2012 Q4a – Hedge Ratios (Immunization) – Answer

Suppose you hold the portfolio P and you trade x units of the futures contract F. Then
your risk is described in terms of the price changes of the original portfolio plus the
price changes of the futures contract, i.e.
Total price changes =P + hF (P.S. we use S instead of P in the lecture notes)

Var (total price change) = Var (P + hF) = Var (P) + h2Var(F) + 2h Cov(P, F)

whereP andF denote the prices of the original portfolio and the futures contract,
respectively. You are interested in minimising the variance of the total price changes,

To minimize the risk, we find the first order condition

2hVar(F) + 2Cov(P, F) = 0

Thus, h = –Cov(P, F) / Var(F) = -0.5

which indicates that you should sell 0.5 units of the futures contract. This is a general
result – the optimal hedge is given by the hedge ratio.
Next, recall that a futures contract is zero (which has a given value which must be
non-negative for the buyer to be happy to buy, and non-positive for the seller to be
happy to sell), so the hedge does not draw on any capital.
.
The marking allocation is as follows. For deriving the optimal hedge the candidate
gets 5 marks, and for explaining the cost of the futures position there are an additional
2 marks.