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Investors use Futures contracts to hedge against price fluctuations, reducing uncertainty in their portfolios or businesses. This helps them protect against losses from market volatility.
Hedging Against Price Changes (Risk Reduction) Futures allow investors to lock in prices for assets, reducing exposure to unfavorable price movements. Example: Stock Market Hedging An investor holds a $1 million portfolio of S&P 500 stocks. To protect against a market downturn, they short S&P 500 futures. If the market drops, losses in the portfolio are offset by gains in the short futures position. Outcome: The hedge reduces overall portfolio risk without selling stocks. Hedging Commodity Price Risk Companies use futures to stabilize costs and revenues. Example: Airline Fuel Hedging An airline is worried about rising fuel prices. It buys crude oil futures to lock in a fixed price. If oil prices rise, the airline pays more for fuel but profits from the futures contract. Outcome: Fuel costs remain predictable, reducing financial risk. Currency Risk Management (Forex Hedging) Companies and investors hedge against foreign exchange fluctuations. Example: Importer Hedging Currency Risk A U.S. company imports goods from Europe and will pay €10 million in 3 months. If the euro appreciates, costs increase. The company buys EUR/USD futures to lock in the current exchange rate. Outcome: The business avoids unexpected currency cost increases. Interest Rate Risk Management Banks and bond investors hedge against rising or falling interest rates. Example: Bond Portfolio Hedging An investor owns long-term bonds and fears interest rates will rise. Rising rates lower bond prices, causing losses. The investor sells Treasury futures to offset potential bond losses. Outcome: The futures position cushions the impact of rate changes. Key Takeaways Futures hedge against financial risks, making costs and revenues more predictable. Used by investors, businesses, and institutions to manage exposure to stocks, commodities, currencies, and interest rates. Not meant for profit but for protection from price volatility. |
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