Hedging Strategies Using Futures
Chapter: 3
Md. Golam Sharoar
Lecturer- Finance & Banking
BSMRSTU; Gopalganj-Bangladesh
Introduction
- Many investors in future markets are hedgers.
- Hedgers use derivatives to reduce the risk that they face from potential future
movements in a market variable.
- A Perfect Hedge is one that completely eliminates the risk. Perfect hedges are
rare.
In this Chapter we will know-
Q. When a short position appropriate?
Q. When a long future contract is appropriate?
Q. Which future contract should be used?
Q. What is the optimal size of the futures position for reducing risk?
Basic Principles
- If the price of the commodity goes down, The gain of the future position offset the
loss on the rest of the company’s business.
- If the price of the commodity goes up, the loss on the future position offset the gain
on the rest of the company’s business.
Short Hedge: A short hedge is a hedge that involves a short position in future
contract.
Long & Short Hedges
A long futures hedge is appropriate when you know you will purchase an asset in the
future and want to lock in the price.
A short futures hedge is appropriate when you know you will sell an asset in the
future & want to lock in the price.
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.
− 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.
Convergence of Futures to Spot
Basis Risk
- Basis is the difference between Spot Price&
Futures Price
- Basis risk arises because of the uncertainty
about the basis when the hedge is closed out.
Simply;
Basis= Spot Price of the Asset to be Hedge- Futures
Price of the contract Used.
- If the asset to be hedged and the asset
underlaying the futures contract are same. The
basis should be zero.
- An increase in the basis is referred to as
strengthening of the basis and a decrease in the
basis is referred to as weakening of the basis.
Basis Risk
Therefore; B1: S1- F1; B2= S2-F2
Let;
As the hedger knows the asset will be sold at
S1: Spot Price at time T1 time T2, and takes a short future position at
time t1;
S2: Spot Price at time T2
-The price realized for the asset is S2
F1: Future Price at time T1
- Profit from the future position is:F1-F2
F2: Future Price at time T2
So the effective price of the asset obtained
B1: Basis at time T1 from Hedging is:
B2: Basis at time T2 : S2+F1-F2= F1+B2
The hedging risk is the uncertainty associated with B2 and known as Basis Risk
Long Hedge
Suppose that,
F1 : Initial Futures Price
F2 : Final Futures Price
S2 : Final Asset Price
You hedge the future purchase of an asset by entering into a long futures contract
Cost of Asset=S2 –(F2 – F1) = F1 + Basis
Short Hedge
Suppose that,
F1 : Initial Futures Price
F2 : Final Futures Price
S2 : Final Asset Price
You hedge the future sale of an asset by entering into a short futures contract
Price Realized=S2+ (F1 –F2) = F1 + Basis
Choice of Contract
Key Factor affecting basis risk in the choice of the future contract and choice of
delivery month-
- Choose a delivery month that is as close as possible to, but later than, the end of the
life of the hedge (Future price are erratic during the delivery month).
- 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.
Optimal Hedge Ratio: Cross Hedging
Hedge Ratio: Ratio between then size of the position taken in futures contract to the
size of the exposure.
Hedge Ratio;
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.
Portfolio: long in 1 unit of the underlying and short in hedge forwards:
Change in the portfolio value: dS - hdF
Variance of the change: V= s2S + h2s2F – 2rhsSsF
Optimal Hedge Ratio
Ex 3.6:
Solution:
sS = $0.65,
sF = $0.81,
r = 0.8.
Optimal Hedge Ratio: = 0.8*0.65/0.81 = 0.642
Futures position must be 64.2% of the exposure
Say, if the exposure is $1,000,000. Then, the futures hedge has to be $642,000.
Optimal Number of Contracts
Optimal Number of Contracts= N*= h*NA/QF
Here,
NA= Size of the position being hedged
QF=Size of one future contract
N*= Optimal number of future contract hedged
Hedging Using Index Futures
To hedge the risk in a portfolio the number of contracts that should be shorted is:
B*r/A
where r is the value of the portfolio, b is its beta (actually, with respect to futures
fluctuations), and A is the value of the assets underlying one futures contract.
Reasons for Hedging an Equity Portfolio
- Desire to be out of the market for a short period of time. (Hedging may be cheaper
than selling the portfolio and buying it back.)
- Desire to hedge systematic risk (Appropriate when you feel that you have picked
stocks that will outperform the market.)
Changing Beta (b)
- Short b1P/A futures contracts to go to zero beta; then, buy b2 P/A futures contracts
to go to beta b2
- What position is necessary to reduce the beta of the portfolio from 1 to 0.75?
- What position is necessary to increase the beta of the portfolio to 2.0?
Changing Beta (b)
Q: A company would like to hedge its $20 Million portfolio (b = 1.2) with
S&P 500 futures. 1 contract is for $250* Index. Index is at 1080 now.
What is the optimal hedge ratio?
Solution:
We Know, To hedge the risk in a portfolio the number of contracts that should be
shorted is-
b= r/A
Number of Contract = 1.2*20/(250*1080) ≈ 89 contracts
What should the company do to reduce b of the portfolio to 0.6?
Short (1.2-0.6)*20/(250*1080) ≈ 44 contracts
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
Question to be solved from the book : 3.1, 3.2, 3.6, 3.7, 3.10, 3.16, 3.18
The End…