InvestorQ : What are the different types of hedges that are available in the F&O market in India and how do they actually work?
Sam Eswaran made post

What are the different types of hedges that are available in the F&O market in India and how do they actually work?

swati Bakhda answered.
4 years ago

Broadly, there are 3 types of hedges that you need to be familiar with.

Long hedge

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.

Further, while investing, suitable securities at reasonable prices may not be immediately available in sufficient quantity. Rushing to invest all money is likely to drive up the prices to our disadvantage. This situation can also be taken care of by using the futures. We may buy futures today; gradually invest money in the cash market and unwind corresponding futures positions.

Similarly, we can take an example from the commodity market, if there is a flour mill and it is expecting the price of wheat to go up in near future. It may buy wheat in forwards/ futures market and protect itself against the upward movement in price of wheat. This would also be an example of long hedge.

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.

Let us take an example from currency market. Assume Company C is into export and import business. Company expects some dollars to flow in after say 6 months. Director Finance of the company is expecting the depreciation in dollar vis-a-vis local currency over this period of time. To protect against this risk of adverse movement in exchange rate of currency, company C may sell dollars in forward /futures market. This selling would protect company against any fall of dollar against the local currency.

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.

For instance, 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. Indeed, in a crude sense, we may say that when we are using index futures to hedge against the market risk on a portfolio, we are essentially establishing a cross hedge because we are not using the exact underlying to hedge the risk against.