Hedging Strategies Using Futures

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Hedging Strategies Using Futures

 ISSUES

 ASSUME

3.1 Basic Principle

3.2 Arguments For and Against Hedging

3.3 Basis Risk

3.4 Cross Hedging

3.5 Stock Index Futures

3.6 Rolling the Hedging Forward


ISSUES

1. When is a short futures position appropriates ?

2. When is a long futures position appropriate ?

3. Which futures contract should be used ?

4. What is the optimal size of the futures position for reducing risk ?
ASSUME

1 Hedge-and forget

2 Futures contracts as forward contracts


3.1 Basic Principles-Short Hedge ( 空頭避險 )
3.1 Basic Principles-Long Hedge ( 多頭避險 )

Hedges that involve taking a long position in a futures contract are


known as long hedges.

A long hedge is appropriate when a company knows it will have to


purchase a certain assets in the future and wants to lock a price now.

Long hedge can be used to manage an existing short position.


3.2 Arguments For and Against Hedging

• Hedging and Shareholders

1 Shareholders can do the hedging themselves.

It assumes that shareholders have as much


2 information about the risks faced by a company
as does the company’s management.

Shareholders can do far more easily than


3
a corporation is diversify risk.
3.2 Arguments For and Against Hedging

• Hedging and Competitors


3.2 Arguments For and Against Hedging

All implications of price changes on a company’s


profitability should be taken into account in the
design of a hedging strategy to protect against the
price changes.
3.3 Basis Risk

1 The asset whose price is to be hedged may not be exactly


the same as the asset underlying the futures contract.

2 The hedger may be uncertain as to the exact when the


asset will be bought or sold.

The hedge may require the futures contract to be closed


3
out before its delivery month.

These problem gives rise to what is termed basic risk.


3.3 Basis Risk

The basis in a hedging situation is as follows:


Basis = Spot price of asset to be hedged – Futures price of contract used
=S–F

An increase in the basis is referred to a strengthening of the basis


.

A decrease in the basis is referred to as a


weakening of the basis
3.3 Basis Risk
Suppose that
F1 : Initial Futures Price
Spot price F2 : Final Futures Price
S1
S2 : Final Asset Price
b1
b1 = S1 –F1
b2 =S2– F2
F1
Long Hedge :
Futures price S2
b2 You hedge the future purchase of an asset by entering into a

F2 long futures contract


The effective price( 有效支付價格 ) that is paid with hedge is
S2 + F1 – F2 = F1 + b2
basis risk( 基差風險 )
Short Hedge :
You hedge the future sold of an asset by entering into a short
t1 t2 futures contract

Figure 3.1 Variation of basic over time The effective price( 有效價格 ) that is obtained for the asset with
hedge is S2 + F1 – F2 = F1 + b2
3.3 Basis Risk

Choice of Contract

One key factor affecting basis risk is the choice of the futures contract to be used
for hedging. This choice has two components:
1.The choice of the assets underlying the futures contracts
2.The choice of the delivery month

A contract with a later delivery month is


usually chosen in these circumstances.
3.4 Cross Hedging
Calculating the Minimum Variance Hedge Ratio ( 最
小變異的避險比率 )

S
h*  
F
h* : Hedge ratio that minimizes the variance of the hedger’s position.
 : Coefficient of correlation between ΔS and ΔF
ΔS : Change in spot price, S, during a period of time equal to the life of the hedge.
ΔF : Change in future price, F, during a period of time equal to the life of the hedge.
σS : Standard deviation of ΔS

σF : Standard deviation of ΔF
3.4 Cross Hedging
Optimal Number of Contracts ( 最
適契約數量 )

h* NA
N*  The futures contracts used should
QF have a face value of h* NA

NA : Size of position being hedged (unit)

QF : Size of one futures contract (unit)


N* : Optimal number of futures contracts for hedging
3.5 Stock Index Future

Hedging Using Stock Index Futures

P
N*  
A
N*: Optimal number of futures contracts for hedging
P : Current value of the portfolio
A : Current value of one futures contract
β : From the capital asset pricing model to determined
the appropriate hedge ratio
3.5 Stock Index Future

Example

Value of S&P 500 index =1000


S&P 500 futures price =1010
Value of portfolio = $5,000,000
Risk-free interest rate = 4% per annum
Dividend yield on index = 1% per annum One future contract is for
Beta of portfolio = 1.5 delivery of $250 times the index

Current value of one futures contract = 250*1000 = 250,000

Optimal number of futures contracts for hedging


P  5,000,000 
N*    1.5     30
A  250,000 
3.5 Stock Index Future

Value of index in
900 950 1 ,000 1,050 1,100
three months :
Time to maturity
Futures price of
1,010 1,010 1,010 1,010 1,010
index today : 1
( 0.04  0.01)
Futures price of index in
902  900952
e 1,003
12
1,053 1,103
three months :
The gain from the short futures position
Gain on futures position = 30* ( 1,010 – 902 ) *250 = $ 810,000
810,000 435,000 52,500 – 322,500 – 697,500

•The loss on the index = 10 %
Return on market : – 9.750% •The
– 4.750%
index pays a
0.250%of 0.25%per
dividend
5.250%3
10.250%
months
• The risk-free interest rate = 1 % per 3 months
Expected return
– 15.125% ••An investor in the
– 7.625%
Expected
index would earn
return–on0.125%
portfolio
= – 9.75 %
7.375% 14.875%
on portfolio :
==$15,000,000*(1
+ 1.5*( – 9.75– –0.15125) = $4,243,750
1 ) = – 15.125 %
Expected portfolio value
in three months 4,243,750 4,618,750 4,993,750 5,368,750 5,743,750
(including dividends) : =$ 4,243,750 + $810,000

Total expected value of


position in three months 5,053,750 5,053,750 5,046,250 5,046,250 5,046,250

3.5 Stock Index Future

Reasons for Hedging an Equity Portfolio

A hedge using index futures removes the risk arising from market and leaves
the hedger exposed only to the performance of the portfolio relative to the
market.

The hedger is planning to hold a portfolio for a long period of time and requires
short-term protection.
3.5 Stock Index Future

Changing the Beta of a Portfolio

 To reduce the beta of the portfolio to 0.75

P 5,000,000
(    *)  (1.5  0.75)  15( short )
A 250,000
 To increase the beta of the portfolio to 2.0

P 5,000,000
(  *   )  (2  1.5)  10(long )
A 250,000
3.5 Stock Index Future

Exposure to the Price of an Individual Stock

 Similar to hedging a well-diversified stock portfolio

 The performance of the hedge is considerably worse,


only against the risk arising from market movements
3.6 Rolling The Hedge Forward

 This involves entering into a sequence of futures


contracts to increase the life of a hedge

 Rollover basis risk

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