Hi,
In this video, we will discuss how to do hedging with Futures contracts.
A person can hedge his position through various derivative instruments.
One of the most commonly used derivative instruments is the futures contract.
Now let us understand this concept from a macro point of view, like, from the producer’s and the end user’s point of view.
People like the producers, importers, exporters, end-users and many others – they all can use futures contracts to protect themselves against adverse price movements.
They offset their price risk, which they are exposed to, due to their day-to-day business activities, by buying or selling a futures contract on a futures exchange, thereby securing for themselves, a pre-determined price for their product.
Let us understand these concepts of hedging with futures with the help of an example.
Say there is a Company called Fun Foods. It is involved in the production of pre-packaged foods. They are a large consumer of flour and other commodities. Now, flour and these other commodities are subject to volatile price movements.
So, in order for the company to assure any kind of inconsistency with their product and meet their profit targets, they need to purchase wheat and other commodities at a predictable and market-friendly rate.
In order to do this, Fun Foods would enter into a derivative futures contract with farmers, who are the producers, to buy 1000 kgs of wheat at a price, say Rs 70 per kg, during an agreed-upon period of time, say one year.
The current market price of wheat, that is the spot price, is Rs. 69 per kg. If the price of wheat, for whatever reason, goes above or below Rs. 70, the farmer is liable to still sell his crop at the price of Rs. 70, hence the Company, that is, Fun Foods, fixed their price for the commodity, maintaining the bottom line for the company, while the farmer is simultaneously assured of a fair value for his crop, ahead of time, even before his crop has been harvested, knowing his fixed profitability. This, done on the exchange with a standardised contract, in terms of maturity and lot size, is an example of hedging with a futures contract.
So, derivative instruments like futures are basically risk-shifting instruments. One can minimize the loss arising from adverse price movements of the underlying asset, and this process is known as hedging.
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