Question

We are going to hedge oil, for a bank that has made huge loans to oil producing companies. If the bank wants to protect itself against default by borrower. Should the bank be long or short the futures contract? Explain why you recommend either a long position or a short position IN DEPTH, no short superficial answers.

Answer 1

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Hedge means protection of oneself from a specific event or risk by way of gaining from it.

Oil companies make a profit with oil prices go up, when oil prices crash then it is not profitable for oil making companies.

There is a huge chance of default by oil-producing companies when oil prices crash down.

So, Bank faces loan default when oil prices crash.

It needs to protect itself from oil prices crash.

SO IT NEEDS TO TAKE SHORT POSITION IN THE FUTURES CONTRACT.

As Bank will get money from SHORT POSITION when prices go down. Its loan default is hedged by a certain extent by short position.