Hedging Strategies Using Futures

Derivatives Securities (MFFINTECH 6003)

Hugh Kim

The University of Hong Kong

Futures
Definition
A futures contract is an agreement to trade the underlying asset in
future (at maturity T ) for a fixed price specified today (at current
time t)
I Futures price Ft(T ) at time t is chosen such that the contract is
"worthless" (at time t)
I Similar to forward contracts, but
I Organization of the market: futures are exchange traded
I Timing of cash flows: futures are marked to market or settled
daily, meaning that gains or losses from a futures are realized
daily, rather than once (at maturity) as with the forward
Hedging using Futures
I Hedging with futures typically involves taking a position in the
futures market that is opposite of the position already held (or
that will be held) in the spot market at a future time
I Purpose is to lock in a price to buy or sell an asset in the future
Short Hedge
I A short hedge is a hedge that involves a short position in futures
contracts (agree to sell the underlying at maturity)
I Appropriate when hedger expects to sell an asset at some time
in the future and the underlying is positively correlated with the
asset
I Hedger is holding a long position in the underlying at a future
time
I A short hedge protects against unexpected drops in the spot price
Long Hedge
I A long hedge is a hedge that involves a long position in futures
contracts (agree to buy the underlying at maturity)
I Appropriate when hedger expects to purchase an asset at some
time in the future and the underlying is positively correlated
with the asset
I Hedger is holding a short position in the underlying at a future
time
I A long hedge protects against unexpected increases in the spot
price
Hedging using Futures: Questions
I Do you need a long or a short hedge to eliminate risks in the
following scenarios?

I A firm expects to produce and sell 90,000 lbs of copper in 5

months

I A copper fabricator knows it will require 100,000 lbs of copper

in 6 months to meet a certain contract
Reasons for Hedging
I Firms should focus on the main business (key competence) and
minimize risks arising from interest rates, exchange rates, and
other market variables
I Hedging can be optimal when an extra dollar of income received
in times of high profits is worth less than an extra dollar of
income received in times of low profits
I Bankruptcy and distress costs
I Costly external financing
I Managerial risk aversion

I Firm may have advantage to hedge compared to (small)

stockholder
I less costly for firm to hedge than for (small) stockholder
I firm has better market information than stockholder
I firm knows more about specific transactions it is going to enter
than stockholder
Reasons against Hedging
I Shareholders are usually well diversified and can make their own
hedging decisions
I Cash flow/liquidity problems: losses of hedging position may
realize while gains on the underlying exposure are unrealized for
long time
I Explaining a situation where there is a loss on the hedge and a
gain on the underlying can be difficult
I Transaction costs
I Requirement for costly expertise
I Need to monitor and control hedging process
I Potential collateral requirements
I Complications from tax and accounting considerations
Imperfect Hedges
I So far we have talked about perfect hedges which completely
eliminate risk
I In reality futures hedges are imperfect
I Mismatch between underlying of futures contract and asset to be
hedged
I Maturity mismatch
Basis Risk
I Basis at time t is defined as the difference between the spot
price of the asset to be hedged (St ) and the futures price of the
(T )
contract used to hedge (Ft )
(T )
bt = St − Ft

I Let St∗ be the spot price of the asset underlying the futures
contract (St 6= St∗ implies a mismatch between underlying of
futures contract and asset to be hedged)
 
(T )
bt = (St − St∗ ) + St∗ − Ft

I Basis risk is uncertainty about the basis when the hedge is

closed out
Basis Risk
I Consider a hedge for a future sale of an asset at time t2 by
entering into a short futures contract at time t1 , then
 
(T ) (T )
Cash Flow = St2 + Ft1 − Ft2
(T )
= Ft1 + bt2

I Consider a hedge for a future purchase of an asset at time t2 by

entering into a long futures contract at time t1 , then
 
(T ) (T )
Cash Flow = −St2 + Ft2 − Ft1
 
(T )
= − Ft1 + bt2
Choice of Contract
I Choose a delivery month that is as close as possible, but later
than the end of the life of the hedge
I Futures prices can be erratic during the delivery month
I Delivery risk
I Use short-maturity contracts (more liquid) and roll them forward,
if delivery is far in the future

I When there is no futures contract on the asset being hedged,

choose the contract whose futures prices are most closely
correlated with the price of the asset being hedged (cross
hedging)
Maturity Mismatch: Example
I On June 15 a company expects to purchase 20,000 bbl of crude
oil at some time in October or November
I Oil futures contracts are traded for delivery every month; the
contract size is 1,000 bbl
I The December futures price on June 15 is $86.00 bbl
I The company purchases the crude oil and closes out its futures
contract on November 10 when the spot price is $88.00 bbl and
the futures price is $87.10 bbl
Maturity Mismatch: Example
I What is the gain/loss on the company’s futures position (ignore
daily settlement for simplicity)?

I What is the basis at close-out?

I What is the effective price paid (bbl)?

I What is the total price paid?

Cross Hedging and Optimal Hedge Ratio
I Cross hedging occurs when the futures’ underlying is different
from the asset being hedged
I Optimal hedge ratio h is the proportion of the exposure that
should optimally be hedged
σS,F σ
h= 2
= ρS,F S
σF σF

σS : standard deviation of ∆S, change in the spot price during the

hedging period [t1 , t2 ]
σF : standard deviation of ∆F (T ) , change in the futures price
during the hedging period [t1 , t2 ]
ρS,F : coefficient of correlation between ∆S and ∆F (T )
σS,F : covariation between ∆S and ∆F (T )
Cross Hedging and Optimal Hedge Ratio
I Assume linear relationship ∆S = k + h∆F + ε,
where E [ε] = 0 and E [∆F ε] = 0
Optimal Number of Futures Contracts
I Value of change in hedged position during period [t1 , t2 ] is

QS ∆S − NQF ∆F = QS (k + h∆F + ε) − NQF ∆F

I Variation is

var (QS ∆S − NQF ∆F ) = (hQS − NQF )2 σF2 + (QS )2 σε2

I Optimal number of futures contracts (N) minimizes

var (QS ∆S − NQF ∆F ),

hQS
N=
QF

N : number of futures contracts

QS : size of position being hedged (units)
QF : size of 1 futures contract (units)
Tailing the Hedge
I Optimal number of contracts Nτ at time τ ∈ [t1 , t2 ] after tailing
adjustment to allow for daily settlement of futures,

(S )
hVτ
Nτ = (F )
Vτ
I Daily adjustments, but often not possible in practice
I Tailing the hedge is important when the interest rate is high and
time to maturity is long
(S ) (S )
Vτ : value of position being hedged, Vτ = Sτ QS
(F ) (F ) (T )
Vτ : value of principal of 1 futures contract, Vτ = Fτ QF
Optimal Hedge: Example
I Suppose an airline will purchase 2, 000, 000 gallons of jet fuel in
one month and hedges using heating oil futures (size of 1
futures contract is 42, 000 gallons)
I From historical data σF = 0.0313, σS = 0.0263, and ρ = 0.928
I Today the spot price is $1.94 per gallon and the futures price is
$1.99 per gallon
Optimal Hedge: Example
I What is the optimal hedge ratio?

I What is the optimal number of contracts (ignoring daily

settlement)?

I What is the optimal number of contracts (today) after tailing?

Hedging a Stock Portfolio
I To hedge the risk in a stock portfolio during period [t1 , t2 ] the
number of index futures contracts that should be shorted at
time τ ∈ [t1 , t2 ] is
(S )
Vτ
Nτ = β S (F )
Vτ
I Daily adjustments, but often not possible in practice
β S : CAPM β of portfolio
(S )
Vτ : value of the portfolio
(F )
Vτ : value of principal of 1 futures contract (contract size multiplied by
futures price)
Hedging a Stock Portfolio: Questions
I You manage a well-diversified equity portfolio (assume no
idiosyncratic risk)
I Value of the portfolio is $5, 000, 000
I Risk-free interest rate is constant at 1% (c.c.)
I S&P 500 index is 1, 000
I Dividend yield on index is 4%
I CAPM β of the portfolio (relative to S&P 500 index) is 1.5
Hedging a Stock Portfolio: Questions
I Suppose you hedge the portfolio over the next 3 months using a
S&P 500 futures contract with 4 months to maturity
I S&P 500 futures is 990.05 and each futures contract is on $250
times the index (if the index increases by 1 point, a long
position pays $250)
I What futures position do you have to take to eliminate as much
risk as possible?
Hedging a Stock Portfolio: Questions
I In 3 months the index drops to 980 and the futures to 977.55
I What is the gain/loss from the futures position? (for simplicity
ignore daily settlement)
 from N = 30.3 short positions is
Gain
(0.33) (0.33)
N F0 − F0.25 $250 = $94, 668

I What is the annualized return on the index? (assume dividends

are reinvested in index)
Hedging a Stock Portfolio: Questions
I What is the annualized return on the stock portfolio? (assume
S&P 500 index tracks the market well and dividends are
reinvested in portfolio)

I What is the gain/loss from the stock portfolio?

I What is the total gain/loss?

Reasons for Hedging a Stock Portfolio
I May want to be out of the market for a while ⇒ hedging avoids
the costs of selling and repurchasing the portfolio while getting
short-term protection in an uncertain market situation
I Uncertain about the performance of the market, but confident
that stocks in the portfolio have been chosen well and will
outperform the market in both good and bad times ⇒ hedging
ensures that the portfolio return is the risk free return plus the
excess return of the portfolio over the market
Changing the Portfolio "Beta"
I Before the CAPM β of the portfolio is reduced to 0
I Futures contracts can be used to change the β to some value
other than 0
I To change the β from β S to β∗ during period [t1 , t2 ], the hedger
needs to take at time τ ∈ [t1 , t2 ] a short position in
(S )
Vτ
Nτ = ( β S − β ∗ ) (F ) futures contract
Vτ
I If N > 0 (β S > β∗ ), it is indeed a short position in futures
I If N < 0 (β S < β∗ ), it is actually a long position in futures
Changing the Portfolio "Beta": Questions
I Consider the data about the S&P 500 from the questions on
"hedging a stock portfolio"

I What futures position do you have to take to reduce the

portfolio β S to 0.5?
(S )
V0 5,000,000
Take N = ( β S − β∗ ) (F ) = (1.5 − 0.5) $$247,512.46 = 20.2 short
V0
positions in futures

I What futures position do you have to take to increase the

portfolio β S to 2?
Reasons for Changing the Portfolio "Beta"
I Portfolio managers adjust their portfolio β as they perceive
changes in risk and returns
I When they are bullish about the market, (believe that market is
strong), or when they are not very risk averse, they will increase
their stock portfolio’s β
I When they are bearish about the market (believe that market is
weak and risk has increased), or when they are more risk averse,
they will decrease their portfolio’s β