ECON F354/ FIN F31:Derivatives and Risk Management
Prof C Hussain Yaganti
BITS Pilani
Hyderabad Campus
BITS Pilani
Hyderabad Campus
Chapter 3: Hedging Strategies using Futures
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Why should we discuss about the Hedging Strategies Using Futures?
Many of the participants in futures markets are hedgers. Their aim is to use
futures markets to reduce a particular risk that they face. This risk might relate
to fluctuations in the price of oil, a foreign exchange rate, the level of the stock
market, or some other variable.
So, a study of hedging using futures contracts is a study of the ways in which
hedges can be constructed so that they perform as close to perfect as possible.
Learning Outcomes of this chapter
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?
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Basic Assumption of this chapter
In general investors try to change the hedging position based on the market
conditions but, in this chapter, we assume that no attempt is made to adjust the
hedge once it has been put in place.
That means, the hedger simply takes a futures position at the beginning of the
life of the hedge and closes out the position at the end of the life of the hedge.
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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
Ex : Pharma company take position on turmeric commodity
A short futures hedge is appropriate when you know you will sell an asset in the
future and want to lock in the price
Ex:any farmer who sells agri commodity like wheat, turmeric, Jeera
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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.
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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
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Basis Risk
In practice, hedging is often not quite as straightforward as this. Some of the
reasons are as follows:
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 date when the asset will be bought or sold.
3. The hedge may require the futures contract to be closed out before its delivery month.
These problems give rise to what is termed basis risk.
Basis is usually defined as the spot price minus the futures price
Over the time, the spot and futures prices do not change by same amount
then it leads
strengthening of the basis.
weakening of the basis.
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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
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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
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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.
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Optimal Hedge Ratio
Ignoring daily settlement of futures (or assuming forwards are used) , the
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, * sS
h r
sF
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.
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Optimal Number of Contracts
∗
∗
ℎ 𝑄𝐴
𝑁 =
𝑄𝐹
where
QA is the size of the position being hedged (units)
QF is the size of one futures contract (units)
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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
0.0263
h 0.928
*
0.78
0.0313
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Example…
The size of one heating oil contract is 42,000 gallons
Optimal number of contracts is
which rounds to 37 0.78 2, 000, 000 42, 000
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Optimal Number of Contracts When Contract Is Settled Daily
𝜎ො𝑆 𝑆𝑄𝐴
∗
𝑁 = 𝜌ෝ
𝜎ො𝐹 𝐹𝑄𝐹
where variables are defined as follows
r̂ Correlation between percentage daily changes for spot
and futures
sˆ S SD of percentage daily changes in spot
sˆ F SD of percentage daily changes in futures
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An Alternative Expression for N* when there is daily settlement
𝑉𝐴
𝑁 = ℎ
∗
𝑉𝐹
where
VA is the value of the position being hedged (= SQA)
VF is the futures price times the size of one contract(= FQF)
and we use with a new hedge ratio
𝜎ො𝑆
ℎ = 𝜌ෝ
𝜎ො𝐹
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Optimal number of contracts
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Optimal Number of Contracts-Example
• 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
VA 1.94 2,000,000 3,880,000
VF 1.99 42,000 83,580
• Optimal number of contracts assuming no daily settlement
0.7777 2,000,000 42,000 37.03
Optimal number of contracts after tailing
0.7777 3,880,000 83,580 36.10
Daily Settlement
Day to day changes in N* are small and often ignored
Tailing the hedge involves dividing N* by one plus the amount of interest that will
be earned over the remaining life of the hedge
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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 VA
b
VF
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Example
Index level=1,000
Index futures price is 1,010
Value of Portfolio is $ 5,05,000
Beta of portfolio is 1.5
One futures contract is for delivery of 250 times the Index
What position in futures contracts on the index is necessary to hedge the
portfolio?
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Changing the Beta of a Portfolio
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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?
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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.
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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 etc.
In practice, a company usually has an exposure every month to the underlying
asset and uses a 1-month futures contract for hedging because it is the most
liquid. Initially it enters into ("stacks") sufficient contracts to cover its exposure
to the end of its hedging horizon. One month later, it closes out all the
contracts and "rolls" them into new 1-month contracts to cover its new
exposure, and so on.
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Hedging in India
In India, the methodology of hedging is dependent on the market
For example:
In the equity market, the hedging avenues are futures contracts and options
contracts apart from spot buy - sell contracts.
In the currency markets, the corresponding avenues are forward contracts
and options contracts (both back - to - back contracts as well as naked
contracts).
In the interest rate markets hedging is done through interest rate futures,
forward rate agreements and swaps.
In the commodity markets, the hedging mechanism is through the usage of
futures contracts (earlier forward contracts).
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Problems
1. Suppose that the standard deviation of quarterly changes in the prices of a
commodity is $0.65, the standard deviation of quarterly changes in a futures
price on the commodity is $0.81, and the coefficient of correlation between
the two changes is 0.8. What is the optimal hedge ratio for a 3-month
contract? What does it mean?
2. A company has a $20 million portfolio with a beta of 1.2. It would like to use
futures contracts on a stock index to hedge its risk. The index futures price is
currently standing at 1080, and each contract is for delivery of $250 times
the index. What is the hedge that minimizes risk? What should the company
do if it wants to reduce the beta of the portfolio to 0.6?
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References
John C. Hull & Basu “Options, Futures, and Other Derivatives”, 11th Edition,
Pearson 2022.
[Link]
information
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