Futures are derivative instruments whose value depends on (or is derived from) the values of other more basic, underlying variables like the prices of traded assets like stocks, commodities, currencies etc. A futures contract is an agreement between two parties to buy or sell an asset at a certain time in the future for a certain price. Futures are broadly used for the following three reasons; Hedging; Arbitrage and Speculation.
Hedging Strategies using Futures
Short Hedge: A short Hedge involves a short position in futures contract. A short position is appropriate when the hedger already owns an asset and expects to sell it at sometime in the future. A Short Hedge can also be used when an asset is not owned right now but will be owned at some time in the future. For example, an exporter who is expected to receive the consideration in 3 months in US Dollars will enter into a Futures contract to sell US Dollar at a pre-fixed price after a period of 3 months.
Long Hedge: These hedges involve taking a long position in a futures contract. A long hedge is appropriate when someone knows that a certain asset is to be purchased in the future and wants to lock in a price now. Long hedges can also be used to manage a short position. This can be better understood in terms of an importer planning to import machinery as a part of his project in India in 3 months. Importer will enter into a Future contract to buy US Dollars at a pre-fixed price.
Cross Hedging: When the asset underlying the futures contract is different from the asset whose price is being hedged it is called Cross Hedging. When cross Hedging is used, setting the Hedging ratio (ratio of the size of the position taken in futures contracts to the size of the exposure) equal to 1 is not always optimal. A pertinent example would be, cross hedging a crude oil futures contract with a short position in natural gas. Even though these two products are not identical, their price movements are similar enough to use for hedging purposes.
Basis Risk: In real life, hedging is often not quite as straightforward. Some of the reasons for this could be: The asset whose price is hedged may not be exactly the same as the asset underlying the futures contract; The hedger may be uncertain as to the exact date when the asset will be bought or sold and the Hedge may require the futures contract to be closed out before its delivery month. These problems give rise to what is termed as basis risk which is defined as: Basis = Spot Price of the asset to be hedged – Futures price of contract used.
Caution: Futures prices are marked-to-market which along with the highly leveraged positions can impact an investor account in case of market excesses. Thus, the potential of loss as well as gain is very large when compared to other derivative instruments.