Hedging with Forward Contracts

In this section, we explore how businesses and investors can use forward contracts to manage risk exposure. A forward contract is an agreement between two parties to buy or sell an asset at a predetermined price (the forward price) on a future date. Hedgers employ forward contracts to protect themselves from potential adverse price movements.

Example: A wheat farmer is concerned about the price of wheat falling before the harvest. To hedge against this risk, the farmer enters into a forward contract to sell a specified quantity of wheat at a predetermined price to a buyer on the harvest date. By doing so, the farmer locks in a selling price, protecting against potential losses if wheat prices decline.

Hedging with Options Contracts

This section delves into how options contracts can be used for hedging purposes. An options contract gives the holder the right, but not the obligation, to buy (call option) or sell (put option) an underlying asset at a specified price (the strike price) on or before a specific date (the expiration date). Hedgers utilize options to minimize potential losses while retaining the flexibility to benefit from favorable price movements.

Example: An airline is concerned about rising fuel prices impacting its operational costs. To hedge against this risk, the airline purchases call options on crude oil futures. If the fuel prices rise, the value of the call options will increase, offsetting the higher fuel costs.

Calculation and Comparison of Hedging Payoffs

This section provides a step-by-step guide on how to calculate and compare the payoffs from hedging strategies involving forward contracts and options.

Example (Forward Contract): A company plans to import raw materials three months from now and wants to hedge against potential currency exchange rate fluctuations. It enters into a forward contract to buy the foreign currency at a fixed exchange rate. If the actual exchange rate on the delivery date is less favorable than the forward rate, the company gains from the hedge.

Example (Options Contract): A coffee retailer wants to protect against rising coffee bean prices. The retailer buys put options on coffee futures. If coffee prices increase, the retailer exercises the put options, effectively locking in a lower purchase price for the coffee beans.