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Short Hedge &Long Hedge

Thread starter #1
Hi
i am little confused with short&long hedge difference.
In the notes, it says short hedge is agreement to sell in the future.
In later notes, it says key difference is whether future price is determined.

What's the connection between these two statements?

e.g. for the coffee bean farmer want to sell coffee bean in the future.
If the farmer promise to sell coffee bean at $3/pound, is long hedge is appropriate treatment?
If the farmer promise to sell coffee bean at future price, is short hedge is appropriate treatment?

Thank you for answering my question
 

Nicole Seaman

Chief Admin Officer
Staff member
Subscriber
#2
Hi
i am little confused with short&long hedge difference.
In the notes, it says short hedge is agreement to sell in the future.
In later notes, it says key difference is whether future price is determined.

What's the connection between these two statements?

e.g. for the coffee bean farmer want to sell coffee bean in the future.
If the farmer promise to sell coffee bean at $3/pound, is long hedge is appropriate treatment?
If the farmer promise to sell coffee bean at future price, is short hedge is appropriate treatment?

Thank you for answering my question
Hello @queliujin

I just wanted to make sure that you are aware of our search function in the forum. There is a great deal of discussion on short and long hedges in the forum. If you click on the search button here: https://www.bionicturtle.com/forum/search/?type=post and search for long hedge or short hedge, there will be many threads that come up that should help to answer your question. This is helpful because many times you will find the answer to your question without having to wait for someone to answer you.

Nicole
 

David Harper CFA FRM

David Harper CFA FRM
Staff member
Subscriber
#3
Hi @queliujin As Nicole mentions, there are actually already several discussions in the forum about this; e.g.,
I realize it may be confusing so I will briefly summarize:
  • A "long" ("short") hedge simply refers to whether the hedge instrument is a long (short) position. If you hedge with a long (short) futures contract, you've performed a long (short) hedge. So, IMO, its best to identify the hedge (if desired), then see if it should be called a long or short hedge. And it's only a hedge if there is an underlying exposure; so, a hedge is a 2nd position in addition to the underlying exposure
  • In your second case, which is the more natural perhaps ("If the farmer promise to sell coffee bean at future [then-prevailing] price"), the farmer plans to sell in the future but does not know the price will be, so the farmer's risk (exposure) is that the price will go down. She hedges such a downside scenario (selling a future too-low price) with a short futures contract b/c such a contract profits if the spot price goes down. Together (the loss on future spot price drop + gain on short futures contract) will effectively lock-in her sale proceeds (but also they will offset if the spot price goes up, because the underlying gain will be offset by a loss on the futures contract)
  • In your first case, the farmer effectively has a short forward contract as the underlying position: a commitment to sell at $3.00 per in the future (this is analogous to the Metallgesellschaft case: their underlying was long-term short forward oil contracts). The farmer does not necessarily need to hedge here. But if the farmer hedges, what is the risk? The risk in this case is an increase in the spot price and a higher future spot price! How so? Well, either way you look at it: a higher spot price is the opportunity cost of the sale (if the future spot price ends up being $5.00, the farmer misses out on $2.00). Or, more akin to MG case, we assume the farmer's cost is correlated with the spot price, maybe the commodity needs to be purchased before it's re-sold; in this alternate view, a higher future spot price could make the $3.00 commitment actually unprofitable. Either way, spot price increase is the risk because the underlying exposure is effectively a short forward. If she hedges, therefore, the hedge is a long futures contract (just as MG hedged the underlying long-term short forwards with short-term long futures contracts). I hope that clarifies!
 
#4
Hi David,

Thank you so much for your response above. I understood everything you said about the above which is why I would like to ask why is a short hedge wanting basis risk to increase?? If I am short a bond futures contract I would want the spot price to come crashing down so that I make money in my futures. Why would I want spot to go up? The price that a short bond futures receives is the futures price * some conversion factor nto spot. This feels very counterintuitive and weird and I don't get this one bit. I will explore the other responses on this topic and let me see where I get.
 
#5
Hi David,

I read through some other forums and I kind of understand this concept now. Basically that I am shorting futures to hedge against spot asset price declines. But really if I want the overall payoff in my strategy to be positive I would ideally like my spot price to go up thereby my long asset goes up but also in my futures I want the futures price/delivery price that I committed myself to receive from my short futures position at time t=1 to be higher than the futures price at time t=2. i.e. we want the futures series to be in backwardation.

what I don't understand though is why am I even looking at 2 futures contracts to analyze the payoff in my whole strategy. why would the 2nd futures be something I would even consider. lets say I am looking at a bond futures contract and these contracts are all 3 months apart from each other with delivery dates in march/june/September/December. when I am hedging for a September delivery obviously I am only going to buy a September futures contract b/c thats the only date I can deliver- i.e. it matches up with the terms of my bond. why does the price of a December contract even matter to me when I would never get into that contract even if I could make a profit out of it? Does my question make sense?

Also to then follow up on this - if my spot goes up wouldn't I lose in my short hedge in the first place? Why doesn't that get considered in the equation when calculating payoff of this whole long asset - short futures strategy?
 

David Harper CFA FRM

David Harper CFA FRM
Staff member
Subscriber
#6
Is this @ankit4685 but under a new account? asked because it almost seems like a continuation of today's earlier https://www.bionicturtle.com/forum/...-short-hedges-hull-chapter-3.10547/post-76407

Classic situation is commodity producer (e.g., corn farmer) who plans to sell in future and so utilizes a short futures contract (aka, short hedge). Symbolically, they are long the spot and short the futures, +S - F, such that they gain by an (unexpected, is a key adjective but set it aside) gains in the spot and losses in the future: Basis = S(0) - F, and they are (+S - F) so that they profit with increases in the basis. Per Hull (relevant emphasis mine):
"Note that basis changes can lead to an improvement or a worsening of a hedger’s position. Consider a company that uses a short hedge because it plans to sell the underlying asset. If the basis strengthens (i.e., increases) unexpectedly, the company’s position improves because it will get a higher price for the asset after futures gains or losses are considered; if the basis weakens (i.e., decreases) unexpectedly, the company’s position worsens. For a company using a long hedge because it plans to buy the asset, the reverse holds. If the basis strengthens unexpectedly, the company’s position worsens because it will pay a higher price for the asset after futures gains or losses are considered; if the basis weakens unexpectedly, the company’s position improves." -- Hull, John C.. Options, Futures, and Other Derivatives (Page 56). Pearson Education. Kindle Edition.
Re: "what I don't understand though is why am I even looking at 2 futures contracts to analyze the payoff in my whole strategy," and the rest, I don't exactly follow (but it's Sunday and I'm doing other work, I'm only attempting an answer in case you are a paid member, but I'm confused by your second post!). When referring to hedges, our basic perspective concerns two positions:
  1. The price risk of the underlying exposure. For example, producer plans to sell commodity in future. Or, company plans to buy commodity input in the future. Or, in the case of Metallgesellschaft the underlying exposure (price risk) was forward contracts to sell oil in the distant future at an already-fixed price; aka, long-term short forward positions.
  2. The hedging position. Basis risk only exists if there is a hedge, and a hedge is a second position. A hedge is optional, it has an expected NPV cost and doesn't always "win." ... I'm a bit lost in your compound question but maybe i'll come back later in the week ... please note the basis risk refers to an unexpected change in the mark-to-market value of the net position. A company can "stack" (and roll) its hedge (open-then-close short-term futures contracts in sequence) against a single longer-term exposure by trading short-term futures. Thanks,
 
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