Futures contracts cash flow hedge
Hedging and key risk management principles have become mainstream financial tools for many pork producers as they look to manage the risks associated with buying grain and selling hogs.
Hedging is an investment to reduce the risk of adverse price movements in an asset. Derivative contracts, such as futures, forwards, puts and calls are now a part of everyday operations as lenders encourage producers to implement risk management strategies.
A futures contract is a financial contract obligating the buyer to purchase an asset (or the seller to sell an asset), such as a physical commodity or a financial instrument, at a predetermined future date and price.
Option contracts, such as puts and calls, give a buyer the right, but not the obligation, to purchase an asset (or the seller to sell an asset) at a predetermined future date and price.
While risk management is considered a necessity from an economic standpoint, it can be a bit of a nightmare from an accounting and financial reporting perspective. But no matter how frightening it may be, understanding how the use of risk management tools affects your financial statements can make a significant impact on your reported earnings. This is especially pertinent as financial statements are being more scrutinized by lenders and potential investors.
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What is a cash flow hedge?
a cash flow hedge ia an instrument designated as hedging the exposure to variability in expected future cash flows attributed to a particular rick. gain/losses on the effective portion of a cash flow hedge are deferred and are reported as a component of other comprehansive income (outside earning) until the cash flow associated with the hedged item are realized. gains/losses on the ineffective portion of a cash flow hedge are reported in current income.
How to hedge risk with futures contracts?
Suppose that you are a portfolio manager and you expect that some investors of your fund will cash out their investments in the next three months. How would you use S&P 500 futures to hedge the risk of changing stock prices?
i would use options instead of futures for better hedge. since you want to hedge changing stock prices, i suppose you already have a long position in stocks. to hedge, i'd buy deep in the money put option that expires in 3 months time. if the stock price falls, i would cash in the put, if stock price rises but still below exercise price, i could still cash in the put, and if stock price rises well above exercise price, i would leave the put unexercised.
if you however insist on using futures, you could sell S&P 500 futures with a certain ratio (no of stocks bought/no of futures sold) …