Hedge contract month

A hedge using futures needs a decision most people overlook: which month's contract to use. Futures on the same underlying trade in several expiry months at once, and the choice is not arbitrary.

The workbook's rule of thumb is simple. Pick the contract that expires just after the date the hedge is meant to be unwound — not before it, and not needlessly far after it either.

Expiring before the unwind date is the real danger: the hedge would vanish before the exposure it was protecting does. Choosing a contract that expires soon after keeps the hedge alive for the whole period that actually needs protecting, without paying for months of unnecessary coverage.

The workbook's worked case (Chapter 15): on 10 May, an investor decides to sell his portfolio on 20 June to meet a financial obligation, and wants to hedge market risk by shorting index futures in the meantime. The correct choice is the index futures contract expiring in June, not May — because the May contract would expire before the 20 June sale date, leaving the portfolio unprotected for the final stretch.

This sits alongside the workbook's broader treatment of hedge types in the same section — long hedge (buying futures to lock in a future purchase price), short hedge (selling futures to protect the value of a holding due for sale), and cross hedge (hedging with a futures contract on a related, not identical, asset when no direct contract exists). Selecting the right hedge contract month applies to all of these: whichever hedge type is used, its protection has to last at least as long as the exposure being covered.

A fund manager holds an equity portfolio worth Rs 20 crore and plans to raise cash by selling it on 15 September to fund redemptions. On 1 August, with July, August and September index futures contracts all trading, the manager needs to pick one.

August contract    → expires before 15 September → hedge lapses too early, wrong choice
September contract → expires just after 15 September → correct hedge contract month

The manager shorts September index futures worth approximately Rs 20 crore of notional value, matching the portfolio being protected. If the market falls 5% before 15 September, the roughly Rs 1 crore loss on the equity portfolio is offset by a matching gain on the short futures position, right up to the sale date — the September contract's expiry falls just after the exposure ends, exactly as the thumb rule prescribes.

Chapter 15 (Introduction to Forwards and Futures) covers hedge contract month directly after long hedge, short hedge and cross hedge, using the 10 May / 20 June illustration. Expect a question that gives an unwind date and a set of available contract months, and asks which one correctly hedges the exposure.

• The contract must expire on or after the unwind date, never before it. A contract expiring even a day early leaves the tail end of the exposure unhedged.
• "Just after," not "as far after as possible." Choosing a needlessly distant contract month adds cost and basis risk without adding protection.
• This decision applies to long, short and cross hedges alike — the contract-month choice is a separate question from which hedge type or which underlying to use.