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Hedging using futures

  • Hedge is a position established to minimize the exposure to the unwanted risks
  • Hedge can be either a short hedge or a long hedge
  • Short hedge: is a hedge in which an investors takes a short position in a contract
  • Question
    • A hen producer, HP, is going to sell hens in 3 months. His cost per hen is $50 and he knows he has to sell it above $50 to make a profit. Currently the price for hens in the market is $51. He knows that many of his friends and locals are breeding hens at the same time. So there is going to be an oversupply of hens in the next 3 months and the price is likely to go down. What should the hen producer do?
  • Answer
    • HP goes short on hen futures contract with a price of $50 or lower. After 3 months if the market price of hens goes down to $45 he makes a loss of ($5) per hen. Just before the futures settlement date when the futures price is close to spot price of $45, he closes his position by going long on a futures contract at $45.Hence he makes $5 on the futures contract and squares his position off
  • What happens if there is a cyclone and the friends suffer a loss of hens and you don’t?
    • Long hedge Is a hedge in which an investors takes a long position in a contract
  • Can someone give me an example?

Is hedging always good?

  • Hedging and shareholders: Shareholders can hedge the risk themselves. Companies don’t need to. But do the shareholders have as much information as the companies? What about transaction costs and commissions? Companies carry out high volume transactions hence cost of hedge is lower.
  • Hedging and competitors: What if the price of hen food was reduced as the hen producers union pressed the suppliers to reduce their prices. HP ‘s profits would rise as he had locked his selling price and the raw material prices went down. For others the change in profits would be 0. What if the raw material prices went up for some reason and the union decided to raise their selling prices in the market proportionately. HP’s profit would reduce while others profit remain the same. Hedging actual is causing fluctuation in profits!!

Any other reasons you can think of?

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