracts are closed before the contract expire by offset. Holders liquidate a position
by arranging an offsetting transaction. This means that buyers sell their positions, and
sellers buy in their positions sometime prior to delivery. When an investor offsets his
or her position, it means that their trading account is adjusted to reflect the final gains
(or losses) arid their position is closed.
Thus, to eliminate futures market position, the investor .simply does the reverse of
what was done originally. As explained above, the clearinghouse makes this easy to
accomplish. It is essential to remember that if a futures contract is not offset, it must be
closed out by delivery.
•
An option involves the right, but not the obligation to take action
•
A futures contract involves an obligation either offset occurs or delivery occurs.
Margin:
Recall that in the case of stock transactions, the term margin refers to the down
payment in a transaction in which money is borrowed from the broker to finance the
total cost. Futures margin, on the other hand, is not a down payment, because
ownership of the underlying item is not being transferred at the time of the transaction.
Instead, it refers to the "good faith" (or earnest money) deposit made by both buyer
and seller to ensure the completion of the contract. In futures trading, unlike stock
trading, margin is the norm. All futures markets participants, whether buyers or sellers,
must deposit minimum specified amounts in their futures margin accounts to
guarantee contract obligations.
• In effect; futures margin is a performance bond.
Each clearinghouse sets its own minimum initial margin requirements (in dollars).
Furthermore, brokerage houses can require a higher margin and typically do so. The
margin required for futures contracts, which is small in relation to the value of the
contract itself, represents the equity of the transactor (either buyer or seller). It is not
unusual for the initial margin to be only a few thousand dollars although the value of
the contract is much larger. As a generalized approximation, the margin requirement
for futures contracts is about 6 percent of the value of the contract. Since the equity is
small, the risk is magnified.
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Lecture 12
FUTURES Contd…
Using Futures Contracts:
Who uses futures, and for what purpose? Traditionally, participants in the futures
market have been classified as either ledgers or speculators. Because both groups are
important in understanding the role and functioning of futures markets, we will
consider each in turn. The distinctions between these two groups apply to financial
futures as well as to the more traditional commodity futures.
Hedgers:
Hedgers are parties at risk with a commodity or an asset, which means they are
exposed to price changes. They buy or sell futures contracts in order to offset their
risk. In other words, hedgers actually deal in the commodity or financial instrument
specified in the futures contract. By taking a position opposite to that of one already
held, at a price set today, hedgers plan to reduce the risk of adverse price
fluctuations—that is, to hedge the risk of unexpected price changes. In effect, this is a
form of insurance.
In a sense, the real motivation for all futures trading is to reduce price risk. With
futures, risk is reduced by having the gain (loss) in the futures position offset the loss
(gain) on the cash position. A hedger is willing to forego some profit potential in
exchange for having someone else assume part of the risk.
How to Hedge with Futures:
The key to any hedge is that a futures position is taken opposite to the position in the
cash market. That is, the nature of the cash market position determines the hedge
futures market. A commodity or financial instrument held (in effect in inventory)
represents a long position, because these items could be sold in the cash market. On
the other hand, an investor who sells a futures position not owned has created a short
position. Since investors can assume two basic positions with futures contracts, long
and short, there are two basic hedge positions;
1. The short (sell) hedge:
A cash market inventory holder must sell (short) the futures. Investors should think of
short hedges as a means of protecting the value of their .portfolios. Since they are
holding securities, they are long on the cash position and need to protect themselves
against a decline in prices. A short hedge reduces, or possibly eliminates, the risk
taken in a long position.
2. The long (buy) hedge:
An investor who currently holds no cash inventory (holds no commodities or financial
instruments) is, in effect, short on the cash market; therefore, to hedge with futures
requires a long position. Someone who is not currently in the cash market but who
expects to be in the future and who wants to lock in current prices and yields until cash
is available to make the investment can use a long hedge which reduces the risk of a
short position.
Hedging is not an automatic process. It requires more than simply taking a position.
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Hedgers must make timing decisions as to when to initiate and end the process. As
conditions change, hedgers must adjust their hedge strategy.
One aspect of hedging that must be considered is "basis" risk. The basis for financial
futures often is defined as the difference between the cash price and the futures price
of the item being hedged:
Basis = Cash price - Futures price
The basis must be zero on the maturity date of the contract. In the interim, the basis
fluctuates in an unpredictable manner and is not constant during a hedge period. Basis
risk, therefore, is the risk hedgers face as a result of unexpected changes in the basis.
Although changes in the basis will affect the hedge position during its life, a hedge
will reduce risk as long as the variability in the basis is less than the variability in the
price of the asset being hedged. At maturity the futures price and the cash price must
be equal, resulting in a zero basis.
The significance of basis risk to investors is that risk cannot be entirely eliminated.
Hedging a cash position will involve basis risk.
Speculators:
In contrast to hedgers, speculators buy or sell futures contracts in an attempt to earn a
return. They are willing to assume the risk of price fluctuations, hoping to profit from
them. Unlike hedgers, speculators typically do not transact in the physical commodity
or financial instrument underlying the futures contract. In other words, they have no
prior market position. Some speculators are professionals who do this for a living;
others are amateurs, ranging from the very sophisticated to the novice. Although most
speculators are not actually, present at the futures markets, floor traders (or locals)
trade for their own accounts as we'll as others and often take very short-term (minutes
or hours) positions in attempt to exploit air short-lived market anomalies.
Why speculate in futures .markets? After all one could speculate in the underlying
instruments. For example, an investor who believed interest rates were going to
decline could buy Treasury bonds directly and avoid the Treasury bond futures
market. The potential advantages of speculating in futures markets include:
1. Leverage: The magnification of gains (and losses) can easily be 10 to 1.
2. Ease of transacting: An investor who thinks interest rates will rise will have
difficulty selling bonds short, but it is very easy to take a short position in a
Treasury bond futures contract.
3. Transaction costs: These are often significantly smaller in futures markets.
By all accounts, an investor's likelihood of success when speculating in futures is not
very good. The small investor is up against stiff odds when it comes to speculating
with futures contracts. Futures should be used for hedging purposes.
FINANCIAL FUTURES:
This section covers financials futures mostly from a speculator’s perspective. The
following two chapters, dealing with the management of equity portfolios and fixed
income portfolios, show other uses from the hedger’s point of view. The chapters
explain how financials futures can logically be used to improve e a portfolio’s
characteristics.
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Stock index futures:
As with other futures contracts, a stock index future is a promise to buy or sell the
standardized units of a specific index price at a predetermined future date. Table 15-2
lists the characteristics of the S $P 500 stock index futures contract. Unlike most other
commodity contracts, there is no actual delivery mechanism at expiration of the
contract. Al settlements are in cash. It is not practical to have speculators or hedgers
deliver 500 different stock certificates in the appropriate quantities to satisfy the
requirements of the contract. The value of the index is known at delivery time, and
crediting or debiting accounts with accrued gains or losses is much more convenient.
A speculator might believe the overall stock market is about to advance and therefore
decide to buy one S$P stock index future contract. Suppose in early may the S$P 500
index is at 1415.70 and the speculator buys a June S$P 500 future contract at
settlement price of 1417.70. The dollars value of the futures contract is set at $250
times the settlement price, so the purchaser of the contract promises to pay
1417.50x$50, or $354,425, at the delivery date. Several weeks later the stock market
has advanced, and the future contract now trades at 1420. the speculator might decide
to close out the position and take her profit of (1420-1417.70)x$250,or $575.note that
only the net gain or loss changes hands; the speculator never actually needs to come
up with $354,425.large gains or losses are possible with stock index futures, and the
leverage they provide is attractive to many people.
Delivery Procedures:
Suppose someone wants to deliver a 5% bond with 20 years, 11 months remaining in
its life, and that the settlement price for the T-bond futures contract on position day is
91-00. By exchange policy, the remaining maturity is rounded down to the nearest
quarter, giving 20 years and three quarters. The invoice price is then
Futures settlement
0.9100
* $100,000
price
Contract size
* 0.8821
$80,271.10
+
2,083.33
Conversion factor
Principal due
Accrued interest
Total due = invoice
$82,354.53
price
Note the accrued interest calculation. The bond matures in 20 years and 11 months,
meaning it is 5 months into the interest rate cycle. Accrued interest on one bond is
therefore 5/6 * $25, or 420.83. On $100,000 par, the total is $2,083.33.
At any given time, several dozen bonds are usually eligible for delivery on the T-bond
futures contract. Normally one of these bonds will be cheapest to deliver. The cheapest
to deliver bond is the deliverable bond preferred by the sellers, because it costs them
the least to use.
For technical reasons, the conversion factors make all bonds equally attractive for
delivery only one when the bonds under consideration yield 6%. If they yield more or
less than this, one bond is going to have the lowest adjusted price, and hence the
cheapest to deliver.
An investor who must buy bonds to deliver against a futures contract will want to get
these bonds as cheaply as possible.
Foreign Currency Futures:
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Management
Foreign currency futures contracts trade at the International Monetary Market of the
Chicago Mercantile Exchange. They all call for delivery of the foreign currency in the
country of issuance to a bank of the clearing house’s choosing.
When a U.S investor buys a foreign security, there are really two relevant purchases.
The actual purchase of the security is one of them, but before the security can be
bought, the investor must exchange U.S. dollars for the necessary foreign currency. In
essence, the investor is buying the foreign currency, and its price can change daily. To
the investor, the changing relationships among currencies of interest constitute foreign
exchange risk. Modest changes in exchange rates can result in significant dollar
differences.
Foreign currency futures were the catalyst that caused the rapid growth in the financial
futures market. These products were immediately successful. Most major corporations
face at least some foreign exchange risk and quickly discovered the convenience of
these futures as a hedging vehicle. Speculators saw a contract easy to understand and
use, and therefore, foreign currency futures were of interest to both hedgers and
speculators. Their success led the exchanges to spawn similar products to hedge other
types of financial risk.
Hedging With Stock-Index Futures:
Common stock investors hedge with financial futures for the same reasons that fixedincome investors use them. Investors, whether individuals or institutions, may hold a
substantial stock portfolio that is subject to the risk of the overall market; that is,
systematic risk. A futures contract enables the investor to transfer part or all of the risk
to those willing to assume it. Stock-index futures have opened up new, and relatively
inexpensive, opportunities for investors to manage market risk through hedging.
Investors can use financial futures on stock market indexes to hedge against an overall
market decline. That is, investors can hedge against systematic or market risk by
selling the appropriate number of contracts against a stock portfolio. In effect, stockindex futures contracts give an investor the opportunity to protect his or her portfolio
against market fluctuations.
To hedge market risk, investors must be able to take a position in the hedging asset (in
this case, stock-index future) such that profits or losses on the hedging asset offset
changes in the value of the stock portfolio. Stock-index futures permit this action,
because changes in the futures prices themselves generally are highly correlated with
changes in the value of the stock portfolios that are caused by market wide events. The
more diversified the portfolio, and therefore the lower the nonsystematic risk, the
greater the correlation between the futures contract and the stock positions.
Index Arbitrage and Program Trading:
A force of considerable magnitude hit Wall Street in the 1980s. It is called program
trading, and it has captured much attention and generated considerable controversy. It
leads to headlines attributing market plunges at least in part to program trading, as
happened on October 19,1987, when the DJIA fell over 500 points. Because program
trading typically involves positions in both stocks and stock-index futures contracts,
we consider the topic within the general discussion of hedging.
The terms program trading and index arbitrage often are used together. In general
terms, index arbitrage refers to attempts to exploit the differences between the prices
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index futures and the prices of the index of stocks underlying the futures contract. For
example, if the S&P 500 futures price is too high relative to the S&P 500 Index,
investors could short the futures contract and buy the stocks in the index. In theory,
arbitrageurs should be able to build a hedged portfolio that earns arbitrage profits
equaling the difference between the two positions. If the price of the S&P 500 futures
is deemed too low, investors could purchase the futures and short the stocks, again
exploiting the differences between the two prices.
If investors are to be able to take advantage of discrepancies between the futures price
and the underlying stock-index price, they must be able to act quickly. Program
trading involves the use of computer-generated orders to coordinate buy and sell
orders for entire portfolios based on arbitrage opportunities. The arbitrage occurs
between portfolios of common stocks, on the one hand, and index futures and options
on the other. Large institutional investors seek to exploit, differences between the two
sides. Specifically, when stock-index futures prices rise substantially above the current
value of the stock-index itself (e.g., the S&P 500), they sell the futures and buy the
underlying stocks, typically in "baskets" of several million dollars. Because the futures
price and the stock-index value must be equal when the futures contract expires, these
investors are seeking to "capture the premium" between the two,-thereby earning an
arbitrage profit. That is, they seek high risk-free returns by arbitraging the difference
between the cash value of the underlying securities and the prices of the futures
contracts on these securities. In effect, they have a hedged position and should profit
regardless of what happens to stock prices.
Normally, program traders and other speculators "unwind" their positions during the
last trading; hour of the day the futures expire. At this time, the futures premium goes
to zero, because, as noted, the futures price at expiration must equal the stock-index
value.
The headlines about program trading often reflect the results of rapid selling by the
program traders. For whatever reason, traders’ decide-to sells the futures. As the price
falls, stock prices also fall. When 'the futures price drops below the price of the stock
index, tremendous selling orders can be unleashed. These volume sell orders in stocks
drive the futures prices even lower.
Investment Analysis & Portfolio Management
Lecture 12
FUTURES Contd…
Financial Futures:
Financial futures are futures contracts on equity indexes, fixed-income securities, and
currencies. They give investors greater opportunity to fine tune the risk-return
characteristics of their portfolios. In recent years, this flexibility has become
increasingly important as interest rates have become much more volatile and as
investors have sought new techniques to reduce the risk of equity positions. The
drastic changes that have occurred in the financial markets in the last 15 to 20 years
could be said to have generated a genuine need for new financial instruments that
allow market participants to deal with these changes.
The procedures for trading financial futures are the same as those for any other
commodity with few exceptions. At maturity; stock-index futures settle in cash,
because it would be impossible or impractical to deliver all the stocks in a particular
index. Unlike traditional futures, contracts, stock-index futures typically have no daily
price limits (although they can be imposed).
We will divide the subsequent discussion of financial futures into the two major
categories of contracts, interest rate futures and, stock-index futures. Hedging and
speculative activities within each category are discussed separately.
Interest Rate Futures:
Bond prices are highly volatile, and investors are exposed to adverse price movements,
financial futures, in effect, allow bondholders and others who are affected by volatile
interest rates to transfer the risk. One of the primary reasons for the growth in financial
futures is that portfolio managers and investors are trying to protect themselves against
adverse movements-in interest rates. An investor concerned with protecting the value
of, fixed-income securities must consider the possible impact of interest rates on the
value of these securities.
Today's investors have the opportunity to consider several different interest rate
futures contracts that are traded on various exchanges. The Chicago Mercantile
Exchange trades contracts on Treasury bills and the one-month LIBOR rate as well as
euro dollars. The Chicago Board of Trade (CBT) specializes in longer-maturity
instruments, including Treasury notes (of various maturities, such as two-year and
five-year) and Treasury bonds (of different contract sizes).
Short Hedges:
Since so much common stock is "held by investors, the short hedge is the natural type
of contract for most investors. Investors who hold stock portfolios hedge market risk
by selling stock-index futures, which means they assume a short position.
A short hedge can be implemented by selling a forward maturity of the contract. The
purpose of this hedge is to offset (in total or in part) any losses on the stock portfolio
with gains on the futures-position. To implement this defensive strategy, an investor
would sell one or more index futures contracts. Ideally, the value of these contracts
would equal the value of the stock portfolio. If the market falls, leading to a loss on the
cash (the stock
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portfolio) position, stock-index futures prices wilt also fall, leading to a profit for
sellers of futures.
Long Hedges:
The long hedger, while awaiting funds to invest, generally wishes to reduce the risk of
having to pay more for an -equity position when prices rise. Potential users of a long
hedge include the following:
1. Institutions with a regular cash flow who use long hedges to improve the timing
of their positions.
2. Institutions switching large positions who wish to hedge during the time it takes
to complete the process, (This could also be a short hedge.)
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