Hedging Strategies Using Futures

ISSUES

ASSUME

3.1 Basic Principle

3.2 Arguments For and Against Hedging
3.3 Basis Risk
3.4 Cross Hedging
3.5 Stock Index Futures
3.6 Rolling the Hedging Forward

ISSUES

1. When is a short futures position appropriates

2. When is a long futures position appropriate

3. Which futures contract should be used

4. What is the optimal size of the futures position for reducing
risk

ASSUME

Hedge-and forget

Futures contracts as forward

contracts
2

3.1 Basic Principles-Short Hedge (

)

3.1 Basic Principles-Long Hedge ( )

Hedges that involve taking a long position in a

futures contract are known as long hedges.

A long hedge is appropriate when a company knows

it will have to purchase a certain assets in the future
and wants to lock a price now.

Long hedge can be used to manage an existing short

position.

3.2 Arguments For and Against

Hedging

Hedging and Shareholders

1 Shareholders can do the hedging themselves.
It assumes that shareholders have as
much
2
information about the risks faced by a
company
as does the companys management.
3

Shareholders can do far more easily than

a corporation is diversify risk.

3.2 Arguments For and Against

Hedging

Hedging and Competitors

3.2 Arguments For and Against

Hedging

All implications of price changes on a

companys profitability should be taken
into account in the design of a hedging
strategy to protect against the price
changes.

3.3 Basis Risk

The asset whose price is to be hedged may

not be exactly
the same as the asset underlying the futures
contract.
The hedger may be uncertain as to the exact
when the
asset will be bought or sold.
The hedge may require the futures contract
to be closed
out before its delivery month.

These problem gives rise to what is termed

basic risk.

3.3 Basis Risk

The basis in a hedging situation is as follows:
Basis = Spot price of asset to be hedged Futures price of
contract
= S used
F

An increase in the basis is referred to a strengthening of the .

basis
A decrease in the basis is referred to as a
weakening of the
basis

3.3 Basis Risk

Suppose that
F1 : Initial Futures Price
F2 : Final Futures Price

Spot price

S2 : Final Asset Price

S1

b1 = S1 F1

b1

b2 =S2 F2

F1
S2

Futures
price

b2

F2

Long Hedge :
You hedge the future purchase of an asset by entering into a
long futures contract
The effective price( ) that is paid with
hedge is

t1

t2

Figure 3.1 Variation of basic over time

basis risk(
)

S2 + FHedge
Short
: F 1 + b2
1 F2 =
You hedge the future sold of an asset by entering into a short
futures contract
The effective price( ) that is obtained for the
asset with hedge is S2 + F1 F2 = F1 + b2

3.3 Basis Risk

Choice of
Contract
One key factor affecting basis risk is the choice of the futures
contract to be used for hedging. This choice has two
components:

1.The choice of the assets underlying the futures

contracts

A contract with a later delivery

2.The choice of the delivery
month
month
is usually chosen in these
circumstances.

3.4 Cross
Hedging

Calculating the Minimum Variance

Hedge Ratio ( )

S
h*
F
h* : Hedge ratio that minimizes the variance of the hedgers
position.
: Coefficient of correlation between S and F
S : Change in spot price, S, during a period of time equal to the life of the
hedge.
S :: Change
Standard
of S
F
in deviation
future price,
F, during a period of time equal to the life of the
hedge.
F : Standard deviation of F

3.4 Cross
Hedging

Optimal Number of
Contracts ( )

h* NA
N*
QF

The futures contracts used

should have a face value of
h* NA

NA : Size of position being hedged (unit)

QF : Size of one futures contract (unit)
N* : Optimal number of futures contracts for
hedging

3.5 Stock Index

Future

Hedging Using Stock Index

Futures

P
N*
A
N*: Optimal number of futures contracts for hedging
P : Current value of the portfolio
A : Current value of one futures contract
: From the capital asset pricing model to determined
the appropriate hedge ratio

3.5 Stock Index

Future
Example

Value of S&P 500 index =1000

S&P 500 futures price =1010
Value of portfolio = $5,000,000
Risk-free interest rate = 4% per annum
Dividend yield on index = 1% per annum
One future contract is for
Beta of portfolio = 1.5
delivery of $250 times the index
Current value of one futures contract = 250*1000 =
250,000
Optimal number of futures contracts for hedging

N*

P
5,000,000
1.5
30
A
250
,
000

3.5 Stock Index

Future

Value of index in
three months
Futures price of
index today
Futures price of
index in three
months
Gain on futures
position

Return on market
Expected return
on portfolio
Expected portfolio
value in three
months
(including
dividends)

900
1,010
902

950
1,010

900 e
952

1 ,000
1,010

1,050

1,100

Time to
maturity
1,010

1,010

1,053

1,103

1
( 0.04 0.01)
12

1,003

The gain from the short futures position

= 30* ( 1,010 902 ) *250 = $ 810,000

loss on the
index = 10 %
810,000 The
435,000
52,500
322,500 697,500
The index pays a dividend of 0.25%per 3
interest rate = 1 % per 3
The risk-free

0.250% 5.250% 10.250%

9.750% months
4.750%
months
An investor in the index would earn = 9.75
$ 5,000,000*(1
=
return on portfolio
0.15125) =
Expected
7.375% 14.875%
$4,243,750
15.125% %
7.625%
0.125%
= 1 + 1.5*( 9.75 1 ) = 15.125 %

=$ 4,243,750 + $810,000
4,243,75 4,618,75 4,993,75 5,368,7 5,743,75
0
0
0
50
0

3.5 Stock Index

Future
Reasons for Hedging an Equity
Portfolio

A hedge using index futures removes the risk arising from

market and leaves the hedger exposed only to the performance
of the portfolio relative to the market.

The hedger is planning to hold a portfolio for a long period of

time and requires short-term protection.

3.5 Stock Index

Future
Changing the Beta of a Portfolio
To reduce the beta of the portfolio to 0.75

P
5,000,000
( *) (1.5 0.75)
15( short )
A
250,000
To increase the beta of the portfolio to 2.0

P
5,000,000
( * ) (2 1.5)
10(long )
A
250,000

3.5 Stock Index

Future
Exposure to the Price of an Individual
Stock

Similar to hedging a well-diversified stock portfolio

The performance of the hedge is considerably worse,

only against the risk arising from market movements

3.6 Rolling The Hedge Forward

This involves entering into a sequence of

futures
contracts to increase the life of a hedge

Rollover basis risk