Chapter 3

Hedging Strategies Using

Futures

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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
A short futures hedge is appropriate
when you know you will sell an asset in
the future and want to lock in the price
A perfect hedge is one that completely
eliminate the risk, but perfect hedges are
rare
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Example: A Short Hedge
It is May 15. An oil producer has
negotiated a contract to sell 1 million
barrels of crude oil.
The price in the sales contract is the spot
price on August 15.
Quotes:
Spot price of crude oil: $50 per barrel
August oil futures price: $49 per barrel

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Example: A Short Hedge (cont.)
The oil producer can hedge with the
following transactions:
May 15: Short 1,000 August futures contracts
on crude oil (1,000 bbls per futures contract)
August 15: Close out futures position
Outcomes: Spot price on August 15 is (1)
$45; (2) $55 per bbl
After gains or losses on the futures are
taken into account, the price received by
the company is close to $49 per barrel.

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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 (Table 3.1)
Explaining a situation where there is a loss on
the hedge and a gain on the underlying can
be difficult

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Table 3.1 Danger in Hedging
When Competitors do not Hedge
 Using futures contract to hedge its purchase
of gold over the next 18 months

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Hedging can Lead to a Worse
Outcome
Suppose that the price of oil at the end of the hedge is $59, so
that the company loses $10 per barrel on the futures contract.
We can imagine a conversation:
PRESIDENT： This is terrible. We've lost $10 million in the futures
market in the space of three months. How could it happen? I
want a full explanation.
TREASURER： The purpose of the futures contracts was to hedge
our exposure to the price of oil, not to make a profit. Don't forget
we made $10 million from the favorable effect of the oil price
increases on our business.
PRESIDENT： What's that got to do with it? That's like saying that
we do not need to worry when our sales are down in California
because they are up in New York.

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Hedging can Lead to a Worse
Outcome (cont.)
TREASURER： If the price of oil had gone down...
PRESIDENT： I don't care what would have happened if the price
of oil had gone down. The fact is that it went up. I really do not
know what you were doing playing the futures markets like this.
Our shareholders will expect us to have done particularly well
this quarter. I'm going to have to explain to them that your
actions reduced profits by $10 million. I'm afraid this is going to
mean no bonus for you this year.
TREASURER： That's unfair. I was only...
PRESIDENT： Unfair! You are lucky not to be fired. You lost $10
million.
TREASURER： It all depends on how you look at it ...
It’s easy to see why many treasurers are reluctant to hedge!

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Convergence of Futures to Spot
(Hedge initiated at time t1 and closed out at time t2)

Futures
Price

Spot
Price

Time
t1 t2 T (Expiration)
(Hedge closed)

10
Basis Risk
Basis is usually defined as the spot
price minus the futures price (S-F)
Basis risk arises because of the
uncertainty about the basis when
the hedge is closed out
The variability in the basis that will
affect profits and/or hedging
performance.

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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
If you hedge the future purchase of an asset by entering
into a long futures contract then net cost of asset is

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

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Example 3.2
Basis Risk in a Long Hedge
It is June 8. A company knows it will need to
purchase 20,000 barrels of crude oil some time
in October or November. The current
December oil futures price is $48.00 per barrel.
Its hedging strategy is as follows:
1. Take a long position in 20 December oil futures
contracts on June 8 at a futures price of $48.
2. Close out the contract when ready to purchase
the oil.

13
Change on Basis
Company is ready to purchase oil on Nov. 10 :
Spot price on Nov. 10 = $50 (S2)
December futures price on Nov. 10 = $49.10 (F2)
Basis on Nov. 10 = $50 - $49.10 = $0.90
Net cost of oil after hedging:
Spot price on Nov. 10 – Gain on Futures
= $50 – ($49.10 – $48) = $48.90
Futures price on June 8 + Basis on Nov. 10
= $48 + $0.90 = $48.90

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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
If you hedge the future sale of an asset by entering into a
short futures contract then price realized is
Price of asset S2
Gain on Futures F1 −F2
Net amount received S2 + (F1 −F2) =F1 + b2

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Change on Basis
S2 + (F1 – F2) = S2 + F1 – F2 + S1 – S1
= S1 + (S2 – F2) – (S1 – F1)
= S1 + (b2 – b1) = S1 + ∆b
At maturity T (if t2=T), b2 =0. Cost of asset (in long
hedge) or price realized (in short hedge):
S2 + (F1 – F2) = S1 – b1 =F1
S2 (A) – F2 (B)
= [S2 (A) – F2 (A)] + [F2 (A) – F2 (B)]
where A and B are different assets

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Convergence of Futures to Spot
(Hedge initiated at time t1 and closed out at time t2)

Futures
Price

b2
b1
Spot
Price

Time

17
Change on Basis (cont.)
Strengthening of the basis
– the basis increases (b2 > b1)
– Improves the short hedger’s position and worsen
the long hedger’s position
Weakening of the basis
– the basis decreases (b2 < b1)
– Improves the long hedger’s position and worsen
the short hedger’s position

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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.
There are then 2 components to basis
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Cross Hedging
Hedge ratio: the ratio of the size of the position
taken in futures contracts to the size of the
exposure
NF
h=
NA
For a long hedge, net amount paid is
S2 NA – (F2 – F1) NF , instead of S2 – (F2 – F1)

Setting the hedge ratio equal to 1.0 is not

always optimal
20
Optimal Hedge Ratio (equation 3.1)
Ignoring daily settlement of futures (or assuming
forwards are used) , the proportion of the exposure
that should optimally be hedged is
σS
h =ρ
*
σF
where
σS is the standard deviation of ∆S, the change in the
spot price during the hedging period,
σF is the standard deviation of ∆F, the change in the
futures price during the hedging period
ρ is the coefficient of correlation between ∆S and ∆F.
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Optimal Hedge Ratio
For example, if ρ =1 and σF = 2σS , the
hedge ratio h* is 0.5
In practice, one usually uses historical data
to perform regression analysis
∆S = a + b ∆F
The optimal hedge ratio, h*, is the slope of
the best-fit line when ∆S is regressed against
∆F, as indicated in Figure 3.2
Figure 3.2 Regression of Change in Spot
Price against Change in Futures Price

Cov ( ∆S , ∆F ) Regression
h=
Var ( ∆F ) slope

ρσ Sσ F σS
= = ρ
σ F2 σF
PROOF OF THE MINIMUM VARIANCE
HEDGE RATIO FORMULA
Minimum variance hedge ratio is h* that minimizes
variance of hedger’s position
e.g. For a long hedge, hedger’s position (net amount paid) is
S2 NA – (F2 – F1) NF
h* minimizes Var (S2 NA – (F2 – F1) NF )
Handout

Figure 3.3 Dependence of

variance of hedger’s position
on hedge ratio

NF
h=
NA
Example (Example 3.3)
Airline will purchase 2 million gallons of jet
fuel in one month and hedges using heating
oil futures
From historical data σF =0.0313, σS =0.0263,
and ρ= 0.928
0.0263
h =0.928 ×
*
=0.78
0.0313

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Optimal Number of Contracts
(equation 3.2)
ℎ ∗ 𝑄𝑄
∗ 𝐴𝐴
𝑁𝑁 =
𝑄𝑄𝐹𝐹
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 continued
The size of one heating oil contract is 42,000 gallons
Optimal number of contracts is
= 0.78 × 2, 000, 000 42, 000
which rounds to 37

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Optimal Number of Contracts
When Contract Is Settled Daily
𝜎𝜎�𝑆𝑆 𝑆𝑆𝑄𝑄𝐴𝐴
= 𝜌𝜌� 𝑁𝑁 ∗
𝜎𝜎�𝐹𝐹 𝐹𝐹𝑄𝑄𝐹𝐹
where variables are defined as follows

ρ̂ Correlation between percentage daily changes for

spot and futures
σˆ S SD of percentage daily changes in spot

σˆ F SD of percentage daily changes in futures

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An Alternative Expression for N* when
there is daily settlement (equation 3.3)
𝜎𝜎𝑆𝑆̂ 𝑆𝑆𝑄𝑄𝐴𝐴 𝑉𝑉𝐴𝐴
∗
𝑁𝑁 = 𝜌𝜌� = ℎ�
𝜎𝜎𝐹𝐹̂ 𝐹𝐹𝑄𝑄𝐹𝐹 𝑉𝑉𝐹𝐹
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
𝜎𝜎�𝑆𝑆
ℎ� = 𝜌𝜌�
𝜎𝜎�𝐹𝐹
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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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Example: Tailing the Hedge
Consider that 2 million gallons of jet fuel is
being hedged with heating oil futures.
Suppose that the spot and futures price are
1.10 and 1.30, respectively.
VA = SQA = 2,000,000 X 1.10 = 2,200,000
VF = FQF = 42,000 X 1.30 =54,600
If ℎ� =0.8, the optimal number of contracts for a
2,200,000
one-day hedge is (0.8) = 32.23
54,600
or 32 when rounded to the nearest whole number
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Table 3.3 Index Futures Quotes

DJIA, $10 times index

S&P 500, $250 times index
Hedging Using Index Futures
(equation 3.4)

To hedge the risk in a portfolio the

number of contracts that should be
shorted is V A
β
VF

where VA is the value of the portfolio, β is

its beta (CAPM), and VF is the value of
one futures contract (= futures price
times contract size)
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Example
Index futures price is 1,000
Value of Portfolio is $5 million
Beta of portfolio is 1.5

What position in futures contracts on the

index (S&P 500) is necessary to hedge the
portfolio?

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Example 2
Suppose that a futures contract with 4
months to maturity is used to hedge the
value of a portfolio over the next 3 month.
Value of S&P 500 index = 1,000
S&P 500 futures price = 1,010
Value of portfolio = $5,050,000
Risk-free interest rate = 4% per annum
Dividend yield on index = 1% per annum
Beta of portfolio = 1.5
Example 2 (cont.)
VF = 1,010 x 250 = 252,500
N* = 1.5 (5,050,000/252,500) = 30
Suppose the index turns out to be 900 in months and
the futures price is 902. The gain from the short
futures position is then
30 x (1010-902) x 250 = $810,000
From CAPM (see Appendix),
Expected return on portfolio = Risk-free interest rate
+ Beta x (Return on index – Risk-free interest rate)
Example 2 (cont.)
Adjust annual rates to quarterly rates
E(Rp) – (4%/4)
= 1.5 x [(-10% + 1%/4) – (4%/4) ]
E(Rp) = -15.125%
The expected value of the portfolio (inclusive of
dividends) at the end of the 3 months is therefore
$5,050,000 x (1-0.15125) = $4,286,187
The expected value of the hedger’s position,
including the gain on the hedge, is
$4,286,187 + $810,000 = 5,096,187
Table 3.4 Performance of Stock
Index Hedge
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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Changing Beta of a Portfolio
In general, to change the beta of the portfolio from
β to β*, where β > β*, a short position in
VA
( β − β *)
VF
is required.
When β < β*, a long position in
VA
(β * −β )
VF
is required.
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
Locking in the benefits of stock picking

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Locking in the Benefits of Stock
Picking
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.
If the beta of your portfolio is not 1, you should
short βVA / VF index futures contract.
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
Each time we switch from one futures contract to
another we incur a type of basis risk

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Table 3.5 Data for the Example on
Rolling oil Hedge Forward
Initial short Close out Oct. 2021 contract
position and short Mar. 2022 contract

In April 2021 a company realizes that it will have 1,000,000 barrels

of oil to sell in June 2022, and decide to hedge its risk with a hedge
ratio of 1.0.
The dollar gain per barrel of oil from the short futures contracts:
(48.20-47.40) + (47.00-46.50) + (46.30-45.90) = 1.70
Compensation for a $3.00 price decline ($46-$49). The best we can
hope is that June 2022 contract was actively traded
Liquidity Issues (Business Snapshot 3.2)
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 huge
long term fixed-price contracts on heating oil and
gasoline (5- to 10-year contracts at 6 to 8 cents
above market) and hedged using stack and roll
The price of oil fell.....

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