Learn hedging with futures

The core idea: If you own an asset and fear it will fall, you sell futures on that asset. When the asset falls, your physical holding loses value BUT your futures position gains (because you sold high and can buy back low). The gains and losses offset, stabilizing your total wealth.

What Is Hedging?

Key principle: Negative correlation. Your hedge moves opposite to your main position. When one loses, the other gains.

Why Futures Are Perfect for Hedging

1. Leverage & Capital Efficiency: You don't pay full price upfront (only margin ~10-20%), so you can hedge large positions without tying up all your cash.

2. Standardization & Liquidity: Futures contracts are standardized (fixed size, expiry, terms) and traded on exchanges, so you can enter/exit easily without negotiating custom terms.

3. Mark-to-Market: Daily settlement means gains/losses are realized incrementally, not all at once at expiry. This matches the daily volatility of your underlying asset.

The Mechanics: How Hedging Works

Scenario 1: You Own Stock, Fear a Fall (Long Hedge)

Your position: You hold 1,000 shares of Reliance at ₹2,500/share (total ₹25,00,000).

Your fear: Market crash in 2 months. Reliance might fall to ₹2,200.

Hedge action: Sell 1 Reliance futures contract (lot size 1,000 shares) at ₹2,500.

Derivation of Hedge Outcome:

Let:

• $S_0$ = spot price today = ₹2,500
• $S_T$ = spot price at expiry
• $F_0$ = futures price today = ₹2,500
• $N$ = number of shares = 1,000

Without hedge: $\text{Wealth at } T = N \cdot S_T$

With hedge: Your physical stock is worth $N \cdot S_T$. Your futures P&L is: $\text{Futures P\&L} = N \cdot (F_0 - S_T)$ (You sold at $F_0$, market settled at $S_T$. If $S_T < F_0$, you profit.)

Total wealth: $\text{Total} = N \cdot S_T + N(F_0 - S_T) = N \cdot F_0$

The spot price $S_T$ cancels out. Your wealth is locked at $N \cdot F_0 = 1000 \times 2500 = ₹25,00,000$, regardless of where the market goes.

Scenario 2: You Will Buy Stock Later, Fear a Rise (Short Hedge)

Your position: You're a fund manager. You have ₹18,00,000 cash, will invest in Nifty stocks in 3 months (after client approval). Current Nifty = 18,000.

Your fear: Market rallies to 19,000 before you invest. You'll buy at higher prices, getting fewer shares.

Hedge action: Buy Nifty futures at 18,000. With Nifty lot size = 50 units, contract value = $50 \times 18{,}000 = ₹9{,}00{,}000$. To hedge ₹18,00,000 exposure, buy 2 lots ($2 \times ₹9{,}00{,}000 = ₹18{,}00{,}000$).

Derivation:

Let $S_0 = 18{,}000$, $S_T$ = Nifty at purchase time.

Without hedge: You buy shares at $S_T$. If $S_T = 19{,}000$, you pay more.

With hedge:

• Futures P&L: $N \cdot (S_T - F_0)$ (you bought at $F_0$, market settled at $S_T$)
• You invest at spot $S_T$, but futures gave you a gain of $N(S_T - F_0)$

Net cost: $\text{Effective cost} = N \cdot S_T - N(S_T - F_0) = N \cdot F_0$

Again, locked in at the futures price.

Hedge Ratio: How Much to Hedge?

For a perfect hedge, $h = 1$ (hedge dollar-for-dollar).

But: In practice, futures and spot don't always move1:1. We refine with beta:

$h^* = \beta \cdot \frac{V_{\text{spot}}}{V_{\text{futures}}}$

where $\beta$ = sensitivity of your asset to the futures contract.

Example: You own ₹1,00,00,000 of HDFC Bank stock. Nifty futures lot = ₹9,00,000. HDFC's beta to Nifty = 1.2.

$h^* = 1.2 \cdot \frac{1{,}00{,}00{,}000}{9{,}00{,}000} \approx 13.33 \text{ lots}$

Sell 13 Nifty futures to hedge. (Why 13, not 11? Because HDFC moves 20% more than Nifty, so you need more futures to offset.)

Worked Example: Farmer Hedging Wheat

Setup: It's April. You're a farmer, expecting10,000 kg of wheat harvest in October. Current spot = ₹25/kg. You fear prices will drop to ₹20/kg by harvest (due to good monsoon everywhere).

Step 1 – Identify exposure: You will sell wheat in October. You're exposed to price falling.

Step 2 – Hedge action: Sell wheat futures for October delivery at ₹25/kg. (Assume 1 contract = 10,000 kg.)

Why this step? You lock in a selling price of ₹25 today. Even if spot crashes, futures P&L compensates.

Step 3 – At harvest (October):

Spot drops to ₹20/kg (your fear came true).

• Physical sale: Sell 10,000 kg at ₹20 = ₹2,00,000.
• Futures P&L: You sold at ₹25, market settled at ₹20. Gain = $10{,}000 \times (25 - 20) = ₹50,000$.

Total revenue: ₹2,00,000 + ₹50,000 = ₹2,50,000 = 10,000 × ₹25.

You achieved your target price!

Alternative scenario: Spot rises to ₹30/kg.

• Physical sale: 10,000 kg × ₹30 = ₹3,00,000.
• Futures P&L: Loss = $10{,}000 \times (25 - 30) = -₹50,000$.

Total: ₹3,00,000 − ₹50,000 = ₹2,50,000. Still locked at ₹25.

Why this works? Futures and spot converge at expiry. Your combined position eliminates price risk.

Basis Risk: When Hedges Aren't Perfect

At expiry, basis = 0 (convergence). But during the hedge, if your asset and the futures contract don't track perfectly, you face basis risk.

Example: You own Tata Steel shares, hedge with Nifty futures. Tata Steel might underperform Nifty due to company-specific news. Your hedge won't fully offset losses.

Why basis risk happens:

1. Asset mismatch: Hedging HDFC with Nifty (not HDFC-specific futures).
2. Time mismatch: Hedging for 4 months, but only 3-month futures available—you roll over, and prices may have changed.
3. Quality/location differences: Hedging Mumbai wheat with Punjab-delivery futures.

Wrong idea feels right because: The textbook formula shows perfect cancellation.

Why it's wrong: That assumes:

• Futures perfectly correlate with your asset ($\beta = 1$, zero basis risk).
• No transaction costs.
• You hold until expiry (no early exit).

Reality: Basis fluctuates. If basis widens against you, the hedge underperforms.

Fix: Use cross-hedge ratio with beta. Monitor basis. Accept that hedging reduces risk, not eliminates.

Cost of Hedging

Hedging isn't free:

1. Opportunity cost: If prices move favorably, your hedge locks in the old price—you miss out on upside.

2. Transaction costs: Brokerage, exchange fees, ST.

3. Margin requirements: You must keep margin deposited as collateral. This ties up capital, and the margin itself typically does not earn interest (any interest depends on broker policy, not a general feature of futures markets).

The trade-off: Certainty vs. Upside. Hedgers choose stability over speculation.

Strategic Hedge Types

• Full hedge ($h = 1$): Lock in price completely. Best when you must meet a fixed budget/revenue target (e.g., airline fuel costs, exporter with dollar receivables).

• Partial hedge ($h < 1$): Hedge only 50-70% of exposure. Retain some upside if prices move favorably. Used by firms with flexible needs or when basis risk is high.

Dynamic hedging: Adjust hedge ratio over time asset value or volatility changes.

Flashcards

#flashcards/stock-market

What is the primary goal of hedging with futures? :: To reduce or eliminate price risk of an existing position, NOT to make profit. You lock in a price to stabilize wealth.

Connections

• 5.1.01-Introduction-to-Futures: Hedging is a primary use-case for futures (vs. speculation).
• 5.1.05-Basis-and-Convergence: Basis dynamics determine hedge effectiveness.
• 5.1.09-Speculation-with-Futures: Opposite mindset—speculators seek profit, hedgers seek safety.
• 4.2.06-Portfolio-Beta: Beta is used to calculate optimal hedge ratio when cross-hedging.
• 6.1.04-Options-for-Hedging: Options provide asymetric hedging (downside protection, retain upside) but cost a premium.

Imagine you have 100 marbles that you'll sell next month. Right now, kids pay₹10 per marble, so you expect₹1,000. But you're worried—what if a new toy comes out and nobody wants marbles? Price might drop to ₹5.

Hedging is like this: Today, you make a deal with your friend. "I promise to sell you 100 marbles next month for ₹10 each, no matter what happens." Your friend agrees (he thinks marbles might become more popular).

Next month, if marbles are only ₹5 in the market, you sell to the market for ₹500, BUT your friend pays you an extra ₹500 because of the deal (he "bought" at ₹10 when market is₹5, so you gain ₹500 from him). Total: ₹1,000. Safe!

If marbles become ₹15, you sell for ₹1,500 in the market, but youowe your friend ₹500 (because he locked in ₹10, you're obligated to compensate him the difference). Total: ₹1,000still.

You gave up the chance to make extra money, but you also protected yourself from losing money. That's hedging—trade excitement for safety.

• Stabilize wealth (goal is safety)
• Hedge ratio = match exposure
• Inverse position (own stock → sell futures)
• Expiry convergence (basis → 0)
• Lock in price (certainty over profit)
• Daily mark-to-market (gradual settlement)

Summary

Hedging with futures transforms uncertain price risk into known outcomes. By taking an opposite position in futures to your physical exposure, you create a zero-sum game: losses in one are offset by gains in the other. The math is elegant—total wealth locks at the initial futures price—but real-world basis risk, transaction costs, and the sacrifice of upside make hedging a strategic choice, not a free lunch. Use full hedges when you must meet fixed targets; use partial or dynamic hedges when flexibility matters. Hedging is financial insurance: you pay (in opportunity cost) for peace of mind.

Concept Map

Hinglish (regional understanding)