TUTORIAL 4
Hedging using Forwards and
Futures
1. Hedging positions
• Long hedge: Taking a long position in a futures contract (buy a
futures contract) when a company wants to buy an asset in the
future and wants to lock in a fixed price today.
• Short hedge: Taking a short position in a futures contract (sell a
futures contract) when a company owns (or will own) a certain asset
and want to lock in a fixed price to sell the asset.
2. Basis Risk
• The Basis is the difference between the spot price of the asset to be hedged and the
futures price of contract.
o b1 = S1 – F1
o b2 = S2 – F2
Reasons for basis risk:
commodity mismatch and maturity mismatch
• Long (Short) Hedge for Purchase (Sale) of an Asset
Cost of Asset 𝑺𝟐
Gain on Futures 𝐹2 − 𝐹1 | 𝐹1 − 𝐹2
Net amount paid Long Hedge 𝑆2 − 𝐹2 − 𝐹1 = 𝐹1 + 𝑏2
Net amount received Short Hedge 𝑆2 + 𝐹1 − 𝐹2 = 𝐹1 + 𝑏2
basis risk: uncertainty associated with b2 at time t2
3. Cross-hedging and hedge ratio
• Cross-hedging: : when the asset to be hedged is not the same as the underlying asset under a
futures contract
• Hedge ratio: the ratio of the size of the position taken in futures contracts to the size of the
exposure.
• Optimal hedge (minimum variance hedge ratio):
• Optimal number of futures contract (ignore daily settlement):
• Optimal number of futures contract (with daily settlement):
•VA is the value of the position
being hedged (VA = SQA)
•VF is the futures price times the
size of one contract (VF = FQF)
4. Hedging Equity Portfolios Using Stock Index Futures
• Reason to hedge: may want to be out of the market for a while. Hedging avoids
the costs
of selling and repurchasing the portfolio
• The number of futures contracts should be shorted:
𝑉𝐴 VA: Current value of the portfolio
N∗ = 𝛽 VF: Current value of one futures contract
𝑉𝐹 (the futures price times the contract size).
5. Using futures index to change the beta of an equity portfolio
• βs is the current beta of the stock portfolio and βT is the target beta we
want to achieve
• Number of futures we need to buy/sell in order to get to the target beta:
If 𝛽𝑇 > 𝛽𝑆 = > 𝑁 > 0 = > we buy futures (to raise beta → long futures)
If 𝛽𝑇 < 𝛽𝑆 = > 𝑁 < 0 = > we sell futures (to reduce beta → short futures)
Additional question 1
Under what circumstances are (a) a short hedge and (b) a long hedge
appropriate?
• A short hedge is appropriate when a company owns an asset and
expects to sell that asset in the future. It can also be used when the
company does not currently own the asset but expects to do so at
some time in the future.
• A long hedge is appropriate when a company knows it will have to
purchase an asset in the future. It can also be used to offset the risk
from an existing short position.
Additional question 2
Explain what is meant by basis risk when futures contracts are used for
hedging?
The basis is the amount by which the spot price exceeds the futures
price. Basis risk exists due to some possibilities such as differences in
maturities of futures contracts selected and hedging period, assets
being hedged and underlying assets.
Question 3.1
Explain what is meant by a perfect hedge. Does a perfect hedge always lead to a
better outcome than an imperfect hedge? Explain your answer.
A perfect hedge is one that completely eliminates the hedger’s risk. A perfect
hedge does not always lead to a better outcome than an imperfect hedge. It just
leads to a more certain outcome.
Consider a company that hedges its exposure to the price of an asset. Suppose the
asset’s price movements prove to be favorable to the company. A perfect hedge
totally neutralizes the company’s gain from these favorable price movements. An
imperfect hedge, which only partially neutralizes the gains, might well give a better
outcome.
Additional question 3
Give three reasons why the treasurer of a company might not hedge
the company’s exposure to a particular risk. Explain your answer.
• (a) If the company’s competitors are not hedging, the treasurer might
feel that the company will experience less risk if it does not hedge.
• (b) The shareholders might not want the company to hedge because
the risks are hedged within their portfolios.
• (c) If there is a loss on the hedge and a gain from the company’s
exposure to the underlying asset, the treasurer might feel that he or
she will have difficulty justifying the hedging to other executives
within the organization.
Book Question 3.3
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 three-month contract? What
does it mean?
The optimal hedge ratio is:
This means that the size of the futures position should be 64.2% of the size of the
company’s exposure in a three-month hedge.
Book question 3.4
A company has a $20 million portfolio with a beta of 1.2. It would like to use futures
contracts on the S&P 500 to hedge its risk. The index futures 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?
• The number of contracts that should be shorted:
Rounding to the nearest whole number, 89 contracts should be shorted.
• To reduce the beta to 0.6, half of this position, or a short position in 44 contracts,
is required
Book question 3.8
Imagine you are the treasurer of a Japanese company exporting electronic equipment to the United
States. Discuss how you would design a foreign exchange hedging strategy and the arguments you
would use to sell the strategy to your fellow executives
The simple answer to this question is that the treasurer should
1. Estimate the company’s future cash flows in Japanese yen and U.S. dollars
2. Enter into forward and futures contracts to lock in the exchange rate for the U.S. dollar cash flows
However, the company should examine whether the magnitudes of the foreign cash flows depend on
the exchange rate. For example, will the company be able to raise the price of its product in U.S.
dollars if the yen appreciates? If the company can do so, its foreign exchange exposure may be quite
low.
The key estimates required are those showing the overall effect on the company’s profitability of
changes in the exchange rate at various times in the future, then decide between using futures and
options to hedge its risk. The results of the analysis should be presented carefully to other executives.
It should be explained that a hedge does not ensure that profits will be higher. It means that profit will
be more certain. When futures/forwards are used both the downside and upside are eliminated. With
options a premium is paid to eliminate only the downside.
Book question 3.13
The standard deviation of monthly changes in the spot price of live cattle is (in cents per pound)
1.2. The standard deviation of monthly changes in the futures price of live cattle for the closest
contract is 1.4. The correlation between the futures price changes and the spot price changes is
0.7. It is now October 15. A beef producer is committed to purchasing 200,000 pounds of live
cattle on November 15. The producer wants to use the December live-cattle futures contracts to
hedge its risk. Each contract is for the delivery of 40,000 pounds of cattle. What strategy should
the beef producer follow?
Answer:
• The optimal hedge ratio is:
• The number of contracted should be longed: N* = h*QA/QF = 0.6*200,000/40,000 = 3 (contracts)
The beef producer requires a long position in 200,000 × 0.6 = 120,000 lbs of cattle. The beef
producer should therefore take a long position in 3 December contracts closing out the position
on November 15.
Book question 3.15
On July 1, an investor holds 50,000 shares of a certain stock. The market price is
$30 per share. The investor is interested in hedging against movements in the
market over the next month and decides to use the September Mini S&P 500
futures contract. The index is currently 1,500 and one contract is for delivery of $50
times the index. The beta of the stock is 1.3. What strategy should the investor
follow? Under what circumstances will it be profitable?
Answer:
𝑉𝐴
• Number of contracts should be shorted: N* =𝛽
𝑉𝐹
It will be profitable if the stock outperforms the market in the sense that its return
is greater than that predicted by the capital asset pricing model.
Book question 3.23
A company wishes to hedge its exposure to a new fuel whose price changes have a 0.6 correlation with
gasoline futures price changes. The company will lose $1 million for each 1 cent increase in the price per
gallon of the new fuel over the next three months. The new fuel’s price change has a standard deviation
that is 50% greater than price changes in gasoline futures prices. If gasoline futures are used to hedge the
exposure what should the hedge ratio be? What is the company's exposure measured in gallons of the
new fuel? What position measured in gallons should the company take in gasoline futures? How many
gasoline futures contracts should be traded? Each contract is on 42,000 gallons.
Answer: The hedge ratio is:
The company has an exposure to the price of 100 million gallons of the new fuel (Loss=Q*∆P =>
Q=1,000,000/0.01=100 millions). It should therefore take a position of 0.9*100=90 million gallons in
gasoline futures.
• The number of contracts required = 90,000,000/42,000 = 2142.9 or 2143 contracts
• Or: N* = h*(QA/QF) = 0.9*(1,000,000/42,000) = 2142.9 or 2143 contracts
Book question 3.25
It is July 16. A company has a portfolio of stocks worth $100 million. The beta of the portfolio is 1.2.
The company would like to use the CME December futures contract on the S&P 500 to change the
beta of the portfolio to 0.5 during the period July 16 to November 16. The index is currently 1,000,
and each contract is on $250 times the index.
a) What position should the company take?
b) Suppose that the company changes its mind and decides to increase the beta of the portfolio
from 1.2 to 1.5. What position in futures contracts should it take?
Answer:
a) N = (0.5-1.2)*100,000,000/(1000*250) = - 280 contracts
→ The company should short 280 contracts
b) N = (1.5-1.2)*100,000,000/(1000*250) = 120 contracts
→ The company should long 120 contracts