5 DRM Future Hedging Strategies

Future Hedging Strategies
Introduction
• Many of the participants in futures markets are hedgers.
• This risk might relate to the price of oil, a foreign exchange

rate, the level of the stock market, or some other variable.
• A perfect hedge is one that completely eliminates the risk.

In practice, perfect hedges are rare.
• Issues associated with hedging are

– When is a short futures position appropriate?
– When is a long futures position appropriate?
– Which futures contract should be used?
– What is the optimal size of the futures position for
reducing risk?
Short Hedges
• A short hedge is a hedge that involves a short position in futures

contracts.
• A short hedge is appropriate when the hedger already owns an asset

and expects to sell it at some time in the future.
• short hedge can also be used when an asset is not owned right now
but will be owned at some time in the future.
• For example, a short hedge could be used by a farmer who owns some
grains and knows that they will be ready for sale at the local market in
two months.
• For example, a U.S. exporter who knows that he or she will receive
euros in three months. The exporter will realize a gain if the euro
increases in value relative to the U.S. dollar and will sustain a loss if
the euro decreases in value relative to the U.S. dollar. A short futures
position helps to offsetting the exporter's risk.
Short hedge pay-off
• On May 15, an oil producer has just negotiated a contract to sell
1 million barrels of crude oil. It has been agreed that the price
that will apply in the contract is the market price on August 15.
• If the spot rate is Rs.100 per barrel, he will be in loss of 2
million INR if future spot rate falls to Rs. 2/- per barrel and will
be in profit of Rs. 2 million if future spot rate goes up by Rs. 2/-
per barrel.
• Suppose he purchases a future contract on crude oil to sell 1

million barrels of crude oil at Rs. 99/- per barrel on 15th august,
then he can fix the fluctuation of price in future transaction.
• If the future spot rate goes up to Rs.105/- per barrel, what will
the amount of loss?
• If the future spot rate goes up to Rs. 95/- per barrel, what will
the amount of loss?
Long Hedges
• 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 asset in the future and wants to
lock in a price now.
• Suppose that it is now January 15. A copper fabricator
knows it will require 100,000 pounds of copper on May 15
to meet a certain contract. The spot price of copper is 140
cents per pound, and the May futures price is 120 cents
per pound.
• The fabricator can hedge its position by taking a long
position in four May futures contracts and closing its
position on May 15.
• Each contract is for the delivery of 25,000 pounds of
copper.
• Suppose the price of copper on May 15 proves to be 125
cents per pound, this should be very close to the
futures price. The fabricator therefore gains
approximately
100,000 x ($1.25 - SI.20) = $5,000
alternative outcome, suppose the futures price is 105

cents per pound on May 15. The fabricator then loses
approximately
100,000 x ($1.20 - $1.05) = $15,000

ARGUMENTS FOR AND AGAINST
HEDGING
• Most companies have no particular skills or expertise in
predicting variables such as interest rates, exchange
rates, and commodity prices.
• It makes sense for them to hedge the risks associated with

these variables as they arise. The companies can then
focus on their main activities—in which presumably they
do have particular skills and expertise.
• y hedging, they avoid unpleasant surprises such as sharp

rises in the price of a commodity.
Hedging and Shareholders
• the shareholders can, if they wish, do the hedging
themselves. They do not need the company to do it for
them.
• shareholders can do far more easily than a corporation
diversify risk.
Hedging and Competitors
• A company that does not hedge can expect its profit

margins to be roughly constant. However, a company
that does hedge can expect its profit margins to
fluctuate!
BASIS RISK
• Basis risk is a type of risk associated with the future hedging.
• Basis = Spot price of asset to be hedged - Futures price of

asset
• 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.
• Prior to expiration, the basis may be positive or negative.
• 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.
Figure illustrates how a basis might change over time in a situation where the
basis is positive prior to expiration of the futures contract.
Notations for basis risk
• 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
• Effective price obtained from hedging is
S2 + F1 - F2 = F1+ b2
• Example 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 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 $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 spot price and futures price on November 10 are
$20.00 per barrel and $19.10 per barrel. The gain on the
futures contract is 19.10 — 18.00 = $1.10 per barrel. The basis
when the contract is closed out is 20.00 — 19.10 = S0.90 per
barrel. The effective price paid (in dollars per barrel) is the final
spot price less the gain on the futures, or
• 20.00- 1.10 = 18.90
• This can also be calculated as the initial futures price plus the
final basis:
• 18.00 + 0.90= 18.90
• The total price received is 18.90 x 20,000 = $378,000.
• Example: 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 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 0.7800 and that the spot and futures
prices when the contract is closed out are 0.7200 and 0.7250,
respectively. The gain on the futures contract is 0.7800 — 0.7250
= 0.0550 cents per yen. The basis is 0.7200 - 0.7250 = —0.0050
cents per yen when the contract is closed out. The effective price
obtained in cents per yen is the final spot price plus the gain on
the futures:
• 0.7200 + 0.0550 = 0.7750
• The total amount received by the company for the 50 million yen
is 50 x 0.00775 million dollars, or $387,500.
Choice of contract
• This choice has two components:
1. The choice of the asset underlying the futures
contract.
2. The choice of the delivery month
• If the asset being hedged exactly matches an asset

underlying a futures contract, the first choice is generally
fairly easy.
• In other circumstances, 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.
Cross Hedging
• Normally, futures are not designed on all types of assets
(financial/ commodity).
• Cross hedging occurs when the asset hedged and the

underlying assets are both different.
• For example, an airliner may be interested for hedging

future prices of Jet Fuel. As the jet fuel is not actively
traded in future exchange, the airliner will use other Crude
oil future to hedge its exposure in Jet Fuel.
Hedge ratio
• Hedge ratio is the ratio of the size of the position taken in the
future contract to the size of the exposure.
• When the asset underlying the future contract is the same as

the asset being hedged, the hedge ratio is normally 1.0.
• Example: When the 20,000 barrels of crude oil is to be

purchased where one crude oil future contains 1000 barrels of
crude oil, 20 crude oil futures can be purchased to hedge the
position . Here the hedge ratio is 1.0.
• But under cross hedge, an optimal hedge ratio will not be

exactly equal to 1.0.
• Here the hedger chooses a value of minimal variance hedge
ratio that minimises the variance of the value of the hedged
asset.
h*= 0.78

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Future Hedging Strategies

• This risk might relate to the price of oil, a foreign exchange

• A perfect hedge is one that completely eliminates the risk.

• Issues associated with hedging are

• A short hedge is a hedge that involves a short position in futures

• A short hedge is appropriate when the hedger already owns an asset

• Suppose he purchases a future contract on crude oil to sell 1

alternative outcome, suppose the futures price is 105

100,000 x ($1.20 - $1.05) = $15,000

• It makes sense for them to hedge the risks associated with

• y hedging, they avoid unpleasant surprises such as sharp

• A company that does not hedge can expect its profit

• Basis risk is a type of risk associated with the future hedging.

• Basis = Spot price of asset to be hedged - Futures price of

• If the asset to be hedged and the asset underlying the futures

• Effective price obtained from hedging is

• If the asset being hedged exactly matches an asset

• In other circumstances, it is necessary to carry out a

• Cross hedging occurs when the asset hedged and the

• For example, an airliner may be interested for hedging

• When the asset underlying the future contract is the same as

• Example: When the 20,000 barrels of crude oil is to be

• But under cross hedge, an optimal hedge ratio will not be

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