Illustrate hedging by a stockiest by using futures market?
To illustrate the concept of hedging, let us assume that, on 1st December, 2008, a stockiest purchases, say, 10 tonnes of paddy in the physical market @ Rs. 1600/- p.q.. To hedge price-risk, he would simultaneously sell 10 contracts of one tonne each in the futures market at the prevailing price. Assuming the ruling price in May, 2009 contract is Rs.1750/- p.q., the stockiest is able to lock in a spread of Rs. 150/- p.q., i.e., about 9% for about 6 months. The stockiest would, in the first instance, take the decision to purchase stock only if such a spread covers his cost of carry and a reasonable profit of margin. Assuming that the stockiest sells his stock in the month of April when the spot price is Rs. 1500/- p.q. The stockiest would incur a loss of Rs. 100/- p.q. on his physical stocks. He would also make a loss of expenses incurred for carrying the stocks. However, since the spot and futures prices move in parity, futures price is also likely to decline, say, from Rs. 1750/- p.q.
