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FUTURES FOR THE HEDGERS The primary economic function of the futures market is hedging.

Hedging is nothing else but buying and selling futures contracts to offset the risks of changing spot markets. Hedgers are those players in the market that own or would own a physical commodity in the near future. The Hedgers are thus concerned about the future prices of the commodity. Hedging is thus used as a tool of risk-management by: Farmers Producers Exporters Bankers Bond Dealers Pension fund managers

The market would have primarily two kinds of players: Buyers (actual users of the commodity) and Sellers (actual producers/manufacturers) of the commodity. The Buyers are concerned about the RISE in the prices while Sellers are concerned with the FALL in the prices. The FEARS of these two players makes the futures market for commodities. The Speculators are players that just want to take positions in the market so that they can take advantage of the market situations that they expect. The Buyers LONG FUTURES and the Sellers SHORT FUTURES. Example of LONG FUTURES Let us say that a wheat miller needs the following quantity of wheat to turn it into flour: Today is the month of September and he needs 10mt in the month of March of next year. He observes that the current spot price of Wheat is Rs 10,000 per MT. The miller wants to hedge his position. He observes that the futures contract for the March of next year is Rs. 10,200. Since the miller wants to hedge his position against facing a price rise, he will buy a futures contract for Rs10, 200. He would do a back of the envelope calculation that if he buys now, he would have to STORE the wheat and has also to consider a notional opportunity cost of interest. The miller when he sees that taking all these costs into consideration he would be better off buying a futures contract he will lock into the futures contract !!! Can the prices keep on fluctuating after he enters into a contract, sure they will !!! So what does he do after he has entered into the contract, he will watch the BASIS on a regular basis. What is the BASIS, the difference between the spot price and the futures price. Why would he watch the BASIS, because he is LOCKED INTO A POISITION the minute he buys the FUTURES contract.

Come March and the situation is as follows: SPOT PRICE of Wheat Contract: Rs 12,000 FUTURES CONTRACT PRICE: Rs 12,000 (this situation is very rare that there will be perfect convergence !!!) Pay-off table September March Spot 10000 12000 Buy wheat at 12000 he thus makes a notional loss of Rs 1800 because his calculation was that the price would be 10,200 Futures 10200 12,000 Sell futures for 100 profit

Cost to the Miller Spot Wheat Less: Actual profit by selling futures Exactly the price he expected to pay !!!

12,000 1,800 10,200

The above is an example of a perfect hedge because the Spot and the Futures price converged !!! Buying Hedge mechanics: NOW At the time of starting production Enter into contract to supply at a future date Buy the futures contract corresponding to the date of supply Buy input from the spot market Close out the futures contract by selling the same contract on the same exchange

Example of a Sellers Hedge (SHORT FUTURES) Now let us complicate the situation for a sellers hedge. Lets say there is a farmer and his harvesting season is March with a delivery in April. Today is in the month of November. The current spot price is Rs 10,000 and the April Futures are Rs 10,200. The farmers wants to lock his price, so he SELLS WHEAT FUTURES at Rs 10,200. Come April because of a bumper monsoon the price of wheat has actually fallen. He can sell wheat at Rs 9,200 only but the Wheat Futures have also fallen to Rs 9,200 (perfect convergence which never happens in the real world !!!) September March Spot 10,000 9,200 Sells wheat at 9,200 he thus makes a notional loss of Rs 1000 because his calculation was that the price would be 10,200 Futures 10,200 9,200 Buy Futures and square off his position in cash gaining Rs 1000

Revenue to the farmer: Spot Wheat Add: Profit from buying futures and cash settlement Exactly the price he expected to receive !!!

9,200 1,000

10,200

HEDGING FOR SELLERS NOW At the time of getting product ready to sell Start production of a product to sell at a future date Sell futures contract corresponding to the date of sale Sell in spot market Close out future contract by buying the same contract on the same exchange

The above two examples are fictitious. WHAT HAPPENS IN THE REAL WORLD, THERE WILL BE FLUCTUATIONS THAT MAY BE FAVORABLE OR UNFAVOURABLE? Suppose in our Long Hedge position the ending table looked like this September March Spot 10000 12000 Futures 10200 12,150 Non-convergence in the futures price with spot The price that the Miller would pay would be: Buy wheat in the spot market Less: Actual profit from futures (12150-10200)= 1,950 12,000 1,950 10,050 Basis -200 -150 The basis has strengthened

Because of non-convergence he has paid less than he expected to pay if there was perfect convergence !!!

September March

Spot 10000 12000

Futures 10200 12,250 Non-convergence in the futures price with spot

Basis -200 -250 The basis has weakened

Buy wheat in the spot market Less: Actual profit from futures (12150-10200)= 1,950

12,000 -2,050 9,950

The Long hedger benefits more if the basis are weakened !!! Basis Change Long/Buying Hedge Short/Selling Hedge Strenghten Unfavourable Favourable Weaken Favourable Unfavourable