Suppose the investor RJ has 10000 shares of Airtel at 350. This means total value of asset in Airtel stock is 35 lakhs. RJ thinks that telecom market would go down in near future because of 2G scam. However, he is bullish on telecom sector in the long run. He knows that this 2G scam is temporary and once the brouhaha is over, telecom will be back. What will he do?
He has another option, apart from using index futures. He can use stock futures. Airtel futures are available in the market for next 1,2,3 months and RJ can sell (short) Airtel future contracts. Usually one contract has 100 units. For complete hedging, RJ will have to sell 100 Airtel futures contract. Let’s say RJ has sold 100 Airtel futures contract at 350. In this case, RJ has achieved 100% hedging. Had he possessed odd number of shares (say 10,200), he wouldn’t be able to hedge 100%.
Let’s analyse the scenario 1 month down the line.
| Initial Value | Final Value (in 1 month) | Gain/Loss | |||
| Airtel Stock | Airtel Future | Airtel Stock | Airtel Future | Airtel Stock | Airtel Future |
Market down by 10% | 35,00,000 | 35,00,000 | 31,50,000 | 31,50,000 | -3,50,000 | 3,50,000 |
Market up by 10% | 35,00,000 | 35,00,000 | 3850000 | 38,50,000 | 3,50,000 | -3,50,000 |
Overall Payoff when Market goes up by 10% = 0
Overall Payoff when Market goes down by 10% = 0
Conclusion
Futures are important from hedging perspective as well as for speculative and arbitrage purposes. Speculators play with futures in anticipation that market will behave as they have guessed it. The advantage of speculation with futures is high gain but it also has potential to wipe out the investment if your guess goes wrong.
Futures are used for hedging purposes by institutional and individual investors alike. In fact most of the investors in index futures are institutional.
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Pankaj Priyadarshi
Pankaj Priyadarshi is an author at Lastbull.com. He has 11 years of international and domestic experience in the areas of Finance, Management, and Business Analysis in the USA and India.He is a co-founder of 'Vertical Grass', a consulting initiative in the area of finance. A Graduate from IIT(Engineering) and ISB(Management).
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