Hedging Strategies Using Futures

RM 1
Principles of Hedging

 A party faces a loss when the price of some asset changes—they

want to reduce this loss by trading futures contracts

 Hedging is done to lock in a price at the current time for a future

transaction

 Hedging helps in forecasting future cash flows with some certainty

RM
Perfect and Imperfect Hedges

 A perfect hedge is achieved when price uncertainty is

fully eliminated and the hedger knows for certain what
the future cash flow will be

 An imperfect hedge is a partial hedge in which the price

uncertainty is reduced but not fully eliminated

RM
Issues in Hedging
 What quantity of assets would be subjected to loss if the
price changes?

 When would losses accrue, i.e. when prices increase or

decrease?

 What futures contract would provide a hedge against

this loss?

 How many futures contracts would be needed to hedge?

RM
Deciding the Hedge
 The hedger needs to decide the type of hedge,
depending upon whether increases or decreases in the
asset price will result in a loss

 Under a hedge, any loss arising from the asset would be

compensated by gain from the futures contract

 The hedger will take an opposite position to the

position he has in the asset

RM
 When a party holds the underlying assets – it is said LONG on spot
market
 Eg. Jeweller holding jewelry- farmer when sows the crop
 A Long position gains with rise in price and loses with price fall

 When a party requires the underlying asset in the future- SHORT ON

the underlying asset.
 Eg. A tea exporter who needs stock of tea to execute pending order
 Flour mill needing future stock of wheat, Producer needing RM
 Gains on fall in price and loses when the price falls

 LONG ON ASSET -- SHORT ON FUTURES

 SHORT ON ASSETS------ LONG ON FUTURES
Hedging Commodity Price Risk I
 When commodity price is likely to increase, the producer of
commodities will benefit, whereas the users will face a loss

 Thus, a trader who needs to buy some commodity at a

future time, or who has a short position in the commodity,
will face a downside risk

 This can be hedged by the trader by taking a long position in

futures, i.e. by agreeing to buy the commodity at a future
time at a known price
 This is known as a long hedge

RM
Hedging Commodity Price Risk
 When commodity prices are likely to decrease, the
producers will face a loss, and the users a gain

A trader who owns a commodity and plans to sell it at a

future time, or who has a long position in the asset, faces
a downside risk

 Downside risk can be hedged by taking a short position in

futures, i.e. by agreeing to sell the commodity at a future
time at a known price
 Known as short hedge
RM
Hedging Currency Risk I
 When exchange rate moves against a trader, he will engage in
hedging

 For an importer who needs to make foreign currency payments,

downside risk arises when foreign currency is expected to
appreciate

 Downside risk can be hedged by taking a long position in the

foreign currency future by agreeing to buy foreign currency at a
known exchange rate

 This is a long hedge

RM
Hedging Currency Risk II

 An exporter who would receive a foreign currency cash

flow at a future time faces a downside risk of the
foreign currency depreciating

 Downside risk can be hedged by taking a short position

in the currency futures by agreeing to sell the foreign
currency at a future time at a known rate

 This is a short hedge

RM
Hedging Interest Rate Risk
 Interest rate risk affects borrowers and investors

A borrower faces downside risk if the interest rate

increases, while an investor faces downside risk if the
rate decreases

 Hedging strategy depends on whether the interest rate

futures are written on the interest rate itself, such as on
Eurodollar futures, or on instruments such as a
government bond

RM
Hedging Interest Rate Risk II

 If futures are on interest rates themselves, like in

Eurodollar futures, a borrower would take a long
position in these futures locking in a known interest at
the current time—this is a long hedge

 An investor would take a short position in these futures,

locking in a known interest rate, which is a short hedge

RM
Hedging Interest Rate Risk III

 If futures are on an instrument such as a government bond,

 The price of the bond will decrease when interest rates

increase. If the price is expected to decrease, a short
position in futures or short hedges are applicable.
Therefore, a borrower should go for a short hedge using
government bond futures

 The price of the bond will increase when interest rates

decrease. If the price is expected to increase, a long
position in futures, or a long hedge, is applicable.
RM
Therefore, an investor would go for a long hedge while
using government bond futures
Long Hedge
 A long hedge is one in which the hedger has a short position in an asset and takes
a long position in futures

 Traders who need to buy the asset at a future time will use long hedge through
commodity futures

 Importers who need to buy foreign currency at a future time will use long hedge
through currency futures

 Borrowers who need to borrow at a future time will use long hedge through
interest rate futures

 Investors who need to invest at a future time will use long hedge through
government bond futures
RM
Short Hedge
 Short hedges are ones in which hedgers take a long position in assets and a short
position in futures

 Traders who own the asset now and need to sell at a future time will use short
hedge through commodity futures

 Exporters who will receive foreign currency cash flows at a future time will use
short hedge through currency futures

 Investors who need to invest at a future time will use short hedge through
interest rate futures

 Borrowers who need to borrow at a future time will use short hedge through
government bond futures
RM
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

RM 16
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

RM 17
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

RM 18
 b1 = S1 – F1
 b2 = S2 –F2

 Gain /loss on the spot market = S2 –S1

 Gain/loss in the future market = F1 –F2

 Total Gain = S2 –S1 +F1 –F2 =( F1 –S1) - ( F2 –S2 ) = b1 - b2

 Should be Zero for a perfect hedge
RM 19
 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
S2 : Asset price at time of purchase
b2 : Basis at time of purchase

Cost of asset S2
Gain on Futures F2 −F1
Net amount paid S2 − (F2 −F1) =F1 + b2

RM 20
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
b2 : Basis at time of sale
Price of asset S2
Gain on Futures F1 −F2
Net amount received S2 + (F1 −F2) =F1 + b2

RM 21
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

 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.

RM 22
Optimal Hedge Ratio

Proportion of the exposure that should optimally be hedged

is
where
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.

RM 23
Example

 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

RM 24
 Example continued

 The size of one heating oil contract is 42,000 gallons

 The spot price is 1.94 and the futures price is 1.99
(both dollars per gallon) so that

 Optimal number of contracts is

which rounds to 37

RM 25
Alternative Definition of Optimal Hedge
Ratio
 Optimal hedge ratio is

where variables are defined as follows

Correlation between percentage daily changes for

spot and futures
SD of percentage daily changes in spot

SD of percentage daily changes in futures

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 HEDGING EFFECTIVENESS
 The variance proportion eliminated by hedging
  

 H.E = h* 2 x σF2 / σS2

RM 27
Optimal Number of Contracts

QA Size of position being hedged (units)

QF Size of one futures contract (units)
VA Value of position being hedged (=spot price time QA)
VF Value of one futures contract (=futures price times QF)

Optimal number of contracts

Optimal number of contracts if after “tailing adjustment” to
adjustment for daily settlement allow or daily settlement of
futures

RM 28
Hedging Using Index Futures

To hedge the risk in a portfolio the number of

contracts that should be shorted is

where VA is the value of the portfolio, b is its beta, and

VF is the value of one futures contract

RM 29
Example
S&P 500 futures price is 1,000
Value of Portfolio is $5 million
Beta of portfolio is 1.5

What position in futures contracts on the S&P 500 is

necessary to hedge the portfolio?

RM 30
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?

RM 31
 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
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.

RM 32
 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 an replace them with

new contract reflect the new exposure

RM 33
 Liquidity Issues - Disaster
 In any hedging situation there is a danger that losses will be
realized on the hedge while the gains on the underlying
exposure are unrealized
 This can create liquidity problems
 One example is Metallgesellschaft which sold long term fixed-
price contracts on heating oil and gasoline and hedged using
stack and roll
 The price of oil fell.....

RM 34