CHAPTER 5

HEDGING STRATEGIES USING

DERIVATIVES
5.1 Hedging Strategies Using Futures
5.1.1 Basic Principles
5.1.2 Basic Risk
5.1.3 Hedging Strategies
5.2 Hedging Strategies Using Options
5.2.1 Strategies involving a single option and a stock
5.2.2 Spreads
5.2.3 Combinations
Reading Materials
TL1. Chapter 1, Chapter 3 and Chapter 11; Options, Futures, and Other
Derivatives; 8th Edition; John C. Hull; Prentice-Hall (2012)

Exercises
Chapter 3: 3.1; 3.2; 3.3; 3.5; 3.8; 3.9; 3.11; 3.20; 3.21
Chapter 11: 11.1; 11.2; 11.3; 11.4; 11.6; 11.7; 11.10; 11.12; 11.13; 11.17
 Hedging Strategies using Futures
◼ Basic Principles: Take positions that neutralize risk
◼ Short hedges
❑ Used when hedger already owns the asset and expected
to sell in the futures
Short hedges _Example
Short hedges _Example
Short hedges _Example
◼ Outcomes
− Scenario 1: SAug.15 = $17.50,
Sale of oil
=>$17.50 million.
Close out futures contract
=> Gain = 18.75-17.50 = $1.25/barrel
Total Gain on Futures Position = $1.25 million
Total amount realized on sale of oil and futures
position =($17.50+ $1.25) million = $18.75 million
Short hedges _Example
− Scenario 2: SAug.15 = $19.50,
∼ Sale of oil
=> $19.50 million.
∼ Close out futures contract
=> Loss = 19.5-18.75 = $0.75/barrel
∼ Total Loss on Futures Position = $0.75 million
∼ Total amount realized on sale of oil and futures
position =($19.50-$0.75) million=$18.75 million
· In both cases, total amount on sale is the same –
locking in sell-price
Long hedges
◼ A long hedge – Used when hedger needs to purchase
asset in the future and wishes to lock in price now
Long hedges _ Example
– Company required to buy 100,000 pounds of copper on
May 15
◼ Hedging Strategy

− Contract size is 25,000 pounds of copper

− No. of contracts: 100,000/25,000=4.
− Jan. 15:
∼ long position in FOUR May futures contracts on
copper
− May 15:
∼ close out the position
Long hedges _ Example
Long hedges _ Example
Possible Outcomes
− Scenario 1: SMay15 = $1.25.
∼ Purchase copper:
100,000 lbs * $1.25 = $125,000
∼ Close out futures position
=>Gain = (1.25 − 1.20) ´ 100,000 = $5,000
∼ Total cost of copper
= $125,000 - $5,000= $120,000.
Long hedges _ Example
− Scenario 2: SMay15 = $1.05.
∼ Purchase copper:
100,000 lbs *$1.05 = $105,000
∼ Close out futures position
=> Loss = (1.20 − 1.05) ´ 100,000 = $15,000
∼ Total cost of copper = $105,000 +$15,000=$120,000.
◼ In both cases, the buy-price is locked in at $1.20/per
pound.
◼ Note: If copper purchased on January 15 cost would
be: $140,000 + storage costs + interest costs.
Basis Risk
In practice, hedging is not so straightforward
as in above examples:
1. The asset whose price is to be hedged is not
exactly the same as the asset underlying the
futures contract.
2. Hedger may be uncertain as to exact date
when the asset will be bought or sold.
3. The hedge may require the futures contract to
be closed out well before its expiration date.
· These problems give rise to – basis risk.
Basis = Spot price of asset to be hedged −
Futures price of contract used
 Example
S1 = 2.50 S2 = 2.00
F1 = 2.20 F2 = 1.90

b1 = S1 − F1 = 0.30 and b2 = S2 − F2 = 0.10

∼ Hedge involves short futures position at t1 / asset sold at t2
∼ Price realized for asset = S = 2.00
∼ Profits on futures position = F1 - F2 = 0.30
∼ Effective price obtained for asset with hedging: =S +(F1-
F2)=$2.30=F1+b2
∼ At time t1,F1 = known, but b2 =unknown => basis risk
Choice of Contract

◼ A key factor affecting basis risk.

− Two components:
1. Choice of asset underlying futures
contract
2. Choice of the delivery month
Basis risk in a short hedge
Example: On March 1
– A U.S. company expects to receive 50 million Japanese
yen at the end of July.
– The September futures price for the yen is currently
0.7800 (in cents per yen, i.e. 1 yen = 0.78c US)
– Contract size: 12.5million yen
· Strategy
− The company can:
∼ Short 4 (=50m/12.5m) Sept. yen futures contracts on
March 1.
∼ Close out the contract when the yen arrive at the end of
July.
Basis Risk − The basis risk arises from the hedger’s
uncertainty as to the difference between the spot price
and September futures price of the Japanese yen at the
end of July.
◼ Time line for short hedging strategy
At the end of July, spot price = 0.7200 and the futures price
= 0.7250
− It follows that
Basis = 0.7200 − 0.7250 = −0.0050 = SJul. − FJul.-Sept.
− Gain on futures
= F Mar.-Sept. − F Jul.-Sept. = 0.7800 − 0.7250 = +0.0550
− The effective price (in cents per yen) received by the
hedger is the end-of-July spot price plus the gain on the
futures:
S2 + (F1 − F2) = 0.7200 + 0.0550 = 0.7750
− This also equals the initial September futures price plus
the basis:
F1 + (S2 − F2) = 0.7800 − 0.0050 = 0.7750
Basis risk in a long hedge
Example: It is July 8:
− A company knows that it will need to purchase 20,000
barrels of crude oil at some time in October or November.
− The current December oil futures price is $18.00 per
barrel.
− Contract size: 1,000 barrels.
· Strategy – The company:
− Takes a long position in 20 Dec. oil futures contracts on
July 8.
− Closes out the contract when it finds it is ready to
purchase oil.
Basis Risk – The basis risk arises from the hedger’s uncertainty
as to the difference between the spot price and the December
futures price of oil at the time when contract closed out
◼ Time line for long hedging strategy
On Nov. 10 company purchases the oil and closes out its
futures con-tract.
−The spot price is $20.00/barrel and the futures price is
$19.10/barrel:
Basis = SNov. − FNov.-Dec. = 20.00 − 19.10 = 0.90
− Gain on futures
= F Nov.-Dec. − F Jul.-Dec. = 19.10 − 18.00 = 1.10
− The effective cost of the oil purchased is the November 10
price less the gain on the futures:
S − (gain/loss on futures) = 20.00 − 1.10 = 18.90 per barrel
− This also equals the initial Dec.futures price + the basis:
F Jul.-Dec. + basis = 18.00 + 0.90 = 18.90 per barrel
Hedging Strategies using Options
◼ Strategies involving a single option and a
stock (Hedge)
◼ Spreads

◼ Combinations
Strategies involving a single option and a stock
◼ Covered Call_ write a call and long the stock
Covered Call_ Example
Covered Call_ Example
Strategies involving a single option and a stock

◼ Protective put_ long put option and long the stock

Protective put
Spreads
Bullish vertical spreads
Bearish vertical spreads
Bearish vertical spreads_ Example
Bearish vertical spreads_ Example
Butterfly Spreads
Butterfly Spreads_ Example
Butterfly Spreads_ Example
Butterfly Spreads_ Example
Combinations
Bottom straddle
◼ Profitable in volatile market
Bottom straddle_ Example
◼ From the Trader’s Desk
Bottom Straddle_ Example
Bottom straddle_ Example
Top straddle
◼ Profitable in stable market
Bottom vertical combinations_ Long strangles
Bottom vertical combinations_ Long strangles

46
Top vertical combinations_ Short strangles

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Top vertical combinations_ Short strangles

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Strip and Strap

Profit Profit

K ST K ST

Strip Strap