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FRM Exam Part I · Using Futures for Hedging

Basic Principles of Hedging with Futures

Updated 11 October 2026 · Fact-checked

Hedging with futures means taking a futures position that offsets the price risk of an asset you own or will trade. Use a short hedge if you will sell the asset, and a long hedge if you will buy it. The hedge locks in roughly the futures price, adjusted for basis.

Understand Basic Principles of Hedging with Futures

A hedge is a trade that reduces an existing risk. If your business gains when a price rises and loses when it falls, you take a futures position that does the opposite. The gain on one side offsets the loss on the other.

A short hedge means selling (going short) futures. You use it when you own an asset or will sell one later. Examples: a farmer with a coming harvest, an oil producer, or a fund holding bonds. If the price falls, the loss on the asset is offset by a gain on the short futures.

A long hedge means buying (going long) futures. You use it when you will need to buy an asset later. Examples: an airline buying jet fuel, a manufacturer buying copper, or an importer who must pay in a foreign currency. If the price rises, the extra cost is offset by a gain on the long futures.

The hedge locks in a price only approximately. The effective price depends on the basis, which is the spot price minus the futures price of the hedged asset. If you hedge with futures that expire later than your transaction date, the basis at close-out is uncertain. That leftover uncertainty is basis risk. A perfect hedge exists only when the basis at close-out is known in advance.

Why hedge? Hedging removes risks that management does not want, such as commodity price, interest rate or exchange rate risk. Arguments for: it stabilises cash flows, supports planning and lowers the chance of financial distress. Arguments against: shareholders can diversify or hedge themselves. Hedging has costs, and it can make results worse if prices move favourably. Competitors who do not hedge may gain when prices move in their favour, which can hurt a hedger whose own product price moves with the input cost. Also, a hedge that loses money while the underlying gains can be hard to explain to people who do not understand the full position.

Key formulas to remember

Basis
Basis = Spot price of asset to be hedged − Futures price of contract used
This is the usual convention. Check the sign convention in the question.
Effective price, short hedge
Price realised = S2 + F1 − F2 = F1 + b2
F1 is the initial futures price, F2 and S2 are the futures and spot prices at close-out, b2 = S2 − F2 is the final basis.
Effective price, long hedge
Price paid = S2 + F1 − F2 = F1 + b2
Same algebra as the short hedge, but now it is the cost you pay. Lower is better.
Futures gain or loss
Short: (F1 − F2) × contract size × contracts. Long: (F2 − F1) × contract size × contracts
Rising futures prices help longs and hurt shorts.
Perfect hedge
Basis at close-out known with certainty, so price is locked at F1 + b2
Basis risk is the uncertainty in b2.

How to solve Basic Principles of Hedging with Futures questions

Use this method for any question on hedging with futures. It works for qualitative and numerical questions.

  1. 1Identify the exposure: will you sell the asset (or own it) or will you buy it later?
  2. 2Choose the direction: sell (short) futures if you sell or hold the asset, buy (long) futures if you will buy.
  3. 3Pick the contract month, normally the one at or just after the transaction date, and note the initial futures price F1.
  4. 4Find the closing prices: spot S2 and futures F2 at the time the hedge is lifted.
  5. 5Compute the futures gain or loss using the position direction and contract size.
  6. 6Add it to the spot result: realised price = S2 + (F1 − F2) for both hedges; for a long hedge treat this as your cost.
  7. 7Check by computing the final basis b2 = S2 − F2; the effective price should equal F1 + b2.
  8. 8Comment on the result: whether basis risk remains, and whether the hedge protected against the adverse move.

Quickest way: Direction and F1 + b2 shortcut

When to use it: Use it for numerical hedging questions where you are given F1, S2 and F2, or the final basis.

  1. Ask: sell later means short, buy later means long.
  2. Skip the gain and loss calculation if you know the final basis: effective price = F1 + b2.
  3. If the basis is stated as zero at close-out, the answer is simply F1.
  4. Multiply by quantity only at the end, such as contracts × contract size.
  5. Eliminate options that put the sign of the basis the wrong way round.

Common mistakes in Basic Principles of Hedging with Futures

  • Choosing the wrong direction, for example going long to hedge an inventory you own.

    Students link owning the asset with being long and forget the hedge must offset it.

    Fix: Hedge the exposure you want to cancel. If you lose when the price falls, sell futures. If you lose when the price rises, buy futures.

  • Assuming a futures hedge locks in the price exactly.

    Textbook intros say the price is locked in, and the basis is forgotten.

    Fix: State that the locked price is F1 + b2. It is exact only when b2 is known, such as when the contract expires on the transaction date.

  • Mixing up the sign of the basis.

    Some sources define basis as futures minus spot.

    Fix: Use spot minus futures unless the question says otherwise, and write the definition at the top of your working.

  • Saying hedging always increases firm value.

    The pro-hedging arguments are memorised without the counterarguments.

    Fix: Remember that shareholders can diversify, hedging has costs, and a hedge can produce a loss on the futures even when the business benefits from the price move.

  • Forgetting that a hedge can lose money on the futures leg.

    Students judge the hedge by the futures P&L alone.

    Fix: Judge the combined position. A futures loss paired with a larger gain on the underlying is a successful hedge.

Worked examples

Example 1

In March a US oil producer expects to sell 100,000 barrels of crude oil in June. The June futures price is USD 80.00 per barrel. Each contract covers 1,000 barrels. The producer hedges with futures. In June the spot price is USD 74.00 and the June futures price is USD 74.50. What is the effective price per barrel, and what does the producer do?

Show the solution
  1. The producer will sell oil, so it needs a short hedge: sell 100,000 ÷ 1,000 = 100 June contracts.
  2. Futures gain per barrel = F1 − F2 = 80.00 − 74.50 = USD 5.50.
  3. Spot sale price = USD 74.00 per barrel.
  4. Effective price = 74.00 + 5.50 = USD 79.50 per barrel.
  5. Check with the basis: b2 = S2 − F2 = 74.00 − 74.50 = −0.50, so F1 + b2 = 80.00 − 0.50 = 79.50.

Answer: Short 100 June contracts. The effective price is USD 79.50 per barrel, or USD 79,50,000 in total on 100,000 barrels (7,950,000 in standard international grouping).

Example 2

In September an airline plans to buy 500,000 gallons of jet fuel in December. It uses heating oil futures, with each contract covering 42,000 gallons, and assumes a hedge of 12 contracts (about 504,000 gallons). The December futures price is USD 2.40 per gallon. In December the spot jet fuel price is USD 2.65 and the futures price is USD 2.70. What is the futures gain per gallon, and the effective price per gallon of fuel bought?

Show the solution
  1. The airline will buy fuel, so it needs a long hedge: buy 12 December contracts.
  2. Futures gain per gallon = F2 − F1 = 2.70 − 2.40 = USD 0.30.
  3. Spot cost = USD 2.65 per gallon.
  4. Effective cost = 2.65 − 0.30 = USD 2.35 per gallon.
  5. Check with the basis: b2 = 2.65 − 2.70 = −0.05, so F1 + b2 = 2.40 − 0.05 = 2.35.
  6. Total futures gain on 504,000 gallons = 0.30 × 504,000 = USD 151,200.

Answer: Long 12 contracts. The futures gain is USD 0.30 per gallon (USD 151,200 in total), and the effective cost is USD 2.35 per gallon, below the spot price of USD 2.65.

Exam tips

  • First decide who is exposed: a seller of the asset needs a short hedge and a buyer needs a long hedge. Many questions test only this.
  • When a question gives the final basis, use effective price = F1 + b2 and skip the long calculation.
  • For the why-hedge discussion, be ready with both sides: stable cash flows and lower distress costs for, and shareholder diversification, costs and competitive effects against.
  • Read carefully whether the answer asks for the futures gain, the effective price or the total amount, and whether the hedge is in contracts or in units.
  • Watch for statements that a hedge eliminates all risk. They are usually the wrong option, because basis risk remains.

Practice questions from Using Futures for Hedging

Basic Principles of Hedging with Futures in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Basic Principles of Hedging with Futures: frequently asked questions

What is the difference between a long hedge and a short hedge?

A short hedge sells futures to protect against a price fall, and suits someone who owns or will sell an asset. A long hedge buys futures to protect against a price rise, and suits someone who will buy an asset later.

Why do companies hedge with futures?

They want to reduce uncertainty about costs and revenues so they can plan, protect margins and lower the chance of financial distress. Futures are liquid, standardised and marked to market daily, which makes them a practical tool.

What are the arguments against hedging?

Shareholders can diversify away many risks on their own. Hedging has costs, and it can create losses on the futures when prices move in the firm's favour. If competitors do not hedge, a hedger can be left with a margin disadvantage when input and output prices move together.

Does a futures hedge lock in the price exactly?

Not always. The effective price is F1 + b2, where b2 is the basis when the hedge is closed. The price is exact only if that final basis is known, which is rare unless the contract expires when the transaction occurs.