32.a. Define Short Hedge

 Sure, let's break down the explanation of a short hedge point by point:

1. **Definition of a Short Hedge**: A short hedge is a risk management strategy used by investors or hedgers to protect an existing long position in an asset from potential price decreases. It involves taking a short (selling) position in a futures contract, which serves as a financial instrument to offset losses that might occur in the long asset position.

2. **Purpose of a Short Hedge**: The primary goal of a short hedge is to mitigate potential losses that could arise due to a decline in the value of the underlying asset. By establishing a short position in the futures contract, the hedger can effectively lock in a selling price for the asset, thus safeguarding against adverse price movements.

3. **Role of Futures Contracts**: Futures contracts are standardized agreements to buy or sell an asset at a predetermined price (the futures price) on a specified future date. These contracts are traded on futures exchanges and can be used for speculation or hedging purposes.

4. **Shorting the Futures Contract**: To implement a short hedge, the hedger sells (goes short) a futures contract. By doing so, the hedger is obligated to deliver the underlying asset at the agreed-upon futures price upon the contract's expiration.

5. **Example of a Short Hedge**: Let's illustrate this with a numerical example:

   Suppose a corn farmer expects to harvest 10,000 bushels of corn in three months and plans to sell the corn in the spot market at that time. The current price of corn is $5 per bushel, but the farmer is concerned that the price might drop by the time of the harvest. To protect against potential losses, the farmer decides to implement a short hedge.

   The farmer sells 10 corn futures contracts, each representing the delivery of 1,000 bushels of corn, at the current futures price of $5.10 per bushel, expiring in three months. This establishes a short position in the futures market.

   **Scenario 1: Corn Price Decreases**: At the time of harvest, the spot price of corn drops to $4 per bushel. While the farmer's actual corn in the spot market lost value, the short futures position gained value. The gain on the short futures position offsets the loss in the spot market, resulting in a net positive return for the farmer.

   **Scenario 2: Corn Price Increases**: On the other hand, if the spot price of corn increases to $6 per bushel, the short futures position would incur a loss. However, the gain in the spot market would offset this loss, and the farmer would still benefit from the higher selling price of corn.

In summary, a short hedge is a useful strategy for protecting a long position when there is an expectation of declining prices. By selling futures contracts, the hedger can secure a selling price for the asset, minimizing potential losses due to adverse price movements.

Example: The current spot price is $24.70/ounce. In order to hedge this entire position, the investor will short six-month futures contracts priced at $25. Compute the profit on the overall position assuming the spot price at time of delivery is either $24.25 or $26.75. Suppose each futures contract represents 5,000 troy ounces of silver.

Sure, let's break down the calculations step-by-step for both scenarios:

**Scenario 1: Spot price at delivery is $24.25 per ounce**

1. The investor will receive 50,000 troy ounces of silver at the market price of $24.25 per ounce. 2. Total market price = 50,000 ounces × $24.25 per ounce = $1,212,500 3. The investor had previously shorted 10 futures contracts, with each contract representing 5,000 troy ounces of silver. 4. Gain per futures contract = Futures price - Spot price at delivery = $25 - $24.25 = $0.75 per ounce 5. Total gain on 10 contracts = 10 contracts × $0.75 per ounce × 5,000 ounces = $37,500 6. Overall profit = Total market price + Total gain on futures contracts = $1,212,500 + $37,500 = $1,250,000 **Scenario 2: Spot price at delivery is $26.75 per ounce** 1. The investor will receive 50,000 troy ounces of silver at the market price of $26.75 per ounce. 2. Total market price = 50,000 ounces × $26.75 per ounce = $1,337,500 3. The investor had previously shorted 10 futures contracts, with each contract representing 5,000 troy ounces of silver. 4. Loss per futures contract = Futures price - Spot price at delivery = $25 - $26.75 = -$1.75 per ounce 5. Total loss on 10 contracts = 10 contracts × -$1.75 per ounce × 5,000 ounces = -$87,500 6. Overall profit = Total market price + Total loss on futures contracts = $1,337,500 - $87,500 = $1,250,000

In both scenarios, the overall profit on the hedged position remains the same at $1,250,000. The short hedge successfully protected the investor from potential losses due to price fluctuations, allowing them to lock in a certain selling price for the silver and ensuring a consistent profit regardless of the spot price at the time of delivery.

Sure, here are some multiple-choice questions related to short hedging:

**Question 1:** What is the primary purpose of a short hedge?

A) Speculate on asset prices.

B) Protect against potential losses in a long position.

C) Increase the value of the underlying asset.

D) Avoid short-term price fluctuations.

**Question 2:** When implementing a short hedge, the hedger takes a _______ position in the futures contract.

A) Long

B) Neutral

C) Short

D) Leveraged

**Question 3:** Which of the following statements is true about a short hedge?

A) It involves buying a futures contract to protect a long position.

B) It is used when the investor expects prices to increase.

C) It locks in a selling price for the underlying asset.

D) It has no impact on potential losses in the long position.

**Question 4:** In a short hedge, if the price of the underlying asset decreases, the short futures position will likely experience:

A) A loss, offsetting the decline in asset value.

B) A gain, magnifying the decline in asset value.

C) No change in value, as it is just a hedging strategy.

D) Unpredictable results due to market fluctuations.

**Question 5:** An investor will receive 30,000 barrels of oil in six months and wants to hedge against potential price decreases. Each futures contract represents 1,000 barrels of oil. If the investor shorts 20 futures contracts at $70 per barrel and the spot price at delivery is $65 per barrel, what is the overall profit/loss on the hedged position?

A) A profit of $30,000

B) A profit of $100,000

C) A loss of $30,000

D) A loss of $100,000

**Question 6:** A farmer expects to harvest 8,000 bushels of wheat in four months and anticipates a drop in wheat prices. The current spot price is $6.50 per bushel, and each wheat futures contract represents 1,000 bushels. To hedge the position, the farmer shorts 10 futures contracts at $6.70 per bushel. If the spot price at delivery is $5.90 per bushel, what is the net result on the hedged position?

A) A profit of $800

B) A profit of $2,000

C) A loss of $800

D) A loss of $2,000

**Answers:**

1) B) Protect against potential losses in a long position.

2) C) Short

3) C) It locks in a selling price for the underlying asset.

4) A) A loss, offsetting the decline in asset value.

5) B) A profit of $100,000

6) B) A profit of $2,000