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Questions about hedge

Thread starter #1
Hi friends,

I'm confused with the concept of hedging. Suppose I own a stock portfolio that I want to hedge, why short futures or forward? Short futures is a contract that I will sell in the future, unlike a producer will sell something in the future, I don't need to sell the stock, don't quite understand.

Another question is when an oil producer for example, promises customer to sell oil at a certain price in the future, to hedge it needs to enter into a long position, but for long positon, it is obligated to buy oil in the future however it's a oil producer that produces its own oil! What about the oil purchased from the long position? don't quite understand also.

Your help will be greatly appreciated!
 

Nicole Seaman

Chief Admin Officer
Staff member
Subscriber
#2
Hi friends,

I'm confused with the concept of hedging. Suppose I own a stock portfolio that I want to hedge, why short futures or forward? Short futures is a contract that I will sell in the future, unlike a producer will sell something in the future, I don't need to sell the stock, don't quite understand.

Another question is when an oil producer for example, promises customer to sell oil at a certain price in the future, to hedge it needs to enter into a long position, but for long positon, it is obligated to buy oil in the future however it's a oil producer that produces its own oil! What about the oil purchased from the long position? don't quite understand also.

Your help will be greatly appreciated!
Hello @Passer-by

There is a great deal of discussion in the forum regarding hedging already. I'm sure you will find the answers that you are looking for by using the search function in the forum. If you are referring to specific practice questions, you should find that copying the first sentence of the actual question into the search box will bring you to a thread where these concepts have been discussed. With the forum becoming extremely busy just before the exam, we just want to make sure that everyone is utilizing the search function fully before asking a question. You may find that you don't have to wait for an answer, which also saves you time :)

Thank you,

Nicole
 

David Harper CFA FRM

David Harper CFA FRM
Staff member
Subscriber
#3
Thank you @Nicole Seaman It's amazing how this seeming simple issue of "is the hedge long or short" is actually more difficult and nuanced on inspection. It's not as trivial as it seems, in part I think, because you can approach the definition of the underlying exposure in slightly different ways. Once you define what risk (exposure) is being hedged, then I think it's easy. Below is from a recent thread where I attempted a summary ("https://www.bionicturtle.com/forum/...-price-or-future-spot-price.13785/#post-58786) ... although I don't mean to distract from the two classic (i.e., Hull based) hedge scenario which are straightforward:
  • a producer who plans to sell the commodity in the future at the (currently unknown) future spot price needs a short hedge (i.e., short futures contract) to offset the risk of a drop in the spot price;
  • similarly, a consumer who plans to buy the commodity the future at the (currently unknown) future spot price needs a long hedge (i.e., long futures contract) to offset the risk of an increase in the spot price. This is the "fundamental dynamic" and I wouldn't worry about the other scenarios too much until you are good with this!
From linked thread:
Hi @ziminli1228 Yes, thank you, despite previous clarifications, unfortunately the text persists in containing a typo(s). I think it should be as I have copied below. To use numbers:
  1. When the producer promises to sell forward at $3.00 (which is effectively a long-term short forward contract), just as you suggest, the exposure (risk) here is the opportunity cost of a higher future spot price. For example, if the future spot price is $4.50, the producer forfeits $1.50 = $4.50 (could have received in spot market) - $3.00 (actually received). But the long hedge, which is to say the long futures position at delivery price = $3.00, earns a profit of $1.50 due to the increase so the producer's net receipt is $3.00 + $1.50. Or put another way, if the producer needs to buy in order to sell, like you say: then the producer needs to buy at 4.50 and sell at 3.00, but the $1.50 keeps the producer's net profit to zero. Whether you assume she/he needs to buy the future spot in order to sell it, or not, in either case here, the producer's underlying position (the short forward) is a "bet against" an increase in future spot price and a "bet in favor of" a future stop price decrease, which is to say "expresses a short view" by locking in the sale price. So here the exposure (risk) is to spot price increase (aka, underlying position is effectively short) and the appropriate hedge is a long position and so is a long hedge.
  2. When the producer promises to sell without a price guarantee, this is the classical situation. The producer is exposed to price decreases; i.e., the underlying position is effectively a long position. The hedge is a short futures contract and so the hedge is a short hedge.
To summarize:
  • Producer will sell in future at predetermined price ($3.00): underlying position is effectively short, such that the appropriate hedge is a long hedge
  • Producer will sell in future at prevailing price: underlying position is effectively long, such that the appropriate hedge is a short hedge.
.. I can see that an issue is the potential ambiguity of "underlying exposure" which can be read two different ways. This is why I am changing this to "underlying position is effectively ... ". Sorry for the confusion, I hope this makes sense!
 
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