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ClydeFrog
New Orleans Saints Fan
LA
Member since Jul 2012
3167 posts

hedging question

What's the difference between selling a forward and buying puts? Let's say in the context of a wheat farmer who wants to hedge against potential losses. These two seem similar to me.


foshizzle
LSU Fan
Washington DC metro
Member since Mar 2008
31727 posts
Online

re: hedging question
Selling a forward means you agree to sell the wheat at a specific price in the future. Unlike the option, there is no question of whether the contract will be exercised. A payoff graph is here:

Image: http://upload.wikimedia.org/wikipedia/commons/thumb/0/05/Short_forward_payoff.png/657px-Short_forward_payoff.png


Buying a put means you have the right (but not the obligation) to sell the wheat at the strike price at some time in the future. The payoff graph is here:

Image: http://upload.wikimedia.org/wikipedia/commons/e/e5/Long_put_option.svg


Notice that when you buy the put, you do not have to actually sell at the negotiated price if the market moves against you. Of course, you pay for that privilege.

Another significant difference is that forward contracts tend to be specifically negotiated, whereas options are often standard contracts.


ClydeFrog
New Orleans Saints Fan
LA
Member since Jul 2012
3167 posts

re: hedging question
quote:

foshizzle


Thanks for the input, it's much appreciated.


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