3.

0 Hedging Strategies Using Futures

 Throughout the chapter, assume:
o One time hedge
 Hedge will not be adjusted as time goes by.
o Ignore daily settlement
 Ignore the fact that if investors are losing on a hedge, there is a cash
outflow (top up margin) required.

3.1 Basic Principles

 Objective: Take a position that neutralizes risks as much as possible.
o Not to speculate or exploiting arbitrage opportunity to earn profit.
 In summary:
1. Short Hedge
 When the company has something to sell.
 The company loves the exposure to price increase (can sell at higher
price) but doesn’t want to take the risk of price decrease (lose out on
selling price), thus it is willing to sacrifice some upside to guarantee a
stable price so that it has no exposure to the downside.
 As PB ↑, profit made on the futures contract ↓ (lose money on the
hedge); As PB ↓, profit made on the futures contract ↑.
 Since the price of selling the asset is locked in at the price at which the
futures contract is entered, the net gain/loss will be 0.
2. Long Hedge
 When the company has something to buy.
 The company loves the exposure to price decrease (can buy at a lower
price) but doesn’t want to take the risk of price increase (have to buy
at a higher price), thus it is willing to sacrifice some downside to
guarantee a stable price so that it has no exposure to the upside.
 As PB ↑, profit made on the futures contract ↑; As PB ↓, profit made on
the futures contract ↓.
 Since the price of selling the asset is locked in at the price at which the
futures contract is entered, the net gain/loss will be 0.
3.2 Short Hedge
 Taking a short position in futures contract.
 Appropriate when the hedger already owns the asset and intend to sell it at some
time in the future.
 Can also be used when an asset is not owned right now but will be owned at some
time in the future.
o A US exporter will receive payments in Euro in 3 months.
o Exporter will realize a gain (loss) if Euro increase (decrease) in value relative
to USD.
o Taking a short position in futures contract yields a gain (loss) if Euro
decrease (increase) in value relative to USD.
 Has an offsetting effect on exporter’s risk.
 Consider an oil producer negotiated a contract to sell 1 million barrel of crude oils
which will be delivered 3 months later at ST . The oil producer is currently in a position
of gaining (losing) $10,000 per 1 cent increase (decrease). Suppose the spot price is
$80 per barrel and crude oil futures price for delivery 3 months later is $79. Given
each futures contract is for delivery of 1,000 barrel, the company can hedge its
exposure by shorting 1,000 futures contracts. This strategy effectively lock in a price
of $79 at maturity.
1. Spot Price 3 Months Later Decreases ($75)
 Profit Realized from Delivery = $75/barrel
 Profit Realized from Short Selling = $79 – $75 = $4/barrel
o Futures price is close to the spot price of $75 at maturity.
 Total Profit Realized = $79/barrel = $79 million
2. Spot Price 3 Months Later Increases ($85)
 Profit Realized from Delivery = $85/barrel
 Losses from Short Selling = $85 - $79 = $6/barrel
o Futures price is close to the spot price of $85 at maturity.
 Total Profit Realized = $85 - $6 = $79/barrel = $79 million
 Regardless the price increase/decrease 3 months later, the company will always lock
their profit at $79/barrel.
3.3 Long Hedge
 Taking a long position in futures contract.
 Appropriate when a company knows it will have to purchase some asset in the future
and wants to lock in a price now.
 Consider a copper fabricator that knows it will require 100,000 pounds of copper 5
months later. The spot price of copper is 340 cents per pound and the futures price for
delivery 5 months later is 320 cents per pound. The fabricator can hedge its position
by taking a long position in 4 futures contracts (each for delivery of 25,000 pounds).
This strategy effectively lock the price of the required copper at 320 cents per pound.
1. Copper Price Increases (325 cents per pound)
 Profit from Longing Futures = 100,000 * (325 – 320) = $5,000
o Futures price is close to spot price of 325 cents at maturity.
 Acquiring the Copper = 100,000 * 325 = $325,000
 Net Cost = $325,000 - $5,000 = $320,000
2. Copper Price Decreases (315 cents per pound)
 Acquiring the Copper = $100,000 * 305 = $315,000
 Loss from Longing Futures = 100,000 * (35 – 320) = $5,000
o Futures price is close to spot price of 315 cents at maturity.
 Net Cost = $305,000 + $5,000 = $320,000
 Under both scenarios, the fabricator effectively lock his cash outflow at 320
cents/pound.
 If the fabricator instead chose to purchase the copper immediately from spot market,
he will effectively paying 340 cents instead of 320 cents per pound and will incur
both storage costs and interest costs.
 Note: Hedging not only neutralizes the risk, it also neutralizes the reward. By
hedging, any favourable movement are forgone by locking it at a price in return
for neutralizing exposure of unfavourable movement.

3.4 Argument In Favour of Hedging

 Most non-financial companies are manufacturing, retailing or wholesaling companies
with no expertise in predicting variable movement.
 Hedging provides protecting against any sharp movement in price of commodity,
allowing them to focus more on their main activities.
3.5 Argument against Hedging
1. Shareholders can do the hedging themselves, if they wish, thus does not
require the company to do for them.
 Open to question because:
o Assumes shareholders have as much information as the
management about the risk faced by the company.
o Ignores commissions and transaction costs.
 Hedging is less expensive when carried out by company
(large transactions) than by individuals (small transactions).
 One thing shareholders can do easily than corporation is to diversify risk.
2. If hedging is not a norm in the industry, it makes no sense for the company to
be different from everyone else.
 Competitive pressure within an industry may be cause by product price
fluctuation to reflect raw material costs, inflation rate, interest rate, …
 Companies that don’t hedge expect profit margin to be relatively constant.
 A company that hedge can expect its profit margin to fluctuate.
o Consider an industry where hedging is not a norm and Company A
decides to hedge against the price of a commodity.

Company A Others
Commodity Price Increase
Effect on Product Price Increase Increase
Effect on Profit Increase None
Commodity Price Decrease
Effect on Product Price Decrease Decrease
Effect on Profit Decrease None
 All implications of price changes to the company’s profitability should be
considered when designing hedging strategy to protect against price
changes.
3. Hedging can lead to a worse outcome.
 Hedging can result in profiting/losing relative to position it would be in
with no hedging.
o If the market variable goes unfavourably, hedging gives an
advantage of limiting losses; but if the market variable goes
favourably, hedging gives disadvantage of limiting gain.
  Many treasurers are reluctant to hedge as not everyone (especially
management and shareholders) fully understand the mechanism of
hedging.

3.6 Basis Risk

 Arise from mismatches in hedged position.
 Occurs when hedge is imperfect, thus losses in an investment are not exactly offset by
the hedge.
o In real life, it is almost impossible to find a futures contract that matures at the
precise date you want for delivery.
 Usually arise from:
o The use of a proxy futures for an asset.
 The asset whose price to be hedge is not exactly the same (proxy) as
the asset underlying the futures contract.
 The asset wanted doesn’t have a futures contract, thus futures contract
of another asset that is close (highly correlated) to the required asset is
used.
 E.g. (Heating Oil to hedge Jet Fuel, etc…)
o The asset purchase/sales date is different from the contract expiration date.
 Futures price converges to spot price at maturity, but if the position
have to be closed before expiration, futures price and spot price will
not converge; there exists a gap between the two prices.
 The hedger may be uncertain on the exact date the asset will be
bought/sold.
 Unless the underlying asset is the asset hedged and the hedge is closed on the
exact day of delivery (contract expiration = delivery date), basis risk will always
present.

3.7 Basis
Basis=Spot Priceof Asset ¿ be Hedged−Futures Price of Contract Used

 If the asset to be hedged and the underlying asset of futures contract is the same, basis
= 0 at expiration.
o Prior to expiration, the basis may be positive/negative.
  As time passes, spot price and futures price may change, but they does not necessarily
change by the same amount.
o Futures price failed to track the spot price, basis that are expected to decrease
over time may increase instead.
o Strengthening of the Basis: Increase in basis. Undesirable by long position.
o Weakening of the Basis: Decrease in basis. Undesirable by short position.
 Assume a hedge is put in place at t 1 and closed out att 2. Suppose S1=$ 2.50,
F 1=$ 2.20, S2=$ 2.00, F 2=$ 1.90. Let b 1 and b 2 be the basis at t 1 and t 2 respectively.
b 1=2.50−2.20=0.30; b 2=2.00−1.90=0.10
Consider:
1. The company knows it will sell the asset at t 2 and take a short position att 1.
 The effective price paid with hedging:
S2 + ( F 1−F2 ) =F1 +b 2

 Note the basis changes can lead to improvement/worsening of a hedger’s

position.
o In this case, the basis b 2 actually improve the hedger’s position,
allowing him to sell at a higher price.
2. The company knows it will buy the asset at t 2 and take a long position att 1.
 The effective price paid with hedging:
S2 + ( F 1−F2 ) =F1 +b 2

 In this case, the basis b 2 worsen the hedger’s position as he has to buy the
asset at a higher price.
 By locking the price at F 1 att 1, companies manage to hedge the undesired price
risk of the asset, but at the same time open to basis risk, which may
improve/worsen the company’s hedging position.

+Basis -Basis
Short Hedge ↑ ↓
Long Hedge ↓ ↑
3.8 Choice of Contract for Hedging
 Key factor affecting basis risk.
 Two considerations:
1. Choice of Asset Underlying the Futures Contract
  Best Choice: Asset being hedged exactly matches the asset underlying the
futures contract.
 If not, careful analysis is required to determine which available futures
contract has futures price most strongly correlated with the price of asset
being hedged.

2. Choice of Delivery Month

 Ideally, choose delivery month that corresponds to the expiration of the
hedge.
 In practice, contract with delivery month later than the expiration of the
hedge is chosen.
o Futures price sometimes are quite erratic during delivery month.
o Long hedgers risk of having to take delivery of the physical asset if
the contract is held during the delivery month.
 Taking delivery is expensive and inconvenient, thus long
hedgers usually prefer to close out futures contract and buy
the asset from usual suppliers.
 Generally, basis risk increases as the time difference between expiration
date and delivery date increases.
 Rule of Thumb: Choose delivery month that is close to, but later than,
expiration of hedge.
o This rule assumes that there is sufficient liquidity in all contracts
to meet hedger’s requirement.
 In practice, liquidity tends to be the greatest in short-maturity futures.
o In some situations, hedgers may be inclined to use short-maturity
futures and roll them forward.

3.9 Cross Hedging

 Occurs when asset being hedged is different from asset underlying the futures
contract.
 Hedge Ratio
o Ratio of the size of position taken in futures contract to the size of exposure.
 o When asset underlying the futures contract is the same as asset being hedged,
Hedge Ratio = 1.
o When cross hedging is used (two assets are different), setting hedge ratio = 1
is no longer optimal.
 Choose a value that minimizes variance of hedge ratio.

3.10 Minimum Variance Hedge Ratio

 Let:
Price
∆ S=Changes∈Spot of hedge
time
Price
∆ F=Changes∈Futures of hedge
time
h¿ =Minimum Variance Hedge Ratio
 h¿ is the slope of the best-fit line from a linear regression of ∆ S against ∆ F , where:
¿ σS
h =ρ
σF
 The parameters ρ , σ S and σ F is estimated using historical data of ∆ S and∆ F .
 Criteria for parameter estimation:
o The time interval is the same as the length of time for which the hedge is in
practice.
 If the hedge is for 2 months, two months of historical of ∆ S and ∆ F is
observed.
o Time interval of data used are not overlapping.

3.11 Optimal Number of Contracts Used for Hedging

 Let:
Q A =¿ Size of position being hedged (unit);
Q F=¿ Size of one futures contract (unit);
N ¿ =¿ Optimal number of futures contract for hedging
 Number of futures contract required:
h¿ Q A
¿
N=
QF
3.12 Tailing the Hedge


3.6 Stock Index Futures

3.7 Stack and Roll