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We assume that no attempt is made to adjust the hedge once it has been put in place. The hedger
simply takes a futures position at the beginning of the life of the hedge and closes out the
position at the end of the life of the hedge.
What is hedging?
Hedging is buying or selling futures contract as protection against the risk of loss due to
changing prices in the cash market. If you are a wheat grower, you want to protect against
falling prices in the cash market. If you need to buy grain, you want to protect against rising
prices in the cash market.
When an individual or company chooses to use futures markets to hedge a risk, the objective
is usually to take a position that neutralizes the risk as far as possible.
Ex: Consider a company that knows it will gain $10,000 for each 1 cent increase in the price
of a commodity over the next 3 months and lose $10,000 for each 1 cent decrease in the price
during the same period.
To hedge, the company’s treasurer should take a short futures position that is designed
to offset this risk.
The futures position should lead to a
o loss of $10,000 for each 1 cent increase in the price of the commodity over the
3 months
o gain of $10,000 for each 1 cent decrease in the price during this period.
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A short hedge is a hedge that involves a short position in futures contracts.
A short hedge is appropriate when the hedger already owns an asset and expects to
sell it at some time in the future and wants to protect himself against falling prices.
A short hedge can also be used when an asset is not owned right now but will be
owned at some time in the future.
Example 1:
It is October and you plan to sell 1 bushel of corn in December. You are uncertain about the
outlook for corn prices and want to protect the value of your inventory from falling prices. The
current cash price in October is $70.00. The December corn futures contract is also trading at
$70.00. You sell 1 corn futures contract @ $70.00.
In December, corn market price is $65.00. You deliver your corn and receive $65.00, and offset
your futures positions by buying a December corn futures contract at $65.00.
In December, cash market price is $77.00. You deliver your corn and receive $77.00 and offset
your futures positions by buying a December corn futures contract at $77.00.
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Cash Market Futures Market
Example 2:
In March, a wheat farmer is planning to plant 100000 bushels of wheat, which will be ready
for harvesting by late August and delivery in September. The farmer knows from past years
that the total cost of planting and harvesting the crops is about $6.30 per bushel.
At that time, September Wheat futures are trading at $6.70 per bushel, and the wheat farmer
wishes to lock in this selling price. To do this, he enters a short hedge by selling some
September Wheat futures.
With each Wheat futures contract covering 5000 bushels, he will need to sell 20 futures
contracts to hedge his projected 100000 bushels production.
By mid-August, his wheat crops are ready for harvesting. However, the price of wheat have
since fallen and at the local elevator, the price has dropped to $6.20 per bushel.
Correspondingly, prices of September Wheat futures have also fallen and are now trading at
$6.33 per bushel.
Selling his harvest of 100000 bushels of wheat at the local elevator yields $6.20/bu x 100000
bushels = $620000.
But the cost of growing the crops is $6.30/bu x 100000 bushels = $630000
Hence, his net profit from the farming business = Revenue Yield - Cost of Growing Crops =
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For all his efforts, the wheat farmer might have ended up with a loss of $10000.
Fortunately, he had hedge his output with a short position in September Wheat futures which
have since gained in value.
Value of Wheat futures Sold in March = $6.70 x 20 contracts x 5000 bushels = $670000
Value of Wheat futures Purchased in August = $6.33 x 20 contracts x 5000 bushels = $633000
Overall profit = Gain in Futures Market - Loss in Cash Market = $37000 - $10000 = $27000
Hence, with the short hedge in place, the farmer can still manage to make a profit of $27000
despite falling Wheat prices.
If you need to buy soybean meal in the future, you will be disadvantaged if prices increase.
You can use a long hedge to control that risk.
Example
It is October and you plan to buy 100 tons of soybean meal in March. You are uncertain about
the outlook for meal prices. Cash meal in October is trading at $250 per ton. The March
Soybean Meal futures contract is also trading at $250.00. You buy 1 contract to cover your
future soybean meal purchases.
In March, cash market price for soybean meal is $236.00. You buy your cash meal at $236.00
and offset your futures positions by selling 1 March Soybean Meal Futures contract at $236.00.
October: Buy soybean meal @ $250 Buy March soybean futures @ $250.00
March: Buy soybean meal @ $236 Sell March soybean futures @ $236.00
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Buy soybean in March at ………………………$236.00
In March, cash market price for soybean is $260.00. You buy your soybean meal at $260.00
and offset your futures positions by selling 1 March Soybean Meal Futures contract at $260.00.
October: Buy soybean meal @ $250 Buy March soybean futures @ $250.00
March: Buy soybean meal @ $260 Sell March soybean futures @ $260.00
It is important to realize that a hedge using futures contracts can result in a decrease or an
increase in a company’s profits relative to the position it would be in with no hedging.
In the example involving selling corn considered earlier, if the price of corn goes down, the
company loses money and the futures position leads to an offsetting gain.
Clearly, the company is better off than it would be with no hedging.
If the price of corn goes up, the company gains from its sale of corn, and the futures position
leads to an offsetting loss. The company is in a worse position than it would be with no
hedging.
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3.2 Basis Risk
The hedges in the examples considered so far have been almost too good to be true. The hedger
was able to identify the precise date in the future when an asset would be bought or sold. The
hedger was then able to use futures contracts to remove almost all the risk arising from the
price of the asset on that date. In practice, hedging is often not quite as straightforward as this.
Some of the reasons are as follows:
1. The asset whose price is to be hedged may not be exactly the same as the asset
underlying the futures contract.
Ex: actual commodity, weight, quality, or amount might differ
2. The hedger may be uncertain as to the exact date when the asset will be bought or sold.
3. The hedge may require the futures contract to be closed out before its delivery month.
Basis is the difference between the cash price for the asset to be hedged and the futures price.
If the hedged asset is identical to the commodity underlying the futures contract, the cash price
and futures price should converge as delivery nears.
If the asset to be hedged and the asset underlying the futures contract are the same, the
basis should be zero at the expiration of the futures contract.
An increase in the basis is referred to as a strengthening of the basis.
A decrease in the basis is referred to as a weakening of the basis.
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To examine the nature of basis risk, we will use the following notation:
We will assume that a hedge is put in place at time t1 and closed out at time t2. As an example,
we will consider the case where the spot and futures prices at the time the hedge is initiated are
$2.50 and $2.20, respectively, and that at the time the hedge is closed out they are $2.00 and
$1.90, respectively. This means that S1 = 2.50, F1 = 2.20, S2 = 2.00, and F2 =1.90.
b1 = S1 - F1 and b2 = S2 - F2
Consider first the situation of a hedger who knows that the asset will be sold at time t2 and takes
a short futures position at time t1.
The effective price that is obtained for the asset with hedging = S2 + F1 - F2 = F1 + b2= $2.30
The value of F1 is known at time t1. If b2 were also known at this time, a perfect hedge would
result. The hedging risk is the uncertainty associated with b2 and is known as basis risk.
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The total amount received by the company for the 50 million yen is 50 x 0.00975 million
dollars, or $487,500.
Consider next a situation where a company knows it will buy the asset at time t2 and initiates a
long hedge at time t1.
The effective price that is paid for the asset with hedging = S2 + F1 - F2 = F1 + b2= $2.30
The value of F1 is known at time t1, and the term b2 represents basis risk.
For a company using a long hedge because it plans to buy the asset, the reverse holds.
If the basis strengthens unexpectedly, the company’s position worsens because it will pay
a higher price for the asset after futures gains or losses are considered; if the basis
weakens unexpectedly, the company’s position improves.
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Example
It is June 8 and a company knows that it will need to purchase 20,000 barrels of crude oil at
some time in October or November. Oil futures contracts are currently traded for delivery every
month on the NYMEX division of the CME Group and the contract size is 1,000 barrels. The
company therefore decides to use the December contract for hedging and takes a long position
in 20 December contracts. The futures price on June 8 is $88.00 per barrel. The company finds
that it is ready to purchase the crude oil on November 10. It therefore closes out its futures
contract on that date. The spot price and futures price on November 10 are $90.00 per barrel
and $89.10 per barrel.
The gain on the futures contract = 89.10 – 88.00= $1.10 per barrel.
The basis when the contract is closed out = 90.00 – 89.10=$0.90 per barrel.
The effective price paid (in dollars per barrel) = final spot price - the gain on the futures
= 90.00-1.10=$88.90
=88.00+0.90=$88.90
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3.4 Hedge Ratio
The hedge ratio compares the value of a position protected through the use of a hedge with
the size of the entire position itself. A hedge ratio may also be a comparison of the value of
futures contracts purchased or sold to the value of the cash commodity being hedged.
Example:
Imagine you are holding $10,000 in foreign equity, which exposes you to currency risk. You
could enter into a hedge to protect against losses in this position.
If you hedge $5,000 worth of the equity with a currency position, your hedge ratio is 0.5
($5,000 / $10,000). This means that 50% of your foreign equity investment is sheltered from
currency risk.
The minimum variance hedge ratio is important when cross-hedging, which aims to minimize
the variance (the risk) of the position's value.
The minimum variance hedge ratio, or optimal hedge ratio, is an important factor in
determining the optimal number of futures contracts to purchase to hedge a position.
∆𝑆 −Change in spot price, S, during a period of time equal to the life of the hedge
∆𝐹 −Change in futures price, F, during a period of time equal to the life of the hedge
𝜎𝑆 −Standard deviation of ∆𝑆
𝜎𝐹 −Standard deviation of ∆𝐹
𝜌 −The coefficient of correlation between ∆𝑆 and ∆𝐹. Then the minimum variance hedge ratio
is,
𝜎𝑆
ℎ∗ =𝜌
𝜎𝐹
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After calculating the optimal hedge ratio, the optimal number of contracts needed to hedge a
position is calculated by dividing the product of the optimal hedge ratio and the units of the
position being hedged by the size of one futures contract.
𝑄𝐴
𝑁 ∗ = ℎ∗
𝑄𝐹
Example:
Assume that an airline company fears that the price of jet fuel will rise after the crude oil market
has been trading at depressed levels. The airline company expects to purchase 15 million
gallons of jet fuel over the next year, and wishes to hedge its purchase price. Assume that the
correlation between crude oil futures and the spot price of jet fuel is 0.95, which is a high degree
of correlation. Further assume the standard deviation of crude oil futures and spot jet fuel price
is 6% and 3%, respectively. The NYMEX Western Texas Intermediate (WTI) crude oil futures
contract has a contract size of 1,000 barrels or 42,000 gallons.
Answer:
𝜌 = 0.95, 𝜎𝑆 = 3%, 𝜎𝐹 = 6%
0.95∗3
ℎ∗ = = 0.475.
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3.5 Stock index futures
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3.6 Hedging an Equity portfolio
Define:
VF : Current value of one futures contract (the futures price x the contract size).
If the portfolio mirrors the index, the optimal hedge ratio is assumed to be 1.0.
Suppose, for example, that a portfolio worth $5,050,000 mirrors the S&P 500. The index
futures price is 1,010 and each futures contract is on $250 times the index. In this case
VA=5,050,000 and VF = 1,010 x 250 = 252,500, so that 20 contracts should be shorted to hedge
the portfolio.
When the portfolio does not mirror the index, we can use the capital asset pricing model. The
parameter beta (𝛽) measures the systematic risk.
The beta of a potential investment is a measure of how much risk the investment will add
to a portfolio that looks like the market. If a stock is riskier than the market, it will have a
beta greater than one. If a stock has a beta of less than one, the formula assumes it will
reduce the risk of a portfolio.
When 𝛽 = 1, the return on the portfolio tends to mirror the return on the index
When 𝛽 = 2, the excess return on the portfolio tends to be twice as great as the excess
return on the index.
It is therefore necessary to use twice as many contracts to hedge the portfolio.
The number of futures contracts required to completely hedge an equity position is given by:
𝑝𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜 𝑉𝑎𝑙𝑢𝑒
N=βportfolio×[𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑓𝑢𝑡𝑢𝑟𝑒𝑠 𝑐𝑜𝑛𝑡𝑟𝑎𝑐𝑡𝑠]
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3.6.2 Adjusting a Stock Portfolio’s Beta using Stock Index Futures
Beta, as defined in the capital asset pricing model, is a measure of a portfolio’s systematic risk.
When a trader uses index futures to hedge a position in an equity portfolio, they are effectively
trying to reduce the portfolio’s systematic risk. As such, hedging is actually an attempt to
reduce a portfolio’s beta.
β=portfolio beta
P=portfolio value
𝑃
Number of contracts required=(𝛽 ∗ − 𝛽) (𝐴)
If the above result is positive, the trader would have to buy the relevant number of futures. If
negative, they would have to sell futures.
Example
Answer
β=1.5
𝑃 200,000,000
Number of contracts required=(𝛽 ∗ − 𝛽)(𝐴)= (1.0 − 1.5) × = −133
2500×300
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