Introduction

Andreas Röthig ()
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Andreas Röthig: Darmstadt University of Technology

Chapter Chapter 1 in Microeconomic Risk Management and Macroeconomic Stability, 2009, pp 3-11 from Springer

Abstract: Abstract In the traditional hedging literature, the two markets in which hedgers trade are spot and futures markets. The trader’s position in the spot market is generally considered as given. According to Johnson (1960), hedging can be meaningfully defined only if the spot market is regarded as the trader’s primary market. The futures market is used solely to counterbalance an existing position in the spot market. Speculators, in contrast, do not have a commitment in the spot market. They take on risk in futures markets in order to profit from expected price changes. The hedger synchronizes his trading activities in spot and futures markets in order to reduce spot risk. In the literature this approach to hedging is labeled risk reduction concept. Risk reduction will be achieved if spot and futures prices move more or less in parallel. If prices are perfectly correlated, risk is abolished, since losses in one market are perfectly offset by profits in the other market. However, as Hardy and Lyon (1923) point out, any divergence from perfect correlation results in an imperfect hedge. The less futures and spot prices move in parallel, the more imperfect the protection offered by hedging is. According to Kobold (1986), spot and futures prices generally do not move exactly in parallel. In fact, futures and spot markets are separate markets. Even speaking of a single spot market may be misleading, since, in general, most commodities are traded in many different places. The futures market, on the contrary, is generally highly centralized. Telser (1986) points out that each futures contract is a perfect substitute for another futures contract with the same maturity. If spot and futures prices do not move exactly in parallel, hedges end up with a profit or loss. Hence, if the motive for hedging is the elimination of spot risk, spot and futures prices, not moving in parallel, prevent complete risk reduction and are therefore unfavorable.

Keywords: Future Market; Future Price; Future Contract; Hedging Strategy; Hedge Ratio (search for similar items in EconPapers)
Date: 2009
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DOI: 10.1007/978-3-642-01565-6_1

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