Long hedge is the transaction when we hedge our position in cash market by going long in futures market.
For example, we expect to receive some funds in future and want to invest the same amount in the securities market.
We have not yet decided the specific company/companies, where investment is to be made.
We expect the market to go up in near future and bear a risk of acquiring the securities at a higher price.
We can hedge by going long index futures today.
On receipt of money, we may invest in the cash market and simultaneously unwind corresponding index futures positions.
Any loss due to acquisition of securities at higher price, resulting from the upward movement in the market over intermediate period, would be partially or fully compensated by the profit made on our position in index futures.
Short Hedge
Short Hedge is a transaction when the hedge is accomplished by going short in futures market.
For instance, assume, we have a portfolio and want to liquidate in near future but we expect the prices to go down in near future.
This may go against our plan and may result in reduction in the portfolio value.
To protect our portfolio’s value, today, we can short index futures of equivalent amount.
The amount of loss made in cash market will be partly or fully compensated by the profits on our futures positions.
Cross Hedge
When futures contract on an asset is not available, market participants look forward to an asset that is closely associated with their underlying and trades in the futures market of that closely associated asset, for hedging purpose. They may trade in futures in this asset to protect the value of their asset in cash market. This is called cross hedge.
If futures contracts on jet fuel are not available in the international markets then hedgers may use contracts available on other energy products like crude oil, heating oil or gasoline due to their close association with jet fuel for hedging purpose. This is an example of cross hedge.
Hedge contract month
Hedge contract month is the maturity month of the contract through which we hedge our position.
For instance, if we use August 2018 contract to hedge our portfolio’s market risk, our hedge contract month would be August 2018 contract.
Similarly, if we hedge say risk on crude oil price with the help of March 2019, hedge contract month would be March 2019.
Speculation /Trading in Futures
Traders are risk takers in the derivatives market. And they take positions in the futures market without having position in the underlying cash market.
These positions are based upon their expectations on price movement of underlying asset.
Traders either take naked positions or spread positions.
A trader takes a naked long position when he expects the market to go up. Money comes by reversing the position at higher price later. Similarly, he takes a short position when he expects the market to go down to book profit by reversing his position at lower price in the future.
Arbitrage opportunities in futures market
Arbitrage is simultaneous purchase and sale of an asset or replicating asset in the market in an attempt to profit from discrepancies in their prices. Arbitrage involves activity on one or several instruments/assets in one or different markets, simultaneously.
Arbitrage in the futures market can typically be of three types:
Cash and carry arbitrage: Cash and carry arbitrage refers to a long position in the cash or underlying market and a short position in futures market.
Reverse cash and carry arbitrage: Reverse cash and carry arbitrage refers to long position in futures market and short position in the underlying or cash market.
Inter‐Exchange arbitrage: This arbitrage entails two positions on the same contract in two different markets/ exchanges.
Cash and Carry Arbitrage
The following data is available on stock A as on March 1, 2018.
Cash market price Rs. 1500 June Futures Rs. 1520.
Contract multiplier for stock 100 shares.
Assume an implied cost of carry of 9% per annum i.e. 0.75% per month.
Theoretically/ fair price of June futures is 1504.69 (= 1500* e0.0075*5/12)
To take advantage of the mispricing, an arbitrageur may buy 100 shares of stock A and sell 1 futures contract on that at given prices.
This would result in the arbitrage profit of Rs. 1531 (= 100 X 15.31), which is the difference between actual and fair prices for 100 shares.
Case I: Stock rises to Rs. 1550 on expiry day – Profit on underlying = (1550 -1500) x 100 = Rs. 5000 – Loss on futures = (1550 ‐ 1520) x 100 = Rs. 3000 – Gain on Arbitrage = Rs. 2,000 – Cost of Arbitrage in terms of financing (Rs. 4.69 for 100 shares) = Rs. 469 – Net gain out of arbitrage = (2000 – 469)= Rs 1531
Case II: Stock falls to Rs.1480 on expiry day – Loss on underlying = (1500‐ 1480) x 100 = Rs. 2000 – Profit on futures = (1520‐1480) x 100 = Rs. 4000 – Gain on Arbitrage = Rs. 2000 – Cost of Arbitrage in terms of financing (Rs. 4.69 for 100 shares) = Rs. 469 – Net gain out of arbitrage = (2000 – 469) = Rs. 1531
Reverse cash and Carry Arbitrage
The reverse cash and carry arbitrage is done when the futures are trading at a discount to the cash market price.
Let us look at the following data on stock A as on March 1, 2018. Cash marketprice Rs. 100 March futures price Rs. 90
The prices trading in the market reflect a negative cost of carry, which offers an opportunity to the traders to execute reverse cash and carry arbitrage as cost of carry is expected to reverse to positive at some point in time during contract’s life.
Assuming the contract multiplier for futures contract on stock A is 200 shares.
To execute the reverse cost and carry, arbitrager would buy one March future sat Rs 90 and sell 200 shares of stock A at Rs 100 in cash market.
This would result in the arbitrage profit of Rs 2000 (200 X Rs 10).
Case I: Stock rises to Rs. 110 on expiry day – Loss on underlying = (110 ‐ 100) x 200 = Rs. 2000 – Profit on futures = (110 ‐ 90) x 200 = Rs. 4000 – Net gain out of arbitrage = Rs. 2000
Case II: Stock falls to Rs. 85 on expiry day – Profit on underlying = (100 ‐ 85) x 200 = Rs. 3000 – Loss on futures = (90 ‐ 85) x 200 = Rs. 1000 – Net gain out of arbitrage = Rs. 2000
Inter‐market arbitrage
This arbitrage opportunity arises because of some price differences existing in same underlying at two different exchanges.
If August futures on stock Z are trading at Rs. 101 at NSE and Rs. 100at BSE, the trader can buy a contract at BSE and sell at NSE.
The positions could be reversed over a period of time when difference between futures prices squeeze. This would be profitable to an arbitrageur.
It is important to note that the cost of transaction and other incidental costs involved in the deal must be analyzed properly by the arbitragers before entering into the transaction.
