4.

Hedging Strategies Using Futures

Chapter 3
Options, Futures, and Other Derivatives, 5th edition 2002 by John C. Hull

4.2

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 & want to lock in the price
Options, Futures, and Other Derivatives, 5th edition 2002 by John C. Hull

4.3

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

Options, Futures, and Other Derivatives, 5th edition 2002 by John C. Hull

4.4

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

Options, Futures, and Other Derivatives, 5th edition 2002 by John C. Hull

4.5

Convergence of Futures to Spot

Futures Price Spot Price

Time

Spot Price Futures Price

Time

(a)

(b)

Options, Futures, and Other Derivatives, 5th edition 2002 by John C. Hull

4.6

Basis Risk
Basis is the difference between spot & futures Basis risk arises because of the uncertainty about the basis when the hedge is closed out

Options, Futures, and Other Derivatives, 5th edition 2002 by John C. Hull

4.7

Long Hedge
Suppose that F1 : Initial Futures Price F2 : Final Futures Price S2 : Final Asset Price You hedge the future purchase of an asset by entering into a long futures contract Cost of Asset=S2 (F2 F1) = F1 + Basis
Options, Futures, and Other Derivatives, 5th edition 2002 by John C. Hull

4.8

Short Hedge
Suppose that F1 : Initial Futures Price F2 : Final Futures Price S2 : Final Asset Price You hedge the future sale of an asset by entering into a short futures contract Price Realized=S2+ (F1 F2) = F1 + Basis
Options, Futures, and Other Derivatives, 5th edition 2002 by John C. Hull

4.9

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. There are then 2 components to basis
Options, Futures, and Other Derivatives, 5th edition 2002 by John C. Hull

Optimal Hedge Ratio: Cross Hedging

Portfolio: long in 1 unit of the underlying and short in h forwards: Change in the portfolio value: S - hF Variance of the change:

4.10

V = + h 2h S F
2 S 2 2 F
Options, Futures, and Other Derivatives, 5th edition 2002 by John C. Hull

4.11

Optimal Hedge Ratio

Proportion of the exposure that should optimally be hedged is h* = S F where S is the standard deviation of S, the change in the spot price during the hedging period, F is the standard deviation of F, the change in the futures price during the hedging period is the coefficient of correlation between S and F.
Options, Futures, and Other Derivatives, 5th edition 2002 by John C. Hull

4.12

Optimal Hedge Ratio

Ex 3.6. S = $.65, F = $.81, = .8. These are quarterly. What is h for a 3-month contract?

S h = F = .8*.65/.81 = .642
*

Futures position must be 64.2% of the exposure Say, the exposure is $1,000,000. Then, the futures hedge has to be for $642,000.

Options, Futures, and Other Derivatives, 5th edition 2002 by John C. Hull

4.13

Hedging Using Index Futures

To hedge the risk in a portfolio the number of contracts that should be shorted is P
A

where P is the value of the portfolio, is its beta (actually, with respect to futures fluctuations), and A is the value of the assets underlying one futures contract and Other Derivatives, 5th edition 2002 by John C. Hull Options, Futures,

4.14

Reasons for Hedging an Equity Portfolio

Desire to be out of the market for a short period of time. (Hedging may be cheaper than selling the portfolio and buying it back.) Desire to hedge systematic risk (Appropriate when you feel that you have picked stocks that will outpeform the market.)
Options, Futures, and Other Derivatives, 5th edition 2002 by John C. Hull

4.15

Example from the text

Value of SP500 index = 1,000 A portfolio is worth: P = $5,000,000 r = 10% (risk-free); q = 4%; = 1.5 (all rates are continuously compounded) Futures on SP500 matures in 4 months and is used to hedge the portfolio over the next 3 months. What are the gains (losses)? F0 = 1,000e(.1-.04)x4/12 = 1,020.20 h = 1.5 x 5mil/.25mil = 30; Assume St=3m= 900; Ft = 900e(.1-.04)1/12 = 904.51 Gains on the short futures:
h(F0-Ft) = 30 x (1,020.2-904.51) x 250 = $867,676

Options, Futures, and Other Derivatives, 5th edition 2002 by John C. Hull

Example

4.16

r = 10% corresponds to 4*ln(1+0.1/4) = 9.877% per year compounded quarterly q = 4% corresponds to 4*ln(1+0.04/4) = 3.98% per year compounded quarterly E(RP) = r + (RM - r) = 2.47 +1.5 x (-10+0.9952.47) = -14.74% E(portf. value) = $5mil x (1-.1474) = $4,263,000 E(value of the hedge) = $4,263,000 + $867,676 = $5,130,676 or about $5mil x 1.025
Options, Futures, and Other Derivatives, 5th edition 2002 by John C. Hull

4.17

Changing Beta
Short 1P/A futures contracts to go to zero beta; then, buy 2 P/A futures contracts to go to beta 2 What position is necessary to reduce the beta of the portfolio from 1 to 0.75? What position is necessary to increase the beta of the portfolio to 2.0?
Options, Futures, and Other Derivatives, 5th edition 2002 by John C. Hull

Changing Beta

4.18

A company would like to hedge its $20 mil portfolio ( = 1.2) with SP 500 futures. 1 contract is for $250* Index. Index is at 1080 now. What is the optimal hedge ratio?
h = 1.2*20/(250*1080) 89 contracts

What should the company do to reduce of the portfolio to 0.6?

Short (1.2-0.6)*20/(250*1080) 44 contracts

Options, Futures, and Other Derivatives, 5th edition 2002 by John C. Hull

4.19

Rolling The Hedge Forward

We can use a series of futures contracts to increase the life of a hedge Each time we switch from 1 futures contract to another we incur a type of basis risk (Metallgesellschaft)

Options, Futures, and Other Derivatives, 5th edition 2002 by John C. Hull