What is the difference between futures and hedging?
Hedging limits losses, acting as insurance against adverse price changes. Futures contracts, agreements to buy or sell assets at a future date for a predetermined price, are often used for hedging purposes.
A future is a contract to buy or sell an underlying stock or other assets at a pre-determined price on a specific date. On the other hand, options contract gives an opportunity to the investor the right but not the obligation to buy or sell the assets at a specific price on a specific date, known as the expiry date.
Hedging is an investment technique or strategy. Derivatives are investment instruments—a type of asset class. The two are related, though, in that hedging strategies—which aim to insure against overall loss—often use certain kinds of derivatives, especially options and futures contracts.
Speculation refers to the practice of trading currencies with the primary aim of making a financial gain from anticipated price movements. Unlike hedging, which involves using strategies to protect against potential losses, speculation entails taking calculated risks to capitalize on market fluctuations.
Investing and hedging differ in their purpose, which is why they are different. Investing aims to generate a profit by buying assets that are expected to increase in value over time, whereas hedging is a risk management strategy used to protect against potential losses by taking opposite positions in related assets.
The choice between futures and options depends on your investment goals and risk tolerance – Both instruments can be used for hedging, but options offer more flexibility and limited risk. Futures and options are two fancy terms used in financial markets that are becoming quite famous in the investor community.
An option gives the buyer the right, but not the obligation, to buy (or sell) an asset at a specific price at any time during the life of the contract. A futures contract obligates the buyer to purchase a specific asset, and the seller to sell and deliver that asset, at a specific future date.
For example, if you buy homeowner's insurance, you are hedging yourself against fires, break-ins, or other unforeseen disasters. Portfolio managers, individual investors, and corporations use hedging techniques to reduce their exposure to various risks.
hedging noun [U] (AVOIDING RISK)
a way of controlling or limiting a loss or risk: This type of hedging protects the trader from getting a margin call, as the second position will gain if the first loses, and vice versa.
There are three types of hedge accounting: fair value hedges, cash flow hedges and hedges of the net investment in a foreign operation.
What is the difference between derivatives for hedging and derivatives for speculation?
Hedging is a technique which is mainly used to reduce the market risk in an existing portfolio or trading position that the trader or investor is facing. Speculation, on the other hand is done to earn profits by guessing how the market might be moving in the future.
Hedging is the balance that supports any type of investment. A common form of hedging is a derivative or a contract whose value is measured by an underlying asset. Say, for instance, an investor buys stocks of a company hoping that the price for such stocks will rise.
A short hedge involves selling futures contracts for wheat. When the farmer sows the fields in October, the price of wheat is $600 per bushel. The farmer calls a broker with instructions to sell wheat futures that expire in June so they coincide with the harvest.
Explain carefully the difference between hedging, speculation, and arbitrage. A trader is hedging when she has an exposure to the price of an asset and takes a position in a derivative to offset the exposure. In a speculation the trader has no exposure to offset.
The first method is by using hedging with futures. Both producers and end-users can use futures to protect themselves against adverse price movements. They offset their price risk by obtaining a futures contract on a futures exchange, hereby securing themselves of a pre-determined price for their product.
Two categories of hedging exist: “long” hedging (where a futures contract is purchased) and “short” hedging (where a futures contract is sold).
The most prevalent benefits include simple pricing, high liquidity, and risk hedging. The primary disadvantages are having no influence over future events, price swings, and the possibility of asset price declines as the expiration date approaches.
A futures contract's underlying asset could be a commodity or a financial instrument, such as a bond. Bond futures are contractual agreements where the asset to be delivered is a government or Treasury bond. Hedging is an investing strategy that attempts to protect holdings.
A futures contract only allows trading of the underlying asset on the date specified in the contract, whereas options can be exercised at any time before they expire. Both options and futures have a daily settlement, and trading options or futures require a margin account with a broker.
For example, if you buy a futures contract for 100 barrels of oil at ₹50 per barrel, you are obligated to buy the oil for ₹50 per barrel even if the market price of oil has risen to ₹60 per barrel by the expiration date. The opposite is true if you sell a futures contract.
What are the key differences between option and futures contracts explain at least 3 differences?
| Options | Futures |
|---|---|
| Options can be exercised early or lapsed without any obligation. | Futures must be fulfilled or closed before expiration. |
| Options have lower liquidity and volume than futures. | Futures have higher liquidity and volume than options. |
The primary motivation to hedge is to mitigate potential losses for an existing trade in the event that it moves in the opposite direction than what you want it to.
To calculate the Hedge Ratio, you divide the change in the value of the futures contract (Hf) by the change in the cash value of the asset that you're hedging (Hs). So, the formula is: HR = Hf / Hs. The Hedge Ratio is calculated by dividing the total value of the portfolio by the total value of the hedged positions.
Hedging is buying or selling futures contract as protection against the risk of loss due to changing prices in the cash market. If you are feeding hogs to market, you want to protect against falling prices in the cash market. If you need to buy feed grain, you want to protect against rising prices in the cash market.
If interest rates rise, futures prices will fall, so sell futures contracts now (at the relatively high price) and buy later (at the lower price). The gain on futures can be used to offset the lower interest earned.
