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4-1

Hedging

• Definition

– risk reduction or avoidance, risk management – establishing a position in the futures market that is "EQUAL & OPPOSITE" to a position in the actual commodity

• Function

– want to lock in the price or profit – pass on price level risk to speculator taking relatively less basis risk

4-2

Long Hedge (1) • Situation : – Anticipatory or procurement hedge – You will purchase an asset in the future and want to lock in the price – Procurement cost = S1 – (F1 – F0) = F0 + B1 Date t=0 t=1 Total Spot (Short at S0) Long at S1 S1 Futures Long at F0 Short at F1 F1 – F0 Basis B0 = S0 – F0 B1 = S1 – F1 – 4-3 Long Hedge (2) • Situation : – Margin fixing hedge – You short sell an asset and will buy it back in the future and want to lock in the margin – Margin = (S0 – S1) + (F1 – F0) = B0 – B1 Date t=0 t=1 Total Spot Short sell at S0 Long at S1 S0 – S1 Futures Long at F0 Short at F1 F1 – F0 Basis B0 = S0 – F0 B1 = S1 – F1 B0 – B1 4-4 .

Short Hedge (1) • Situation – Anticipatory or sales hedge – You will sell it in the future and want to lock in the price – Sales price = S1 + (F0 – F1) = F0 + B1 Date t=0 t=1 Total Spot (Long at S0) Short at S1 S1 Futures Short at F0 Long at F1 F0 – F1 Basis B0 = S0 – F0 B1 = S1 – F1 – 4-5 Short Hedge (2) • Situation – Inventory hedge – You hold an asset now and will sell it in the future and want to lock in the margin – Sales margin = (S1 – S0) + (F0 – F1) = B1 – B0 Date t=0 t=1 Total Spot Long at S0 Short at S1 S1 – S0 Futures Short at F0 Long at F1 F0 – F1 Basis B0 = S0 – F0 B1 = S1 – F1 B1 – B0 4-6 .

• Var(SP) >> Var(Basis) – volatility(level) >> volatility(difference) – Always workable for hedging • Is it possible to hedge basis risk? 4-7 Hedging Rules using Basis (1) “A SHORT HEDGER IS LONG THE BASIS. or SP drops relative to FP 4-8 . quality.Basis Risk • Arises since there may be difference between SP & FP when hedge is closed out – transportation cost.” (1) prefers when basis is wider than normal (SP < FP) and expected to increase (2) makes profit if basis narrows or increases. etc. or SP rises relative to FP (3) makes loss if basis widens or decreases.

or SP rises relative to FP (3) makes profit if basis widens or decreases.FP FP SP.” (1) prefers when basis is narrower than normal (SP < FP) and expected to decrease (2) makes loss if basis narrows or increases.FP FP SP t t SP 4-10 .Hedging Rules using Basis (2) “A LONG HEDGER IS SHORT THE BASIS. or SP drops relative to FP 4-9 Illustration : Short Hedge • Assuming contango (SP < FP) SP.

10 – X = ? Basis $0.15? (B widens or drops) (4) What if in backwardation? Date t=0 t=1 Total Spot Long at $20.10 under ? ? 4-11 Attractiveness of Hedging (1) Without basis risk (constant basis).00 = –2. • What if comparing with speculation? – No hedging implies speculation on spot 4-12 .05? (B narrows or soars) (3) What if X = 18.00 18.00 Futures Short at $20.Example : Short Hedge (1) What if X = 18.00 Short at $18.00 – 20. you always get S0 as an effective price (2) You don’t need to predict future price.10 Long at $X 20. and just need to judge current price level (3) Hedging is never risky nor costs too high.10? (2) What if X = 18.

Choice of Contract • Choose most highly correlated with the asset price – Cross hedging : futures contract not directly corresponding to the asset being hedged • Choose a delivery month that is as close as possible to the end of the life of the hedge – Also futures expiry date > end of hedge life 4-13 Strip vs Stack Hedges • Choice of contract also depend on – liquidity (유동성) – risk exposure period • Strip hedge : exposure > contract expiry – Crude oil trade of 36 months with futures as far as 17 months • Stack hedge : exposure < contract expiry 4-14 .

50] 16.40] 15.00 [0.3) = 1.Illustration • Strip hedge Contract expiry Risk exposure • Stack hedge Contract expiry Risk exposure 4-15 Rolling Hedge Forward • A series of futures to increase hedge life – switches from one contract to another – incurs a type of basis risk • Rolling over short futures : (F0.3 – F3.1 – F1.2 – F2.80] 18.2) + (F2.40 17.50 16.90 4-16 .30 [0.1) + (F1.70 [0.20 17.

R2 from the simple OLS 4-18 .Optimal Hedge Ratio • Proportion of the exposure that should optimally be hedged h=ρ σS σ σ σ = SF S = SF 2 σF σSσF σF σF • Equivalent to simple OLS coefficient of ∆S t = α + β ∆Ft + ε t ˆ β =σ σ2 SF F 4-17 Hedging Effectiveness • Proportion of the variance that is eliminated by hedging 2 Var ( S ) − Var ( R * ) Var ( R * ) 2 σF E = = 1− = h 2 = ρ2 Var ( S ) Var ( S ) σS * Var ( S ) = Var of unhedged position Var ( R * ) = Var of minimum risk portfolio • Equivalent to coefficient of determination.

5 risk-free interest rate = 10%/yr dividend yield on index = 4%/yr • If the value of S&P 500 in 3 months turns out to be 900.Hedging Using Index Futures • To hedge the risk in a portfolio the number of contracts (N) that should be shorted is N = β*(P/A) β : beta of (Rp– rf) regressed on (Rm– rf) P : value of the portfolio A : value of the stocks underlying futures contract 4-19 Example • Situation : to hedge the value of S&P 500 over the next 3 months – – – – – – current value of portfolio = $5 million current value of S&P 500 = 1.000 (pt) futures on S&P500 = $250 x index beta of portfolio = 1. the expected value of hedge? 4-20 .

262.130.020.4) = 900e(0.000/(250 x 1.5 x [5.000e(0.262.75 • Expected value of portfolio in 3 months? $5.10-0.51 • Gains from short positions in futures? 30 x (1020.5)] = -14.20 • Futures prices in 3 months? F(3.51) x 250 = $867.5 x (-9.000.04)x(1/12) = 904.000)] = 30 • Current futures prices? F(0.20 – 904.4) = S0e(r-q)T = 1.5% – using CAPM pricing (Rp– rf) = β(Rm– rf) Rp = 2.0 – 2.04)x(4/12) = 1.676 4-21 Step (2) : Spot Position • Expected return (%) on the portfolio? – loss on index = -[10 – 4 x (3/12)] = -9% – rf for 3 months = 10 x (3/12) = 2.1475) = $4.000.500 • Expected value of spot and futures? $4.Step (1) : Futures Position • How many futures contracts on S&P? 1.676 = $5.5 + [1.000 x (1 – 0.500 + $867.176 4-22 .10-0.

Step (3) : More Important? • If the value of S&P 500 in 3 months turns out to be 900 => 1.100. the expected value of hedge? • Guess – gains of cash increase. losses of futures increase 4-23 Reasons for Hedging an Equity Portfolio • To hedge systematic risk – Appropriate when you feel that you have picked stocks that will outperform the market.000 => 1. but uncertain the market as a whole • To be out of the market for short period – Hedging may be cheaper than selling the portfolio and buying it back 4-24 .

exchange rates. and other market variables 4-25 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 4-26 .Arguments in Favor of Hedging • Companies should focus on the main business they are in and take steps to minimize risks arising from market – interest rates.

4 (p. to 4-24.Assignment • Ch. • 헤징의 개념을 현실에서 적용하였거나 할 수 있는 사례를 정리 • 중간고사 일정 – 일시: 10월18일 1-2시(1시간) – 문제유형 : 주관식 4-5문제 40점만점 (계산기 지참) – 중간고사 기간에도 모의투자는 계속하기 바람 4-27 .96) : 4-21.

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