Abstract
Undertaking business always involves taking risk. The future development of a company and their business is more uncertain the higher the risk that the company is facing. Risk management is a important factor in operating business. With the development of future markets entrepreneurs and investors obtained another risk management tool that made it possible to reduce risk. Futures are derivatives that can be used either for speculating or risk management. Especially in the area of financial futures, a rapid growth could be observed during the last few decades. Almost every month a new type of contract appears to meet the needs of a continuously growing corporate and institutional market.
This paper considers future contracts as hedging application to reduce price risk. Futures are standardized contracts to buy or sell an asset in the future. There are various types of futures which differ in the type of the underlying asset.
Futures are traded at organized exchanges. We consider the trading of future, their requirements, and market participants and their motivation.
Different commercial users of future contracts hedge in different ways. A long hedge is used to reduce price risk of an anticipated purchase whereas a short hedge reduces the price risk of an asset that is already held. If there is no exact, the hedgers needs matching, contract available, the hedger should use a cross hedging strategy. With all these strategies the hedger takes, to the asset opposite, a position in the future market that is highly correlated with the change in price of the asset in the spot market. Losses in one market are offset by gains in the other market.
For a successful hedge it is essential to choose an appropriate contract and hedge ratio. Faults can result in losses. The example of hedging a stock portfolio shows the application of an index future and presents the behavior of the hedged portfolio in different scenarios of stock market development.
Table of Contents
I. Introduction
1. Problem background
2. Course of examination
II. Main Part
1. Futures
1.1 Definition
1.2 Types of futures
1.3 Trading futures
1.3.1 Exchange and clearing house
1.3.2. Margins and daily settlement
1.3.3 Basis and convergence
1.4 Market participants and their motivation
2. Hedging with futures
2.1 Definition
2.2. Types of hedges
2.2.1 Short hedge
2.2.2 Long hedge
2.2.3 Cross hedging
2.3 Hedge Ratio
3. Hedging of a portfolio – an example
3.1 The portfolio and the future
3.2 Determining the hedge ration
3.3 Impact of market development
III. Conclusion
Objectives and Topics
The primary objective of this paper is to examine futures contracts as a strategic tool for risk management, specifically focusing on their application in hedging financial portfolios against price volatility. The research addresses how market participants utilize these derivatives to offset risks associated with spot market positions through a practical demonstration of hedging a stock portfolio.
- Fundamentals of futures contracts and market mechanics.
- Classification of hedging strategies: short, long, and cross hedging.
- The role of the hedge ratio and the management of basis risk.
- Practical application: constructing a hedge for an equity portfolio using S&P 500 index futures.
- Evaluation of portfolio performance under various market scenarios.
Excerpt from the Book
2.2.1 Short hedge
There are three basic types of hedges: a short hedge, a long hedge, and a cross hedge. The most common hedge is the short hedge. The hedger already owns the asset that he wants to hedge. The hedger sells a future contract with the same underlying like the asset. For example a farmer who grows corn wants to lock in the current price for his harvest which occurs in fall because he expects that the price may fall. This farmer sells a future in corn that expires at the time of the harvest. At expiration the farmer sells his corn to the other contracting party to the contracted price. It is more common to close the short position in the future before it expires than to deliver the underlying (reversing trade). If the price for corn rises, the farmer would lose money in the future contract, but he would have a higher income from selling the corn in the market. If the price for corn decreases, the lower gains he would have with selling the corn in the market, would be offset by the profit from the future contract when he covers his position before expiration. This is due to the fact that spot price and future price must be equal at expiration.
Summary of Chapters
I. Introduction: This section provides the background on increasing market risks and outlines the paper's aim to evaluate futures as a risk management tool.
II. Main Part: This chapter defines futures, describes exchange trading mechanisms, analyzes various hedging strategies, and provides a quantitative example of hedging a stock portfolio.
III. Conclusion: This section summarizes the findings, emphasizing that while futures are effective tools for hedging, improper application can negatively impact portfolio performance.
Keywords
Futures, Hedging, Portfolio Management, Price Risk, Derivatives, Basis Risk, Hedge Ratio, S&P 500, Spot Market, Clearing House, Margin, Speculation, Cross Hedging, Financial Risk, Market Volatility
Frequently Asked Questions
What is the core focus of this research?
The research focuses on the utility of futures contracts as instruments for risk management, specifically exploring how they are used to mitigate price risk in financial portfolios.
What are the central thematic areas?
Key themes include the structural mechanics of futures markets, participant motivation, various hedging strategies like short and long hedging, and the importance of basis risk management.
What is the primary research goal?
The primary goal is to demonstrate how to hedge a stock portfolio effectively using index futures and to analyze the impact of different market developments on the hedged position.
Which scientific methods are applied?
The paper utilizes a descriptive analysis of financial theory and a quantitative case study approach, involving mathematical calculations of hedge ratios and portfolio beta.
What topics are covered in the main body of the text?
The main part covers the definition and types of futures, the mechanics of trading (margins, settlement, convergence), hedging strategies, and a practical example using an S&P 500 futures contract.
Which keywords best describe this study?
Essential keywords include Hedging, Futures, Portfolio Management, Basis Risk, and Derivatives.
How is the hedge ratio calculated in the case study?
The hedge ratio is determined by multiplying the value of the portfolio by the portfolio beta and dividing it by the value of the future contract (the product of the contract size and the futures price).
What happens to the portfolio if the market remains unchanged?
According to the case study, even in an unchanged market, the portfolio suffers a loss in the future market because the basis between the spot and future prices narrows as the contract approaches expiration.
- Quote paper
- Marco Scheidler (Author), 2003, Hedging a portfolio with futures, Munich, GRIN Verlag, https://www.grin.com/document/41921
