Long and short of futures and forward contracts

Dec 14 2012, 09:38 IST
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SummaryWhile the future fascinates some of us, for others, it is a source of fear. Financial agents can be sub-divided into two categories.

market and have to face a situation where the spot price increases. If so, he will have to face the spectre of a substantial loss. Quite obviously, both parties cannot read the market movement correctly. Thus, either the long or the short is condemned to accept a loss in the case of speculation using futures and forward contracts.

Such contracts may be used as risk mitigation tools as well. The long may be a party who has a short spot position in the underlying asset, that is, he is under a prior obligation to acquire the underlying asset at a future date. His worry would obviously be that the spot price of the asset will increase and he can lock in a purchase price by going long in a forward or a futures contract.

On the other hand, the short may take the derivatives position because he has a prior long position in the underlying asset. That is, he owns the asset and is concerned about a perceived price decline. Such a party can lock in a sale price by going short in such contracts. By the time contract expiration approaches, the price of the underlying asset would have either increased or decreased. If it were to have increased, the party that has gone long would be perceived as wise and sound.

On the contrary, if the underlying asset were to have declined in value, the party with a short futures position would have credit bestowed on him for his ability to read the market accurately. In practice, only one of them will be right ex-post and, thus, while one will be complimented for his foresight, the other will be castigated for his foolishness. Such criticism is, however, unfair. For, hedgers use such contracts to mitigate their exposure to price uncertainty and not because they are convinced at the outset that their view on the market will be vindicated subsequently.

Hindsight, as someone said, is a perfect science. Hedgers are not prescient and, hence, there is every possibility that in their quest to mitigate risk, they end up looking foolish to the uninitiated. To hedge or not to hedge is a classic dilemma that is faced by a treasurer or a CFO. The hard part is convincing the CEO that the outcome with hedging will not always be better than the outcome without hedging. In other words, we hedge because we

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