Question

For each of the following scenarios, describe a hedging strategy using future contracts. In your answers, you need to specify what type of futures to be used and whether to buy or sell. (a) A corn farmer fears that this year's harvest will be at record high levels across the country. (2 marks) (b) Telstra will pay for its order of iPhones to Apple Inc. in three months in U.S. dollars. (2 marks) (c) A gas-powered electricity generator is concerned about rising cost, (2 marks) (d) A stock mutual fund invests in large blue-chip stocks and is concerned about a possible decline in the stock market after the federal election. (2 marks)

Answer 1

(a) The underlying asset in this case is the corn and since the farmer is long on the underlying asset (possesses the underlying asset or has bought it), any price drop will harm the farmer's interest. If harvests are record high, then corn prices will fall owing to excessive supply. Therefore, the farmer faces a prospect of price drop and should go short (Sell) corn futures to adequately hedge his/her position. Any loss in the spot market (corn market) will be compensated by an almost equal gain the futures market (corn futures market), thereby hedging the farmer's position appropriately.

(b) Telstra imports iPhones from the US and therefore generates a payable (expense) in US dollars. This implies that Telstra is short (does not possess) on the underlying asset (US dollar) and needs to buy the same to repay its import liabilities. Any rise in the underlying asset's price (US Dollar) will harm Telstra's interest. Hence, in order to hedge against such a price rise Telstra will buy US dollar future. These US dollar futures will fix the price at which Telstra will purchase US dollar when the iPhone payments become due.

(c) The power generator needs to pay for resources (material, labour, etc) incurred during the course of its regular business. If the prices of those resources increase the power generator faces a loss. If the resources are considered as an underlying asset then a hedging strategy against such a possible rise in prices would involve purchasing futures on those resources such that the prices of those resources are fixed. A fixed resource price is a hedge against rising costs and beneficial to the power generator.

(d) The mutual fund invests in blue-chip stocks which implies that it is long (possesses or has bought) on the underlying asset. Any fall in the stock market implies a drop in price of the underlying asset, thereby harming the mutual fund. In order to hedge against a fall in asset price, one needs to go short (sell) stock futures. A short position in stock futures compensates for any drop in prices of the actual asset, thereby acting as a perfect hedge.