Introduction

In this Chapter 5, we will delve into the crucial aspect of calculating the profit and loss (P&L) for short and long hedges. A key goal of hedging is to mitigate potential losses arising from adverse price movements. Understanding how to calculate and interpret the P&L on hedges is essential for risk management and effective decision-making in financial markets. In this chapter, we will explore the step-by-step process of computing P&L for both short and long hedges, providing relevant examples to illustrate the concepts.

Calculating Profit and Loss on a Short Hedge:

A short hedge involves selling futures contracts to protect against the decline in the price of an underlying asset. To calculate the P&L on a short hedge, follow these steps:

Step 1: Identify the Initial Futures Price (F0) and the Hedge Price (Ft).
Step 2: Determine the Contract Size of the Futures.
Step 3: Calculate the Number of Contracts Used for Hedging (N).
Step 4: Calculate the Initial Value of the Hedge (Initial P&L).
Step 5: Monitor the Price Movement of the Underlying Asset.
Step 6: Determine the New Hedge Price (Ft’).
Step 7: Calculate the Updated Value of the Hedge (Updated P&L).
Step 8: Interpretation of the P&L and Decision-Making.

Example: Suppose a corn farmer wants to protect against a potential decrease in corn prices. The farmer enters into a short hedge by selling 5 corn futures contracts at $500 each. The initial corn futures price is $4.20 per bushel, and the contract size is 5,000 bushels. After three months, the corn futures price decreases to $4.00 per bushel. Calculate the P&L on the short hedge.

Calculating Profit and Loss on a Long Hedge

A long hedge involves buying futures contracts to protect against the rise in the price of an underlying asset. To calculate the P&L on a long hedge, follow these steps:

Step 1: Identify the Initial Futures Price (F0) and the Hedge Price (Ft).
Step 2: Determine the Contract Size of the Futures.
Step 3: Calculate the Number of Contracts Used for Hedging (N).
Step 4: Calculate the Initial Value of the Hedge (Initial P&L).
Step 5: Monitor the Price Movement of the Underlying Asset.
Step 6: Determine the New Hedge Price (Ft’).
Step 7: Calculate the Updated Value of the Hedge (Updated P&L).
Step 8: Interpretation of the P&L and Decision-Making.

Example: Consider an airline company seeking to protect against rising fuel prices. The company enters into a long hedge by buying 10 crude oil futures contracts at $60 per barrel. The initial crude oil futures price is $62 per barrel, and each contract represents 1,000 barrels. After one month, the crude oil futures price increases to $65 per barrel. Calculate the P&L on the long hedge.