Long hedge
Also written Buying hedge
A hedge made by buying futures to protect against a price rise before a planned future purchase — the gain on futures offsets the higher cash price, locking in roughly the futures price.
In plain language
A long hedge protects someone who will buy later and is afraid the price will rise before then.
The workbook's definition: long hedge is the transaction when we hedge our position in cash market by going long in futures market.
Typical situations the workbook gives:
- You expect to receive money in future and plan to invest it in shares, but you fear the market will have risen by then. Buy index futures today; when the money arrives, invest it and unwind the futures.
- You have the money but suitable shares are not available in enough quantity, and rushing to buy would push prices up. Buy futures now, invest gradually in the cash market and unwind futures bit by bit.
If the price rises, you pay more in the cash market but make a profit on the futures. If the price falls, you pay less in the cash market but lose on the futures. Either way, the effective price lands close to the futures price you locked in. You give up the benefit of a fall to be protected from a rise.
How it works
- Instrument: stock futures for a specific stock (hedge ratio 1:1 by lot size), or index futures for an undecided or broad purchase.
- Contract month: the workbook's thumb rule is to choose the contract that expires just after the date on which you plan to unwind.
- Quantity: match the number of shares to the lot size. For a portfolio against index futures, use the beta-based hedge ratio.
- Unwind: on the purchase date, buy in the cash market and square off the long futures at the same time.
The hedge is rarely perfect. Futures and spot prices do not move identically before expiry, so the effective price ends near — not exactly at — the original futures price.
The formula
Net cost = Cash purchase cost − Gain on futures (or + Loss on futures)
Effective price per share = Net cost / Number of shares
A worked example
The workbook's example (Chapter 5, section 5.1). On 10 May you want to buy 1,500 shares of ABC Ltd, trading at Rs 455, but your funds arrive only on 20 June when a bank deposit matures. June futures trade at Rs 457.30; lot size 1,500. Buy one lot.
Scenario 1 — price rises. On 20 June spot is Rs 520, futures Rs 521.20.
| Rs | |
|---|---|
| Cost of buying 1,500 × 520 | 7,80,000 |
| Less gain on futures (521.20 − 457.30) × 1,500 | (−) 95,850 |
| Net cost | 6,84,150 |
| Per share | 456.10 |
Scenario 2 — price falls. On 20 June spot is Rs 390, futures Rs 391.10.
| Rs | |
|---|---|
| Cost of buying 1,500 × 390 | 5,85,000 |
| Add loss on futures (457.30 − 391.10) × 1,500 | (+) 99,300 |
| Net cost | 6,84,300 |
| Per share | 456.20 |
A Rs 130 swing in the share price moved the effective cost by just 10 paise. Both land close to the Rs 457.30 futures price.
Why NISM asks about it
Chapter 3, section 3.9 (Important terms in hedging), defines the long hedge with the index-futures investment example. Chapter 5, section 5.1, works it with the ABC Ltd stock futures numbers above. The paper asks which hedge suits a given situation (planned purchase → long hedge) and the effective price after the hedge.
Common exam traps
- Planned purchase → long hedge; planned sale or existing holding → short hedge. The direction follows what you will do in the cash market, not what you own today.
- A long hedge gives up the benefit of a price fall. In Scenario 2 the cheaper shares were offset by a futures loss.
- Effective price ≈ futures price, not spot price. It is near Rs 457.30, not Rs 455.
- Choose the contract expiring just after the unwind date, not the one expiring before it.
- A long hedge is still a hedge, not a speculative long: the investor has a matching cash-market exposure.
Where this is taught
- Series IV · Chapter 5: Strategies using Interest Rate Derivativesintroduced here
- Series XVI · Chapter 5: Uses of Commodity Derivativesintroduced here
- Series VIII · Chapter 5: Strategies using Equity Futures and Equity Optionsintroduced here
- Series V-D · Chapter 22: Strategies using Interest Rate Derivativesintroduced here
Related terms
- Hedge ratioThe number of futures (or options) needed to hedge a position. For one stock with its own futures it is 1:1; for a portfolio against index futures it is portfolio value × beta ÷ contract value.
- BasisThe difference between the spot price and the futures price of an asset — positive when spot exceeds futures, negative when futures exceeds spot, and zero at expiry.
- Futures contractA standardised forward traded on an exchange, where the exchange fixes every term except the price and the clearing corporation guarantees settlement, so neither side carries the other's default risk.
- HedgerA participant who already carries interest rate risk from a real business exposure and uses derivatives to remove it, rather than to take a view on the market.
- Short hedgeA hedge made by selling futures to protect an existing holding or a planned sale against a price fall — the futures gain offsets the lower cash price, locking in roughly the futures price.
- Cross hedgeHedging an exposure with futures on a different but closely associated asset, because no futures contract exists on the asset itself — for example, hedging a stock portfolio with index futures.
- Risk transferThe economic function by which commodity price risk moves off the hedger, who does not want it, onto the speculator, who is willing to carry it for a return.
- Weakening basisA change in basis (spot minus futures) towards a less positive or more negative number — futures rising relative to spot — which benefits a long hedger.
- Naturally longThe position every business holds in its finished goods — it gains when their prices rise and loses when they fall, which is why finished goods are hedged by selling futures.
- Naturally shortThe position every business holds in its raw materials — it must buy them in future, so a price rise hurts it exactly as a short position would, and a long hedge cancels the exposure.
- Offsetting hedgeA hedge undertaken to offset price risk that has arisen from a physical market activity already carried out — one of the workbook’s two basic hedging strategies, the other being locking in a price.
- Long positionAn outstanding, unsettled buy position in a derivatives contract — the buyer of a futures contract, or the buyer (holder) of an option, is said to be long.