Hedging Strategies Using Derivatives for Exam FM

Hedging with Forwards

A forward contract locks in the future price of an asset, eliminating both upside and downside risk. A producer who will sell a commodity in the future can short a forward to lock in the selling price. A consumer who will buy can go long. The cost of hedging with a forward is zero at inception (no premium), but the hedger gives up the possibility of benefiting from favorable price movements.

On Exam FM, hedging with forwards is straightforward: the hedged position's payoff is the sum of the underlying position's payoff and the forward's payoff.

Hedging with Options

Options provide insurance-like protection while preserving upside (or downside) potential. Buying a put protects a long position against price declines (a "protective put" or "floor"). Buying a call protects a short position against price increases (a "cap"). The cost is the option premium.

A collar combines a long put with a short call, creating a range of outcomes. The collar's cost can be zero (a "zero-cost collar") if the put premium equals the call premium. On Exam FM, you should be able to diagram the payoff and profit of these strategies.

Comparing Strategies

No hedge: full exposure to price changes. Forward hedge: locks in a price, zero cost, no flexibility. Put hedge (for a long position): protects the downside, preserves the upside, costs the put premium. Collar: limited downside and limited upside, lower cost than a put alone. Exam FM problems compare the profit diagrams of these strategies and ask which achieves a given objective at the lowest cost or which best fits a given risk tolerance.