Long Hedge
Long Hedge is known as a hedge fund managing and distributing funds for talking long positions in future contracts. It involves the purchase of certain assets to reduce the fear of the price increase in the future. The hedge itself is quite simple, with the purchaser of a commodity simply entering a long future position. A company knows that it is due to buy an asset that in the future can hedge by taking a long futures position. The long hedge is initiated when a future contract is purchased in order to reduce the price variability of an anticipated future long position. Equivalently a long hedge locks up the interest rate of price of the cash security that will be purchased in the future subject to small adjustment due to the basis risk. The primary objective of the long hedge is to benefit from the high long term interest rates, even though funds are not currently available for investment. A long hedge is also known as an anticipatory hedge, because it is effectively a substitute position for a future cash transaction[1].
Disadvantages of long hedge
The disadvantages of long hedge[2]:
- Financial institutions are prohibited from employing long hedges, since their regulatory agencies believe that long hedges are similar to speculation, and these agencies do not want institutions to be tempted into affecting the institution's return with highly leveraged speculative futures positions.
- If the financial manager inaccurately forecast the way of the future interest rates, then the company still locks up the futures yield rather than fully participating in the higher returns available because of the greater interest rate
- If the futures market already anticipate a collapse in interest rates similar to the decrease forecasted by financial manager, then the futures price reflects this lower rate, negating any return benefit from the long hedge. Particularly, one hedges only against unanticipated changes that the futures market has not yet forecasted. If the eventual cash price increases only to a level below the current futures rice, then a loss occurs on the long hedge. Therefore, a progress in return from a long hedge in comparison to the future cash market investment occurs only if the manager is a superior forecast of the future interest rates. Nevertheless, long hedge does lock-in the currently available long-term futures rate, thereby reducing the risk of unanticipated changes in the rate.
- If rates rise instead, to drop down then bond prices will decline causing an immediate cash outflow due to margin calls. This cash outflow will be offset only over the life of the bond via a greater yield on investment. Thus the net investment decision.
Difference between long and short hedge
Basis risk makes it very difficult to offset all pricing risk, but a high hedge ratio on a long hedge will remove a lot of it. The opposite of a long hedge is a short hedge, which protects the seller of a commodity or assets by locking in the sale price. Hedges, both long and short, can be thought of as a form of insurance. There is a cost to set them up, but they can save a company a large amount in an adverse situation[3].
Long hedge[4]:
- requires taking a long position in the futures contract
- appropriate when a certain asset or commodity would be purchased in the future and one is interested in locking in the price now
Short hedge[5]:
- involves a short position in the future contract
- applicable when a hedger already owns an asset and expects to sell it in the future
Examples of Long Hedge
- A company that produces steel may use a long hedge to protect against rising steel prices. The company would buy a futures contract on steel, which would enable them to lock in a price. If the price of steel increases, the company will benefit from the higher prices without having to buy the steel at a higher price.
- A farmer may use a long hedge to protect against rising grain prices. The farmer may buy a futures contract on grain, which will enable them to lock in a price for their crop. If the price of grain increases, the farmer will benefit from the higher prices without having to sell their crop at a lower price.
- An investor may use a long hedge to protect against a decline in stock prices. The investor may buy a futures contract on the stock, which will enable them to lock in a price for their shares. If the price of the stock declines, the investor will benefit from the lower prices without having to sell their shares at a lower price.
A Long Hedge is also used in conjunction with other approaches to reduce risk and protect against adverse market movements. These other approaches include:
- Options - Options are derivatives that give the holder the right (but not the obligation) to buy or sell a certain asset at a predetermined price. This allows a trader to buy a put option which gives them the right to sell the asset at a predetermined price if the market moves against them.
- Forward Contracts - A forward contract is an agreement between two parties to buy or sell an asset at a predetermined future date and price. It allows for a trader to lock in a price for a future purchase of an asset and protect against any adverse market movements.
- Futures - A futures contract is an agreement between two parties to buy or sell an asset at a predetermined future date and price. Futures provide a trader with the ability to hedge their exposure to the market by entering into a contract with a third party to buy or sell a particular asset at a predetermined price.
In summary, Long Hedge is an effective tool for reducing risk and protecting against adverse market movements. It can be used in conjunction with other approaches such as options, forward contracts, and futures to help mitigate the risk associated with investing in the markets.
Footnotes
| Long Hedge — recommended articles |
| Short Call — Options — Buying Hedge — Long put — Zero cost collar — Futures — Selling Into Strength — Interest Rate Collar — Short call option |
References
- Janakiramanan S. (2007) Derivative Securities and Risk Management in Asia and Australia, Pearson Prentice Hall, California p. 101-111
- Kleinman G. (2013) Trading Commodities and Financial Futures, Pearson Education, New Jersey, Chapter 4
- Mishra B. (2009) Financial Derivatives, Excel Books, India, chapter 5, p. 97
Author: Anna Marczyk
