Lecture 2.

Mechanics of Futures Markets
& Hedging Strategies Using Futures
EF4420. Derivative Analysis and Advanced Investment Strategies

Dr. Yongjin Kim

20 January, 2017

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Lecture Outline

• Mechanics of Futures Markets
• Specification of Futures Contract
• Payoff of Forward and Futures
• Delivery of Futures

• Hedging Using Futures
• Perfect and Imperfect Hedge
• Cross Hedge

• Hedge Using Stock Index Futures

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Specification of Futures Contract

• Recall that an exchange acts as an intermediary connecting buyers
and sellers of futures contracts.

• Thus, the exchange should specify in detail the exact nature of the
contracts. These include..

1 Underlying asset
• For commodities, there can be a variation in quality of the asset (e.g,
grade ”A“ orange juice).
• For financial assets, usually no variation in the grade of the asset.

2 Contract size
• Amount of asset that will be delivered under one contract (e.g. One
future contract on British pound is to buy/sell £62,500).

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Specification of Futures Contract

3 Delivery arrangement
• Place where delivery will be made (e.g. warehouse in Florida)

4 Delivery month
• Futures contract is referred to by its delivery month (e.g., corn futures
on CME has delivery months of March, May, July, September, and
December).

• The exchange must specify the exact period during the month when
the delivery can be made.

• For many futures contract, the delivery period is whole month.

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Payoff of Forward and Futures
• Forward and futures are very similar to each other, but a forward
contract is simpler to analyze.

• Let F denote the forward price (the promised price to buy/sell at the
maturity T of the contract).

• Payoff of forward contract:
(
long position: ST − F
short position: F − ST

where ST is the spot price of the asset at the maturity.

• A forward contract is settled only once on the expiration date, so cash
flow takes place only on the date.

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Payoff of Forward and Futures
• Suppose we enter a futures contract on day 0 and the contract will
expire on date T .

• Unlike forward, the futures will be settled every day.

Ex. Suppose we long futures on gold at the futures price of $1,250 per
ounce on day 0.
• If later futures prices are as follows, then ...
Day Futures price Daily gain
0 1,250
1 1,241 (1,241-1,250) = -9
2 1,238 (1,238-1,241) = -3
3 1,244 (1,244-1,238) = 6
.. .. ..
. . .
T FT (FT − FT −1 )

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Payoff of Forward and Futures - Daily Settlement of
Futures

• Suppose we long futures with futures price F0 .

• On the next day, suppose that new futures price becomes F1 . Then,
we settle the old contract and receive F1 − F0 . Right after the
settlement, we start with new futures contract with F1 .

• Assume that the risk-free rate is 0. Then, the cumulative gain from 0
to contract end T is

(F1 − F0 ) + (F2 − F1 ) + (F3 − F2 ) + . . . + (FT − FT −1 )
=FT − F0

• This is the same as payoff of forward contract.

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Operation of Margin Accounts
• The exchange requires investors to set up a margin account when
they enter a position in futures.
• Initial margin: the amount that must be deposited at the time the
contract is entered (e.g. $3,000 per contract)

• Once the margin account is set up, the gain/loss from daily
settlement of futures will be added/subtracted to the account.

• During the contract period, investors are also required to maintain
the balance in the margin account at a certain level.
• Maintenance margin: the minimum amount that must be
maintained during the contract.
• If the balance in the account falls below the maintenance margin,
investors receive a margin call from exchange. Then, they need to top
up the margin account up to the initial margin.
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Operation of Margin Accounts - Example

• On day 0, we long a futures contract on gold at the futures price of
$1,250 per ounce. The contract size is 100 ounce per contract.

• Initial margin is $3,000 and maintenance margin is $2,000 per
contract.

Day Futures price Daily gain Margin account Margin calls
balance
0 1,250 3,000
1 1,241 (1,241-1,250)×100 = -900 2,100
2 1,238 (1,238-1,241)×100 = -300 1,800 1,200
3 1,244 (1,244-1,238)×100 = 600 3,600
4 1,242 (1,242-1,244)×100 = -200 3,400
.. .. ..
. . .

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Futures Price and Spot Price
• Consider futures contracts for delivery on date T . Let Ft denote the
futures price on the contract starting on date t.

• Let St be the spot price of the underlying asset on date t.

• Then, (
For t < T , Ft 6= St (usually)
For t = T , Ft = St

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Delivery of Futures
• There are two types of delivery of futures:
1 Physical delivery: physically deliver underlying assets (e.g. commodity)
2 Cash settlements: final payoff of futures is paid in cash (e.g. stock
index)

• Physical delivery may incur additional costs.
• warehouse costs
• transportation costs
• to feed and look after livestock

• In reality, the majority of future contracts are closed before the
delivery.
• To close the position, investors can enter the opposite position of the
original one.
Ex. Suppose we took a long position of futures on gold for September delivery at
futures price of $1,250 on Jan 1. To close the position on May 30, we short
the futures for September delivery at futures price of $1,320. 11 / 38
Market Quotes
• Example of futures price quotes

• Prices
• Open: the price at which contracts were trading at the beginning of
the trading day
• High: the highest price during the day
• Low: the lowest price during the day
• Settlement: the price used for calculating daily gain/loss (usually
closing price of the day)
• (Trading) Volume: the number of contracts traded in a day
• Open interest: the number of contracts outstanding
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Market Quotes

Q. One day, one trader who already holds 10 futures contracts sells those
10 futures contracts to a new trader entering the market.

• How does this change the trading volume?

• How does this change the open interest?

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Hedging Using Futures

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Hedging Using Futures

• Hedgers participate in futures market to reduce a particular risk they
face (e.g, fluctuations in oil price, foreign exchange rate).

• To hedge a risk, hedgers take a futures position that neutralizes the
risk as far as possible.

1 Short hedge: a hedge that involves a short position in futures
• reduce the risk when a hedger expects to sell an asset in the future

2 Long hedge: a hedge that involves a long position in futures
• reduce the risk when a hedger expect to buy an asset in the future

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Short Hedge - Example

• On May 15, an oil producer negotiates a contract to sell 1 million
barrels of crude oil. The price in the sales contract is the spot price
on August 15.

• Oil futures price for August delivery is $79 per barrel, and each
contract is for delivery of 1,000 barrels.

Q. To hedge the risk, what position on futures should the producer take?
⇒ short 1,000 futures contract.

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Short Hedge - Example

What if the the spot price of oil on August 15 turns out to be ...
1 $75 per barrel

Total revenue = |75 ×
{z1M} + |(79 − 75) × 1M = 79M
{z }
sales contract futures contract

2 $85 per barrel

Total revenue = |85 ×
{z1M} + |(79 − 85) × 1M = 79M
{z }
sales contract futures contract

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Long Hedge - Example

• On Jan 15, a copper fabricator knows it will require 100,000 pounds
of copper on May 15 to meet a certain contract.

• Copper futures price for May delivery is $3.20 per pound, and each
contract is for delivery of 25,000 pounds.

Q. To hedge the risk, what position on futures should the fabricator take?
⇒ long 4 futures contract.

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Long Hedge - Example

What if the the spot price of copper on May 15 turns out to be ...
1 $3.25 per pound

Total payment = 3.25 × 100, 000 − (3.25 − 3.20) × 100, 000 = 320, 000
| {z } | {z }
sales contract futures contract

2 $3.05 per pound

Total payment = 3.05 × 100, 000 − (3.05 − 3.20) × 100, 000 = 320, 000
| {z } | {z }
sales contract futures contract

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Perfect Hedge

• In the previous examples, hedging using futures eliminates the risk
completely, thus leaving no risk.

• This is called a perfect hedge. A perfect hedge is possible when all
of the following conditions are satisfied:
1 The asset whose price is to be hedged is the same as the asset
underlying futures contract.

2 The hedger is certain of the exact date to buy/sell the asset.

3 The delivery date of futures contract is the same as the date to
buy/sell the underlying asset.

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Perfect Hedge

• Suppose that on date 0, a company knows it will sell an underlying
asset on date T.

• To hedge the risk, the company short futures contract for delivery on
date T at futures price F0 .

• Then, the total revenue is

ST + (F0 − FT ) = ST + (F0 − ST ) = F0

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Imperfect Hedge
• Futures contracts may not be available for a certain delivery month or
a certain underlying asset.

• Then we try to use futures with the closest delivery month and on the
most similar underlying asset. However, this does not eliminate risk
completely.
1 Mismatch in delivery date
• Suppose that on date 0, a company knows it will sell an underlying
asset on date 1.

• However, the company finds no futures available for delivery on date 1.
The closest delivery date is T .

• Shorting the future on date 0 and closing on date 1, the revenue is

S1 + (F0 − F1 ) = F0 + (S1 − F1 )
| {z }
6=0

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Imperfect Hedge

2 Mismatch in underlying asset
• Suppose that on date 0, a company knows it will sell an underlying
asset A on date T .

• However, no futures is available for the underlying asset A. Asset B is
the most similar asset for which future contract is available.

• Let S denote the spot price of A and S ∗ denote the spot price of B.

• Shorting the future on date 0 and closing on date T, the revenue is

ST + (F0 − FT ) = F0 + (ST − ST∗ )
| {z }
6=0

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Imperfect Hedge - General Case
• Suppose that on date 0, a company knows it will sell an underlying
asset A on date 1.

• Also, suppose that we try to hedge using futures on asset B for date
T delivery.

• Then, the revenue is

S1 + (F0 − F1 ) = F0 + (S1 − F1 )
| {z }
basis

1 In perfect hedge, basis = 0
2 In imperfect hedge, basis is uncertain and usually nonzero.

S1 − F1 = (S1 − S1∗ ) + (S ∗ − F1 )
| {z } | 1 {z }
mismatch in asset mismatch in delivery

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Cross Hedging

• Cross hedging is to hedge a risk of price of an asset using futures
contract on a different underlying asset.

Ex. An airline that is concerned about the future price of jet fuel uses
futures contract on heating oil.

• Hedge ratio = size of position in futures contract
size of exposure

1 In perfect hedge, hedge ratio = 1

2 In cross hedge, hedge ratio is not equal to one usually.

• In cross hedging, the hedge ratio is chosen to minimize the variance
of the value of the hedged position.

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Cross Hedging - Minimum Variance Hedge Ratio

• Assume that we have one unit of an asset and shorts futures on h
units of underlying asset.

• Let ∆S denote the price change in the asset and ∆F denote the
change in futures price in the hedge period.

• Then, the change in the portfolio value is

∆S − h∆F

• The variance of the value change is

Var (∆S) − 2h × Cov (∆S, ∆F ) + h2 × Var (∆F )

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Cross Hedging - Minimum Variance Hedge Ratio

• We want to find h such that minimizes the variance.

• To do so, we calculate the derivative of the variance with respect to h
and set it equal to 0:

Cov (∆S, ∆F )
h∗ =
Var (∆F )

• The hedge ratio can be rewritten as
σS
h∗ = ρ
σF
where ρ is the correlation coefficient between ∆S and ∆F , σF is the standard deviation of
∆F , and σS is the standard deviation of ∆S .

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Cross Hedging - Minimum Variance Hedge Ratio

• Given the optimal hedge ratio, we want to know the optimal number
of futures contract.

• Let QA denote units of assets to be hedged, and QF denote units of
underlying assets of one futures contract.

• Then, the number of contracts N ∗ should satisfy

N ∗ QF
h∗ =
QA

• Thus,
h∗ QA
N∗ =
QF

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Cross Hedging - Example

• An airline expect to purchase two million gallons of jet fuel in one
month and decides to use heating oil futures for hedging. The
standard deviation of futures price is σF = 0.0313, the standard
deviation of jut fuel price is σS = 0.0263, and the correlation
coefficient is ρ = 0.928.

Q1. What is the minimum variance hedge ratio?

Q2. Each of the futures contract is for 42,000 gallons of heating oil. How
many contracts does the airline need?

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Stock Index Futures

• A stock index tracks changes in the value of a hypothetical portfolio
of stocks (e.g. Dow Jones Industrial Averages, S&P 500)

• In the exchange, we have futures contract on these indices available.

• Suppose we invest in a portfolio of stocks (not same as the index
portfolio). Futures on this specific portfolio is not available.

• How can we hedge the risk of the portfolio value?
⇒ we use futures on a stock index.

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Stock Index Futures
• Suppose we invest $1 in the portfolio and short futures on$ h amount
of index.

• Let rS denote the return on the portfolio and rF denote the the return
on futures over the hedging period.

• Then, the change in the portfolio value is

rS − hrF

• To minimize the variance of the value change, we choose

Cov (rS , rF ) Cov (rS , rM )
h∗ = ≈ =β
Var (rF ) Var (rM )

where rM is the return on the market portfolio.

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Stock Index Futures

• We want to know the optimal number of contracts on the index.

• Let VA be the current value of the portfolio, VF be the current value
of one futures contract.

• Then, the number of contracts N ∗ should satisfy

N ∗ VF
β=
VA

• Thus,
VA
N∗ = β
VF

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Stock Index Futures - Example

• Suppose we want to hedge the value of a stock portfolio over the next
three months. We use a futures contract with four months to
maturity. The situation is ...
• S&P 500 index = 1,000
• S&P 500 futures price = 1,010
• Value of portfolio = $5,050,000
• Risk-free interest rate = 4% per annum
• Beta of portfolio = 1.5
• One futures contract is for delivery $250 times the index.

• The optimal number of contract to be shorted:

5, 050, 000
N = (1.5) = 30
250 × 1, 010

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Stock Index Futures - Example

• What if S&P 500 index and futures prices are as follows three months
later?

S&P 500 index 900 1,100
in three months
Futures price 902 1,103
in three months
Gain on futures position
Expected return on portfolio
Expected portfolio value
Total value of position
in three months

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Stock Index Futures - Example

• If S&P 500 index is 900 and futures price is 902, then...
• Gain on futures = (1, 010 − 902) × 250 × 30 = 810, 000

• Return on the market portfolio is (900 − 1000)/1000 = −10%

• Using CAPM, the expected return on the portfolio is

E (r ) = rf + β(E (rm ) − rf ) = 1 + (1.5)(−10 − 1) = −15.5%

• Then, the expected portfolio value is

5, 050, 000 × (1 − 0.155) = 4, 267, 250.

• Total value of position is 810,000 + 4,267,250 = 5,077,250

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Stock Index Futures - Example

• If S&P 500 index is 1,100 and futures price is 1,103, then...
• Gain on futures = (1, 010 − 1, 103) × 250 × 30 = −697, 500

• Return on the market portfolio is (1, 100 − 1000)/1000 = 10%

• Using CAPM, the expected return on the portfolio is

E (r ) = rf + β(E (rm ) − rf ) = 1 + (1.5)(10 − 1) = 14.5%

• Then, the expected portfolio value is

5, 050, 000 × (1 + 0.145) = 5, 782, 250.

• Total value of position is -697,500 + 5,782,250 = 5,084,750

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Stock Index Futures - Example

• What if S&P 500 index and futures prices are as follows three months
later?

S&P 500 index 900 1,100
in three months
Futures price 902 1,103
in three months
Gain on futures position 810,000 -697,500
Expected return on portfolio -15.5% 14.5%
Expected portfolio value 4,267,250 5,782,250
Total value of position 5,077,250 5,084,750
in three months

• With hedging, the total value of position is almost independent of the
value of the index.

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Things To Do

• Read the textbook chapters 2.1 - 2.7, 3.1 - 3.5

• Assignment 1 (due on Friday, 3 February at 11 pm)

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