Long & Short Hedges

Hedging Strategies Using

 A long futures hedge is appropriate when
Futures you know you will purchase an asset in
the future and want to lock in the price
Chapter 3  A short futures hedge is appropriate
when you know you will sell an asset in
the future & want to lock in the price

Fundamentals of Futures and Options Markets, 7th Ed, Ch3, Copyright © John C. Hull 2010 1 Fundamentals of Futures and Options Markets, 7th Ed, Ch3, Copyright © John C. Hull 2010 2

Arguments in Favor of Hedging Arguments against Hedging

 Shareholders are usually well diversified

Companies should focus on the main and can make their own hedging decisions
business they are in and take steps to  It may increase risk to hedge when
minimize risks arising from interest competitors do not
rates, exchange rates, and other market  Explaining a situation where there is a loss
variables on the hedge and a gain on the underlying
can be difficult

Fundamentals of Futures and Options Markets, 7th Ed, Ch3, Copyright © John C. Hull 2010 3 Fundamentals of Futures and Options Markets, 7th Ed, Ch3, Copyright © John C. Hull 2010 4

Convergence of Futures to Spot Basis Risk

(Hedge initiated at time t1 and closed out at time t2)

 Basis is the difference between

spot & futures
Futures
Price  Basis risk arises because of the
uncertainty about the basis
when the hedge is closed out
Spot
Price

Time

t1 t2

Fundamentals of Futures and Options Markets, 7th Ed, Ch3, Copyright © John C. Hull 2010 5 Fundamentals of Futures and Options Markets, 7th Ed, Ch3, Copyright © John C. Hull 2010 6
 Long Hedge Short Hedge

 Suppose that  Suppose that

F1 : Initial Futures Price F1 : Initial Futures Price
F2 : Final Futures Price F2 : Final Futures Price
S2 : Final Asset Price
S2 : Final Asset Price
 You hedge the future purchase of an
asset by entering into a long futures  You hedge the future sale of an asset by
contract entering into a short futures contract
 Cost of Asset=S2 – (F2 – F1) = F1 + Basis  Price Realized=S2+ (F1 – F2) = F1 + Basis

Fundamentals of Futures and Options Markets, 7th Ed, Ch3, Copyright © John C. Hull 2010 7 Fundamentals of Futures and Options Markets, 7th Ed, Ch3, Copyright © John C. Hull 2010 8

Choice of Contract Optimal Hedge Ratio

 Choose a delivery month that is as close Proportion of the exposure that should optimally be
hedged is
as possible to, but later than, the end of h
S
the life of the hedge F

 When there is no futures contract on the where

asset being hedged, choose the contract S is the standard deviation of S, the change in the
spot price during the hedging period,
whose futures price is most highly F is the standard deviation of F, the change in the
correlated with the asset price. There are futures price during the hedging period
then 2 components to basis  is the coefficient of correlation between S and F.

Fundamentals of Futures and Options Markets, 7th Ed, Ch3, Copyright © John C. Hull 2010 9 Fundamentals of Futures and Options Markets, 7th Ed, Ch3, Copyright © John C. Hull 2010 10

Hedging Using Index Futures

Tailing the Hedge (Page 63)

To hedge the risk in a portfolio the

 Two way of determining the number of contracts
to use for hedging are number of contracts that should be
 Compare the exposure to be hedged with the value of shorted is
the assets underlying one futures contract V
 Compare the exposure to be hedged with the value of  A
one futures contract (=futures price time size of
VF
futures contract where VA is the current value of the
 The second approach incorporates an portfolio, is its beta, and VF is the
adjustment for the daily settlement of futures current value of one futures (=futures
price times contract size)
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 Reasons for Hedging an Equity
Portfolio Example
 Desire to be out of the market for a short Futures price of S&P 500 is 1,000
period of time. (Hedging may be cheaper Size of portfolio is $5 million
than selling the portfolio and buying it Beta of portfolio is 1.5
back.) One contract is on $250 times the index
 Desire to hedge systematic risk
What position in futures contracts on the
S&P 500 is necessary to hedge the
portfolio?
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Changing Beta Stock Picking

 If you think you can pick stocks that will
 What position is necessary to reduce the
outperform the market, futures contract
beta of the portfolio to 0.75?
can be used to hedge the market risk
 What position is necessary to increase the
 If you are right, you will make money
beta of the portfolio to 2.0?
whether the market goes up or down

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Rolling The Hedge Forward

 We can use a series of futures

contracts to increase the life of a
hedge
 Each time we switch from 1 futures
contract to another we incur a type of
basis risk

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