Topic 5 Hedging Strategies Using Futures

I. Basics of Hedging

1.1. A Simplest Example

Hedging in futures markets is to use futures markets to reduce a particular risk that
they face. This risk might relate to the price of oil, foreign exchange rate, the level of the
stock market, etc.

The easiest case in using futures to hedge a position is when the futures contract
(1) is written on precisely the asset you wish to hedge; and
(2) the contract matures at the same time as your investment horizon.

In this case, you simply buy or sell enough futures to offset your current position. We
have seen this kind of hedging strategy in earlier discussion.

For example,
Hold one unit of stock ST
Sell a futures contract on stock F0-ST
---------------------------------------- -----------
Total F0

In this way, we can lock in a stock price of F0 at time T.

1.2. Long Hedge and Short Hedge

A hedge that involves a short position in futures contracts is called a short hedge, while
a hedge that involves taking a long position in a futures contract is known as long hedges.

Examples: table 4.1 short hedge; table 4.2 long hedge on pages 75-76 of Textbook 4th
edition; or trading notes 3.1 and 3.2 on pages 48-49 of Textbook 5th edition.

Example: Naïve hedge for index futures

Suppose the futures price today for 6-month delivery is 1025, and the stock index
value is 1000. You hold $2.5 million of market index. How many futures contracts
should you sell to hedge?

Suppose the contract multiplier is $250. This means that the contract gives the same
exposure to the market as $250*1000=$250,000 worth of stock. For example, if the
market rises by 10 points (1%), the profit on each contract will be $250*10=$2,500. This
is the same profit as would be earned on a $250,000 indexed stock portfolio.

This holding of stocks will produce profits to you once the stock index rises up, but
incurs loss once the stock index drops down. This is where hedging can play a role in
reducing risk. Since you bought and hold the market index, to offset your exposure, you

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should enter the short side of $2,500,000/$250,000=10 contracts. (note: each short future
= $250*1000)

Suppose that in 6 months, the index is either 950 or 1050, we can have the following
profitability figures.

Index=950 Index=1050
stock holdings $2,375,000 $2,625,000
futures profits 187,500 ( 62,500)
------------------- ---------------- -------------------
TOTAL $2,562,500 $2,562,500

where
stock value=ST/S0 * initial value = Index value/1000*$2,500,000

[we assume for simplicity that dividends = 0]

futures profits = 10 contracts * 250 *(F0-ST)

= 10 contracts * 250 * (1025- final index value)

So, through hedging, you have locked in a risk-free return of 2.5%, which equals
1,025/1,000-1=F0/S0 - 1.

We may view the hedge ratio in this example as

(Value of stock held)/(Value of one contract on stock index (S&P))

=($2,500,000)/(1000 * 250) = 10 contracts = "Naive" hedge.

In this case, you want to sell futures in an amount equal to your holdings of the asset
you wish to hedge.

II. Basis Risk

2.1 Basis risk

The hedges in our examples considered so far have been almost too good to be true.
The hedger was able to identify the precise date in the future when an asset would be
bought or sold. The hedger was then able to use futures contracts to remove almost all the
risk arising from the price of the asset on that date. In practice, hedging is often not quite
as straightforward. Some of the reasons are as follows:

1. The asset whose price is to be hedged may not be exactly the same as the asset
underlying the futures contract.

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 2. The hedger may be uncertain as to the exact date when the asset will be bought or
sold.

3. The hedge may require the futures contract to be closed out well before its
expiration date.
These problems give rise to what is termed basis risk.

The basis in a hedging situation is defined as:

Basis = Spot price of asset to be hedged - Futures price of contract used

If the asset to be hedged and the asset underlying the futures contract are the same, the
basis should be zero at the expiration of the futures contract.

When the spot price increases by more than the futures price, the basis increases. This
is referred to as a strengthening of the basis. When the futures price increases by more
than the spot price, the basis declines. This is referred to as a weakening of the basis.

To examine the nature of basis risk, we will use the following notation:
S1: spot price at time t1
S2: spot price at time t2
F1: futures price at time t1
F2: futures price at time t2
b1: basis at time t1
b2: basis at time t2

We will assume that a hedge is put in place at time t1 and closed out at time t2.

As an example, let S1=2.50, F1=2.20, S2=2.00, and F2=1.90.

From the definition of the basis,

b1 = S1-F1 and
b2 = S2-F2
and in our example, b1 = 0.30 and b2 = 0.10.

Consider first the situation where a hedger knows that the asset will be sold at time t2 and
takes a short position at time t1. The price realized for the asset is S2, and the profit on the
futures position is F1-F2. The effective price that is obtained for the asset with hedging is
therefore
S2 + F1 – F2 = F1 + b2

The effective price can be regarded as the price that the hedger pays earlier (F1) minus
the profit from the short hedge (F2-S2). In our example, this is $2.30.

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 The value of F1 is known at time t1. If b2 were also known at this time, a perfect hedge
would result. The hedging risk is the uncertainty associated with b2 and is known as
basis risk.

Consider next a situation where the company knows it will buy the asset at time t2 and
initiates a long hedge at time t1. The price paid for the asset is S2 and the loss on the
hedge is F1-F2. The effective price that is paid with hedging is therefore
S2 + F1- F2 = F1 + b2

This is again $2.30 in the example. The value of F1 is known at time t1 and the term b2
represents basis risk.

2.2 Choice of futures contract for hedging

Two considerations dominate the issue of the choice of futures contract for hedging
purpose.

1. Choice of the asset underlying the futures contract.

If the asset being hedged exactly matches an asset underlying a futures contract, it
becomes a natural choice. In other circumstances, it is conventional to choose future
contracts that has futures prices that are most closely correlated with the price of the asset
being hedged.

2. The choice of the delivery month

A good rule of thumb is to choose a delivery month that is as close as possible to, but
later than, the expiration of the hedge. Suppose delivery months are March, June,
September, and December for a particular contract. For hedge expirations in December,
January, and February, the March contract will be chosen.

2.3 Illustrative Examples of Basis Risk

Illustrative Example 1: (Textbook 4th edition: page 82-83, table 4.4; Textbook 5th edition:
page 56 Trading Note 3.3)
Suppose it is March 1. A U.S. company expects to receive 50 million Japanese yen at the
end of July. Yen futures contracts on the Chicago Mercantile Exchange have delivery
months of March, June, September, and December. One contract is for the delivery of
12.5 million yen. The company will choose the September contract for hedging purposes.

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. The basis risk
arises from uncertainty about the difference between the futures price and the spot price
at this time. We suppose that the futures price on March 1 in cents per yen is 0.7800 and
that the spot and futures prices when the contract is closed out are 0.7200 and 0.7250,
respectively. The basis is –0.0050, and the gain from the futures contracts is 0.0550. The
effective price obtained in cents per yen is the spot price plus the gain on the futures:
0.7200 + 0.0550 = 0.7750

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This can also be written as the initial futures price plus the basis:
0.7800 – 0.0050 = 0.7750

The company receives a total of 50*0.00775 million dollars, or $387,500.

Illustrative Example 2: (Textbook 4th edition: page 83-84, table 4.5; Textbook 5th edition:
page 57,Trading Note 3.4)
Suppose it is June 8, and a company knows that it will need to purchase 20,000 barrels of
crude oil at some time in October or November. Oil futures contracts are currently traded
for delivery every month on NYMEX, and the contract size is 1,000 barrels. The
company decides to use the December contract for hedging. On June 8 it takes a long
position in 20 December contracts. At that time, the futures price is $18.00 per barrel.
The company finds that it is ready to purchase the crude oil on November 10. It therefore
closes out its futures contract on that date. The basis risk arises from uncertainty as to
what the basis will be on the day the contract is closed out. We suppose that the spot
price and futures price on November 10 are $20.00 per barrel and $19.10 per barrel,
respectively. The basis is therefore $0.90, and the effective price paid is $18.90 per barrel,
or $378,000 in total. This example is summarized in Table 4.5.

2.4 Basis Risk across Assets

For investment assets such as currencies, stock indices, gold, and silver, the basis risk
tends to be much less than for consumption commodities. The reason is that arbitrage
arguments lead to a well-defined relationship between the futures price and the spot price
of an investment asset. The basis risk for an investment asset arises mainly from
uncertainty as to the level of the risk-free interest rate in the future. In the case of a
consumption commodity, imbalances between supply and demand and the difficulties
sometimes associated with storing the commodity can lead to large variations in the
convenience yield. This in turn leads to a big increase in the basis risk.

III. Cross-Hedge

If the asset being hedged doesn't match exactly an asset underlying a futures contract,
it is necessary to carry out a careful analysis to determine which of the available futures
contracts has futures prices that are most closely correlated with the price of the asset
being hedged.

One way to do it is to do cross-hedge. Usually if an investor forms a portfolio, there

won’t necessarily be futures contract on that portfolio available in the market. But the
portfolio is correlated with the market portfolio represented by the index portfolio, then
we can use the futures contract written on the index portfolio to cross hedge the own
portfolio.

Example: Non-indexed stock portfolio

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 Suppose that the portfolio beta is 0.6 and the portfolio is initially worth $2,500,000.
Then for every 1% move in the value of the index, your stock portfolio will move by
0.6% (on average). For example, if the HSI index falls by 25 (from 1000 to 975), a drop
of 2.5%, you would expect your portfolio to fall by 1.5%, from $2.5 million to
$2,462,500. Then it should not be surprising that we scale our hedge position down by
0.6, therefore selling only 6 contracts.

Hence, if our stock portfolio is $2.5 million, we need to sell $2.5 million *0.6 =
$1,500,000 worth of HSI index, which requires that we sell $1,500,000/(1,000*250)=6
contracts, which is 0.6 the number of contracts when the portfolio was indexed. You can
think of this as a volatility-adjusted hedge position:

Adjusted hedge = Naive hedge * relative volatility

We scale the "naive" hedge position (which would hold equal dollar amounts in the
stock and the futures) by the relative volatility of the portfolio and the contract.
[loss on stock 2.5million*1.5%; gain on futures: 6*250*25=37,500]

IV. Minimum Variance Hedge Ratio

How do we estimate the volatility adjustment?

An obvious choice is regression analysis. In fact this is how stock betas are estimated.
We would like to mention a few points.

First, we know from regression theory that the estimate of the beta of a stock portfolio
is
= Cov(rp, rHSI)/(σ2HSI) =  p / σHSI

where  is the correlation coefficient between portfolio return and the HS index return.

This formula for beta is also the solution to a direct variance-minimizing approach to
the hedging problem.

If the investment in the portfolio is Ip, and we hedge by selling H futures contracts,
each with nominal value N, then hedged revenues, R, will be

R(hedged)=rpIp + HN[rHSI - r]

Var[R(hedged)]=σp²Ip² + (HN)²σHSI2 + 2HNIpCov(rp, rHSI)

To minimize variance with respect to H, we differentiate and set equal to zero:

(dVar)/(dH)) = 2HN²σ2HSI - 2NIpCov(rp, rHSI) = 0

So, H= (Ip / N) (Cov(rp, rHSI))/(σ²HSI))

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 = "Naive hedge" * regression slope (i.e. portfolio beta)

In fact, the regression is designed to minimize the sum of squared residuals, so it

makes sense that the regression slope minimizes the variance of the return on the hedged
position. The "least squares" criterion is also a "least basis risk" criterion, at least if we
measure basis risk by the variance of the hedged return.
[This formula is equivalent to formula 4.2 on page 86.]

Example: Textbook 4th edition: Question 4.18 on page 95; Textbook 5th edition: Question
3.18 on page 72.

VI. Stock Index Futures

Stock index futures can be used to hedge an equity portfolio.

Define P: current value of the portfolio;

A: current value of the stocks underlying one futures contract

If the portfolio mirrors the index, a hedge ratio of 1 is clearly appropriate, and the
number of futures contracts that should be shorted is N* = P/A.

When the portfolio does not exactly mirror the index, we can use the beta from the
CAPM to determine the appropriate hedge ratio. Beta again is the slope of the best-fit line
obtained when excess return on the portfolio over the risk-free rate is regressed against
the excess return of the market over the risk-free rate.

Assuming that the index underlying the futures contract is a proxy for the market, then
N* = β(P/A).

Example: suppose that

Value of S&P 500 index = 1,000
Value of portfolio = $5,000,000
Risk-free interest rate = 10% per annum
Dividend yield on index = 4% per annum
Beta of the portfolio = 1.5

We assume that a futures contract on the S&P 500 with four months to maturity is used
to hedge the value of the portfolio over the next three months. One futures contract is for
delivery of $250 times the index. The current futures price should be
1000exp((0.10-0.04)*4/12) = 1,020.20

The number of futures contract that should be shorted to hedge the portfolio is
1.5*(5,000,000)/(250,000) = 30

Suppose the index turns out to be 900 in three months. The futures price will be

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 900exp((0.10-0.04)*1/12) = 904.51

The gain from the short futures position is therefore

30*(1020.20-904.51)*250 = $867.

V. Hedging Effectiveness

A common question: is the hedged position riskless?

No. You have hedged out the exposure to market risk, but you have not eliminated the
exposure to non-market uncertainties. Think back to the measurement of the beta of a
stock using the index model regression. The beta is the slope of the line, but there is
scatter around the line. That scatter represents the impact of non-market risk factors that
obviously cannot be offset by taking positions in the market index.

Algebraically,
r = α+ βrM + e, where e is firm-specific risk.

Var(r) = Var(βrM )+ Var(e) = β²σM2 + σ²(e)

= systematic risk + non-systematic risk

By hedging, you reduce the portfolio beta to zero, but the non-systematic risk remains.
The non-systematic risk that remains is the basis risk. It is the risk surrounding the
relationship between the spot price and the futures price. In the simple case that the
futures contract is written on the asset to be hedged, basis risk would be minimal or non-
existent because the parity relationship would tie the futures price to the spot price.

Measure of hedging effectiveness

Proportion of risk eliminated through hedging.

Recall that the R-squared tells us the proportion of total volatility explained by the
right-hand-side variables in a regression. In this context,

R-squared = (Systematic risk)/(Total risk)

= (Risk of unhedged position – Residual risk of hedged position) / (Risk of
unhedged position))
= 1 - (Residual risk)/(Total risk)
= “Hedging effectiveness”

A high R-squared means that most of the volatility is due to market factors and
therefore can be hedged. (Notice also that for the single-factor regression, the R-squared
is the square of the correlation coefficient between the firm and the market index returns.
High correlation means that the hedge will be effective.)

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 In practice, the hedge will be effective for well-diversified portfolios but not for
single stocks.

V. Points to Remember
After learning this topic, you should understand what long hedge and short hedge are, and
what the basis risk is in long and short hedge. You should be able to distinguish between
the naïve hedge, adjusted hedge in cross-hedge, and the minimum variance (optimal)
hedge ratio. You are also expected to be able to apply the optimal hedging ratio to stock
index hedging.