In the second iteration of this derivatives course, we will fly past all the definitions we outlined in the introductory blog and now explore how derivatives are used to reduce risk. Essentially, in the first blog, we understood and oiled the derivative machine; this blog is about using it without blowing it up.
Markets move sharply. Often, rudely, without warning. Traders use derivatives to ‘hedge’ against these sharp turns in the market. We are going to look at how this is done.
Hedging???
The word hedging, for this instance, comes from Old English, which meant ‘fence’ for protecting against things. It evolved in the betting culture to mean insuring oneself against loss. In modern finance, we say it to protect oneself against loss in markets from investments.
A hedge does not eliminate all risk; it instead reshapes it into something more predictable by reducing the variance of future prices or cash flows.
There are two basic moves when trying to reduce your risk:
- Long hedge: buying futures to protect against rising prices
- Short hedge: selling futures to protect against falling prices
Basis Risk
The basis is the gap between the spot price and the futures price.
Basis = Spot – Futures prices
When the basis shifts unexpectedly:
- A short hedge (selling futures) benefits if the basis strengthens
- A long hedge (buying futures) benefits if the basis weakens
But the key point is simpler: If your hedge depends on spot–futures convergence, any deviation in that convergence introduces risk. Basis risk is the reminder that hedging reduces uncertainty, but never abolishes it.
The quality of the hedge of protection depends on how the basis moves. If this basis were constant, the hedge would be perfect. But it does not. This basis represents the uncertainty in your hedging bet relative to the underlying bet.
Basis risk exists because of three key reasons:
- The futures contract could mature on a fixed date, when your underlying exposure may resolve earlier or later.
- There could be an asset mismatch, where often the exact contract an investor needs to hedge their bet does not exist.
- Spot and future prices also respond differently to different market behaviours, which change with evolving economic conditions such as supply, demand, interest rates, bond yields, and liquidity conditions.
Hedging With Futures
A futures contract allows investors to lock in a price today for a transaction that will take place in the future. So if you’re worried about:
- Prices rising: you buy futures (long hedge).
- Prices falling: you sell futures (short hedge).
The futures contract moves inversely to the risk you’re trying to protect. If the wrong price movement hits you in the real world, the futures contract cushions the impact.
Hedging With Options
Options let you protect the downside without giving up the upside.
- A put option acts like insurance: if prices crash, it pays out.
- A call option caps how much you’ll suffer from rising input costs.
Options are the financial equivalent of wearing a helmet; you hope you won’t need it, but you’re very glad it’s there when something goes wrong.
Hedging with Swaps
Where futures hedge price levels, swaps hedge cash flows. Companies use interest rate swaps to convert unpredictable floating-rate payments into stable fixed-rate payments. Or the reverse, turning fixed payments into floating if they expect rates to fall. Swaps are less dramatic than futures or options, but they quietly stabilise trillions of corporate liabilities.
