If the stock market rises instead of fall as David expected, the price of stock market index future contract will decrease and the price of the stocks goes up. In general, the systematic risk of the portfolio that cannot be reduced by diversification has been hedged.
A hedge is an investment position intended to offset potential losses/gains that may be incurred by a companion investment. In simple language, a hedge is used to reduce any substantial losses/gains suffered by an individual or an organization. According to Bruce Greenwald, investors who primarily trade in futures may hedge their futures against synthetic futures. A synthetic in this case is a synthetic future comprising a call and a put position. Long synthetic futures means long call and short put at the same expiry price. To hedge against a long futures trade a short position in synthetics can be established, and vice versa.
The diagrams above are payoff diagrams (TheOptionsGuide,2013) of long stock and short future. If David buy a future contract on the S&P 500 Index, he payoff at the maturity date, T, is the difference between the cash value of the index, ST, and the futures price, F. Payoff=ST-F. From these two diagrams it is clear that the trend of long stock is in the opposite direction with short futures, and this is how hedging works.
If an equity portfolio is hedged with the appropriate futures contract sold short, any decline in the value of the equity shares will be offsets by an increase in the value of the future position. If the value of the equity shares rises, the corresponding futures contracts will lose value. At a certain level of futures loss additional deposits will be required to keep the contract open. If the portfolio rises in value, the cost of the hedging will increase in proportion to the portfolio increase.
David hedges his portfolio to provide sub-market returns and helps ensure that he can meet future repayment obligations to his clients. Portfolio...
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