Who is Hedgers ?
A trader or commodity producer who trade to protect against price fluctuation in the commodities or financial instruments. They applied different pricing strategies on the same underlying assets to minimise the risk into the portfolio.
What is Hedging ?
Hedging is a risk management strategy employed to offset losses in investment by taking an opposite position in a related asset. These strategies typically involve in derivatives such as options and futures contract. As an investment, it protects an individual’s finances from being exposed to a risky situation that may lead to loss of value. However, hedging doesn’t necessarily mean that the investments won’t lose value at all. Rather, in the event that happens, the losses will be mitigated by gains in another investment.
Types of Hedging
- A long hedge is one where a long position is taken on a futures contract. It is typically appropriate for a hedger to use when an asset is expected to be bought in the future. Alternatively, it can be used by a speculator who anticipates that the price of a contract will increase.
- A short hedge is one where a short position is taken on a futures contract. It is typically appropriate for a hedger to use when an asset is expected to be sold in the future. Alternatively, it can be used by a speculator who anticipates that the price of a contract will decrease.
Example
Imagine you have bought 250 shares of Infosys at Rs.2,284/- per share. This works out to an investment of Rs.571,000/-. Clearly you are ’Long’ on Infosys in the spot market. After you initiated this position, you realize the quarterly results are expected soon. You are worried Infosys may announce a not so favorable set of numbers, as a result of which the stock price may decline considerably. To avoid making a loss in the spot market you decide to hedge the position.
In order to hedge the position in spot, we simply have to enter a counter position in the futures market. Since the position in the spot is ’long’, we have to ’short’ in the futures market.
Here are the short futures trade details —
Short Futures = Rs. 2285/-
Lot size = 250
Contract Value = Rs.571,250/-
Now on one hand you are long on Infosys (in spot market) and on the other hand we are short on Infosys (in futures price), although at different prices. However the variation in price is not of concern as directionally we are ’neutral’. You will shortly understand what this means.
Arbitrary Price LongSpot P&L Short FuturesP&L Net P&L
2200 2200 - 2284 = -84 2285 - 2200 = -85 -84 + 85 = +1
2290 2290 – 2284 = +6 2285 – 2290 = -5 +6 – 5 = +1
2500 2500 – 2284 = +216 2285 – 2500 = -215 +216 – 215 = +1
The point to note here is — irrespective of where the price is headed (whether it increases or decreases) the position will neither make money nor lose money. It is as if the overall position is frozen. In fact the position becomes indifferent to the market, which is why we say when a position is hedged it stays ’neutral’ to the overall market condition.
Steps for hedge the portfolio
- Find out the Portfolio Beta
- Calculate the hedge value = the product of the Portfolio Beta and the total portfolio investment
- Calculate the number of lots required = Hedge Value / Contract Value
Who is Arbitrageurs ?
An arbitrageur is an individual who earns profits by taking advantage of inefficiencies in financial markets. Arbitrage opportunities arise when an asset is priced differently between multiple markets at the same time. Such price differences are inefficiencies resulting from deficiencies in the marketplace.
This is a deal that produces risk free profits by exploiting a mispricing in the market. A simple arbitrage occurs when a trader purchases an asset cheaply in one location/ exchange and simultaneously arranges to sell it at another location/ exchange at a higher price. Such opportunities are unlikely to persist for very long, since arbitrageurs would rush in to buy the asset in the cheap location and simultaneously sell at the expensive location, thus reducing the pricing gap.
An arbitrageur uses trading strategies designed to profit from small differences in the price of equivalent assets. The assets can be stocks, bonds, currencies, commodities, or any other financial instruments that can be bought and sold. Deficiencies in financial markets, such as delays in updating stock prices, can result in prime opportunities for an arbitrageur.
To conduct arbitrage, an investor purchases stocks on one exchange while simultaneously selling the same stock on another exchange. If the transaction happens simultaneously, there is no chance that the stock price will change during the transaction. By selling the same stock at a higher price, the arbitrageur can earn a risk-free profit equal to the difference between the mispriced assets.
What is Arbitraging ?
Arbitrage is a type of trade in which a security, currency, or commodity is nearly simultaneously bought and sold, in different market. The purpose of arbitrage is to take advantage of the difference in prices available for the same financial instrument being offered on different exchanges. Arbitrage is not only legal in the United States, but it also considered useful to market as it helps to promote market efficiency and also provides liquidity for trading.
The two possible scenarios for a market resulting into arbitrage opportunities have been named as Contango markets and Normal Backward markets. They are explained as follows:
Case 1: Contango market
If the spot futures price (FO) is greater than the theoretical futures price (S0ert) as suggested by the parity equation, in this scenario the trader can BUY STOCK and SELL FUTURES (Assuming the trader operates in India and also assuming that the arbitrageur already possesses the futures)
Case 2: Normal Backward market
If the spot futures price (FO) is less than the theoretical futures price (S0ert) as suggested by the parity equation then the trader can SELL STOCK and BUY FUTURES (Assuming the trader operates in India and also assuming that the arbitrageur already possesses the stock).
Arbitraging Strategies in the Derivatives Market
Strategy 1
Strategy 2
Disclaimer
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