Futures and Options – The basics.

Futures: Hedging & it’s importance

HEDGING.

Imagine this situation- you just bought a fundamentally good stock at a bargain. You know that you’ve done your home work and have bought the share at the right price and time. But still, in a surprise move, the market may think other wise and would send the stock price crashing. You may not even understand why the stock price tumbled. Such pitfalls are common in stock markets.What a weird place to be. isn’t it?

Now, is there a way to protect your money in such cases?

Yes ! There are many methods. One such method is to use futures to hedge your position. Before we explain that, let’s understand the meaning of hedging. Hedging is any act that trys to protect an investment from price risk to the maximum extend possible.So, it’s just like insurance. We insure our life - against death , against serious health problems, don’t we? But, we don’t take insurance for cold & cough. Similarly, hedging is not a strategy to employ for small investors because of the cost and effort involved. Hedging is effective when your investment involves a substantial amount.

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Futures: Risk levels of participants.

Future contracts, as we have already seen, are instruments used for ‘transferring risk’. In other words, future contracts are basically used for Financial risk management.

That brings us to one basic question. When and for whom is risk management necessary? Risk management is necessary only for those who have a risky asset position. I.e., when you have assets (shares / gold / currency / commodity etc) which fluctuates heavily in value. The uncertainty of price movements that surrounds such investments necessitates the use of derivatives. Many examples were discussed in our early posts on how derivatives help investors in reducing the risk they face.

The point i would like to bring here is that you should be very clear about why you are using derivatives.

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Futures: Arbitrage & its meaning.

ARBITRAGE

Buying in one market (say, spot market) and simultaneously selling in another market (say, futures market) to make risk free profits when there is substantial mismatch between two prices is called arbitrage. Arbitrage is described as risk free because participants are not speculating on market movements. Instead, they bet on the mis-pricing of a share/asset that has happened between to related markets.

In short, when you earn by selling and buying same security at different rates in different markets, it is called Arbitrage. It is a highly technical field. Market’s mis-pricing is taken advantage by traders to make risk free gains.

Mispricing? How?

The futures price has a definite relationship with the spot price. In normal market conditions, futures price would be greater than the spot price because of the effect of cost of carry and it moves in tandem with the price of the underlying asset. So, broadly we can say that if the spot price of the share moves up by Rs 5, the futures position would also have made a profit of Rs 5.  The correlation is not very accurate but, almost so.

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Futures: Compounding and discounting techniques.

We discussed continuous compounding in the last post. Derivatives pricing are done using this method of compounding. The justification is that returns on assets like shares change continuously-on a minute by minute basis. However, in real life, since interest rates are expressed as an annual percentage, conversion to continuous rate is necessary to make accurate calculations.

We also saw in the last article that interest rates and dividends are the two factors that determine the theoretical pricing of futures. The correctness of calculations therefore depends on how accurately you’ve assumed these two figures.

HOW TO FACTOR IN EXPECTED DIVIDENDS

In the case of dividends, you can only make a best guess by studying the past dividend history and the present financial strength of the company. That’s where it ends. Dividends have to be discounted at appropriate rate to find the present value. The technique used for this is continuous discounting – the reverse process of continuous compounding.

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