DERVFOP - Lecture 3

Hedging Strategies Using Futures

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Perfect hedge

I O
One that completely eliminates the risk.
Very rare to do.
Hedge-and-forget strategies – hedger simply
P takes a futures position at the beginning of the
life of the hedge and closes out the position at
the end of the life of the hedge.

dynamic hedging strategy

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 buy sell
Long & Short Hedges
A long futures hedge is appropriate when you
know you will purchase an asset in the future
and want to lock in the price
A short futures hedge is appropriate when you
know you will sell an asset in the future and
want to lock in the price

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Arguments in Favor of Hedging

Companies should focus on the main

business they are in and take steps to
minimize risks arising from interest rates,
exchange rates, and other market variables

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Arguments against Hedging

Shareholders are usually well diversified and

can make their own hedging decisions
It may increase risk to hedge when
competitors do not
Explaining a situation where there is a loss on
the hedge and a gain on the underlying can
be difficult

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Basis Risk
Basis is usually defined as the spot price
minus the futures price
Basis risk arises because of the uncertainty
about the basis when the hedge is closed
out
Basis = Spot price of asset to be hedged -
Futures price of contract used

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 Basis Risk
Strengthening of the basis – an increase in
the basis
Weakening of the basis – decrease in the
basis

Short hedge long hedge

basis strengthens o improves basis strengthens D position
worsens

weakens D worsens weakens D improves

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 yb
Long Hedge for Purchase of an Asset

Define
F1 : Futures price at time hedge is set up
F2 : Futures price at time asset is purchased ty
S2 : Asset price at time of purchase t
b2 : Basis at time of purchase t

Cost of asset S2
es Gain on Futures F2 −F1

OO
Net amount paid S2 − (F2 −F1) =F1 + b2

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Short Hedge for Sale of an Asset

Define
F1 : Futures price at time hedge is set up
F2 : Futures price at time asset is sold
S2 : Asset price at time of sale En
b2 : Basis at time of sale
te
Price of asset S2
Gain on Futures F1 −F2
Net amount received S2 + (F1 −F2) =F1 + b2
O
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 Asst o
Delivery month
Choice of Contract

Choose a delivery month that is as close as

possible to, but later than, the end of the life
of the hedge March June Sept December
When there is no futures contract on the
asset being hedged, choose the contract
whose futures price is most highly correlated
with the asset price. This is known as cross
hedging.

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 Example 3.1 short hedge
It is March 1. A U.S. company expects to receive 50 million
O
Japanese yen at the end of July. Yen futures contracts on the CME
Group have delivery months of March, June, September, and
December. One contract is for the delivery of 12.5 million yen. The
company therefore shorts four September yen futures contracts on
March 1. When the yen are received at the end of July, the company
closes out its position. We suppose that the futures price on March 1
in cents per yen is 1.0800 and that the spot and futures prices when
the contract is closed out are 1..0200 and 1.0250, respectively.
F 1.0800
99in F p Sox 1.0750

f4
Fa 1.0750 1 0800 1.0250 D
0200
4537,500
Si a 1
059name
b 198500
sio
amount received
i orso net net amount received
010050 S t gain I 0800 C o 00507
1.0200 t 6.0550 7 0750
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 Example 3.2 long hedge
t F
It is June 8 and a company knows that it will need to purchase

a
20,000 barrels of crude oil at some time in October or November. Oil
futures contracts are currently traded for delivery every month by the
CME Group and the contract size is 1,000 barrels. The company
therefore decides to use the December contract for hedging and
takes a long position in 20 December contracts. The futures price on
June 8 is $48.00 per barrel. The company #nds that it is ready to
purchase the crude oil on November 10. It therefore closes out its
futures contract on that date. The spot price and futures price on
November 10 are $50.00 per barrel and $49.10 per barrel.

F 48 99in F F Tpgindant St gain

Fu 49.10 spy gg 50 1.10
Sit 50,00
P M

ggtfg
be 50 49.10
q.si I 48.90 12
 CROSS HEDGING
- In the previous examples (3.1 and 3.2), the asset
underlying the futures contract was the same as the
asset price whose price is being hedged.
- Cross hedging occurs when the two assets are
different.
- Example: jet fuel futures are not actively traded,
company could choose to use heating oil futures
contracts to hedge its exposure

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 CROSS HEDGING
- Hedge ratio – is the ration of the size of the position
taken in futures contracts to the size of the exposure.
- When the asset underlying the futures contract is the
same as the asset being hedged, it is natural to use a
hedge ratio of 1.0
- When cross hedging is used, setting the hedge ratio
equal to 1.0 is not always optimal. The hedger should
choose a value for the hedge ratio that minimizes the
variance of the value of the hedged position.

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 Minimum Variance Hedge ratio

Optimal Hedge Ratio (equation 3.1)

Ignoring daily settlement of futures (or assuming
forwards are used) , the proportion of the exposure
that should optimally be hedged is
sS

O
*
h =r
where sF

sS is the standard deviation of DS, the change in the

spot price during the hedging period,
sF is the standard deviation of DF, the change in the
futures price during the hedging period
r is the coefficient of correlation between DS and DF.

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Optimal Number of Contracts (equation 3.2)
∗
∗
ℎ 𝑄𝐴
𝑁 =
𝑄𝐹
where
QA is the size of the position being hedged
(units)
QF is the size of one futures contract (units)

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Example 3.3 D heating oil contract
42,000
An airline expects to purchase 2 million gallons of jet fuel in 1 month
and decides to use heating oil futures for hedging. We suppose that
for 15 successive months, data on the change, ∆S, in the jet fuel
price per gallon and the corresponding change, ∆F, in the futures
price for the contract on heating oil that would be used for hedging
price changes during the month. In this case, the usual formulas for
calculating standard deviations and correlations give 𝜎𝐹 = 0.0313, 𝜎𝑠
= 0.0263, and 𝜌= 0.928

OF 0.0313 H PET 0.9289 33

Os 0.0263
0 78
P 0.928
n 0.78 f 7,000,000
Nt I 42,000
W 3
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Example 3.3

Airline will purchase 2 million gallons of jet

fuel in one month and hedges using heating
oil futures
From historical data sF =0.0313, sS =0.0263,
and r= 0.928

O
0.0263
h = 0.928 
*
= 0.78
0.0313

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Example 3.3
The size of one heating oil contract is 42,000 gallons
Optimal number of contracts is
= 0.78  2, 000, 000 42, 000
which rounds to 37

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Optimal Number of Contracts When
Contract Is Settled Daily

𝜎ො𝑆 𝑆𝑄𝐴
O
= 𝜌ෝ𝑁∗
𝜎ො𝐹 𝐹𝑄𝐹
where variables are defined as follows

r̂ Correlation between percentage daily changes for

spot and futures
sˆ S SD of percentage daily changes in spot

sˆ F SD of percentage daily changes in futures

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An Alternative Expression for N* when
there is daily settlement (equation 3.3)

a
𝑉𝐴
𝑁∗ = ℎ෠
𝑉𝐹
where
VA is the value of the position being hedged (= SQA)
VF is the futures price times the size of one
contract(= FQF)
and we use with a new hedge ratio
𝜎ො𝑆
ℎ෠ = 𝜌ෝ
𝜎ො𝐹
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Example 3.4 (daily settlements)
Consider another situation where 2 million gallons of jet fuel is being
hedged with heating oil futures. Suppose that the spot and futures
price are 1.10 and 1.30, respectively. In this case, 𝑉𝐴 = 2, 000, 000 *
1.10 = 2, 200, 000 while 𝑉𝐹 = 42,000 * 1.30 = 54,600. If 𝜌ො = 0.8, what
is the optimal number of contracts for a one-day hedge?
1.70 21200 00
VA 2,000 00 T
VF 42,000 x 1 30 54,600

N G8 X 2,200,000
32 23
54 600
WE
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Daily Settlement

Day to day changes in N* are small and often

ignored
Tailing the hedge involves dividing N* by one
plus the amount of interest that will be earned
over the remaining life of the hedge

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Hedging Using Index Futures
(equation 3.4)

To hedge the risk in a portfolio the number of

contracts that should be shorted is
∗
𝑉𝐴
𝑁 =𝛽
𝑉𝐹
where VA is the value of the portfolio, b is its
beta, and VF is the value of one futures contract

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Example 3.5
Index level = 1,000
Index futures price = 1,010
Value of portfolio = $5,050,000
Beta of portfolio = 1.5
One futures contract is for delivery of $250 times the index.
- What position in futures contracts on the index is necessary to
hedge the portfolio?

5,059000
NE BYE 1s 252,500

VE 250 X 1,010
252 500
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Example 3.5 (cont.)
Index level = 1,000
Index futures price = 1,010
Value of portfolio = $5,050,000
Beta of portfolio = 1.5
One futures contract is for delivery of $250 times the index.
- Suppose the index turns out to be 900 in 3 months and the
futures price is 902.

N x quin x 250
F F
30 X x 250 810,000
11010 901

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Changing Beta
What position is necessary to reduce
the beta of the portfolio to 0.75?
What position is necessary to increase
the beta of the portfolio to 2.0?

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Why Hedge Equity Returns
May want to be out of the market for a while.
Hedging avoids the costs of selling and
repurchasing the portfolio
Suppose stocks in your portfolio have an
average beta of 1.0, but you feel they have
been chosen well and will outperform the
o
market in both good and bad times. Hedging
ensures that the return you earn is the risk-
free return plus the excess return of your
portfolio over the market.

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Stack and Roll

We can roll futures contracts forward to

hedge future exposures
Initially we enter into futures contracts to
hedge exposures up to a time horizon
Just before maturity we close them out and
replace them with new contract reflect the
new exposure
etc

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