NISM Series XVI - Commodity Derivatives Exam Notes
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Short put position shall devolve into long position in the underlying futures contract
Hedges can be undertaken to offset price risk that has arisen in a physical contract. This is known as 'offsetting hedge'.
Hedge ratio indicates the number of lots/contracts that the hedger is required to buy or sell in the futures market to cover his risk exposure in the physical / spot market.
Hedge ratio = coefficient of correlation between spot and futures price * (standard deviation of change in spot price / standard deviation of change in futures price
Limitations of hedging - 1) Price risk cannot be totally eliminated, 2) Basis risk continues to remain, 3) Transaction cost is to be incurred, 4) Margin is to be maintained leading to cash flow pressures, 5) If hedging is selectively carried out on a few positions based on one's view, then hedging may result in losses.
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