Your Money: Of futures market, spot prices and hedging risks

If so, the hedger can lock in the initial spot price. Sometimes a hedger may use a futures contract on a related product to hedge.

By Sunil K Parameswaran 

In asset markets, the key variable of interest is the price of the underlying asset. Thus, in stock markets, investors will be worried about changes in the price of the underlying asset. In the case of precious metals, the focus is on the changes in the price of the product. In bond markets, investors worry about changes in the yield to maturity or YTM, which determines the price of the debt security.

In futures markets, traders focus on the difference between the futures price of a product, and its spot price. This difference is termed as the ‘basis’ and is the key variable of interest in such markets. Some authors define the basis as F-S, that is, the difference between the futures price and the spot price. Others define it as S-F.

Futures and spot price
From an analytical standpoint, the choice is irrelevant. Risk in spot markets is measured by the variance of the asset price, or in the case of a model like the Capital Asset Pricing Model (CAPM), by the beta of the asset. Beta is defined as the covariance of the asset return with the return on the market portfolio, divided by the variance of the market portfolio. In futures markets, risk is measured by variance of the basis.

For a seller the effective sale price is F0 + bt, where F0 is the futures price at the outset, and bt is the basis at the time of the transaction. For a buyer the effective purchase price is F0+bt. Thus, the higher the basis, the better off the seller, whereas the lower the basis, the better off the buyer. The basis may be perceived as an artificial price, for it is nothing but the difference of two prices.

Hence, since short hedgers, or people who are short in the futures contract, stand to benefit from a rising basis, we say that ‘short hedgers are long the basis’. On the other hand, long hedgers, or people who are long in the futures market, will gain from a falling basis. Thus, we say that long hedgers are short the basis.

Price movements
If a trader does not hedge he is exposed to price risk, whereas if he does he is exposed to basis risk. Thus, hedging with futures replaces price risk with basis risk. Speculators, who will trade on the basis of perceived price movements in the spot market, will take decisions based on perceived movements in the basis, in the futures market.

At expiration, the spot and futures prices must converge to rule out arbitrage. Hence at expiration the basis will be zero. Thus, a necessary condition for perfect hedge, which is defined as a hedge that locks in the initial futures price with absolute certainty, is that the transaction date is the same as the expiration date of the futures contract. If so, the terminal basis is assured to be zero. There could be a situation, where the terminal basis is coincidentally equal to the initial basis.

If so, the hedger can lock in the initial spot price. Sometimes a hedger may use a futures contract on a related product to hedge. These hedges are termed as cross hedges, and the basis consists of two components. The first is the basis of the asset underlying the futures contract, and the second is the difference between the spot prices of the two assets.

The writer is CEO, Tarheel Consultancy Services