Which of the following is TRUE? To hedge a natural short position with futures, the hedger should: a. Initially sell the futures contract and then buy the same contract at the delivery date. b. Initially buy the futures contract and then sell the same contract before the delivery date. c. Initially buy the futures contract and then sell the same contract after the delivery date. d. Initially buy the futures contract and then sell the same contract at the delivery date.
Question
Which of the following is TRUE?
To hedge a natural short position with futures, the hedger should:
a. Initially sell the futures contract and then buy the same contract at the delivery date.
b. Initially buy the futures contract and then sell the same contract before the delivery date.
c. Initially buy the futures contract and then sell the same contract after the delivery date.
d. Initially buy the futures contract and then sell the same contract at the delivery date.
Solution
The correct answer is:
b. Initially buy the futures contract and then sell the same contract before the delivery date.
Here's why:
A natural short position means you are exposed to the risk of prices falling. To hedge this risk, you would want to lock in a price now for a future transaction, which is what a futures contract allows you to do.
If you initially buy a futures contract, you are agreeing to buy the underlying asset at a set price at a future date. If the price of the asset falls (which is the risk you're exposed to), you're protected because you've locked in a higher price.
Then, before the delivery date, you would sell the same futures contract. This allows you to avoid actually taking delivery of the asset, while still benefiting from the protection the futures contract provided against falling prices.
So, the process of buying the futures contract and then selling the same contract before the delivery date is a way to hedge a natural short position.
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