Hedging with Futures

Hedging with futures contracts is conceptually identical to hedging with forward contracts, and the payoff profile on a futures contract is drawn just like the profile for a forward contract. The only difference in hedging with futures is that the firm will have to maintain an account with a broker so that gains and losses can be credited or debited each day as a part of the marking-to-market process.

Even though there is a large variety of futures contracts, it is unlikely that a particular firm will be able to find the precise hedging instrument it needs. For example, we might produce a particular grade or variety of oil, and find that no contract exists for exactly that grade. However, all oil prices tend to move together, so we could hedge our output using futures contracts on other grades of oil. Using a contract on a related, but not identical, asset as a means of hedging is called cross-hedging.

When a firm does cross-hedge, it does not actually want to buy or sell the underlying asset. This presents no problem because the firm can reverse its futures position at some

Surf over to these home pages at www.cbot.com, www.cme.com, and www.liffe.com. All of these web sites provide a great deal of information about the services and financial products found on the respective exchanges.

To get some real-world experience at very low cost, visit the fascinating futures exchange at the University of Iowa: www.biz.uiowa.edu/iem..

cross-hedging

Hedging an asset with contracts written on a closely related, but not identical, asset.

Ross et al.: Fundamentals I VIII. Topics in Corporate I 23. Risk Management: An I I © The McGraw-Hill of Corporate Finance, Sixth Finance Introduction to Financial Companies, 2002

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