Forward-Futures Hedging

Strategies
1. Long hedge and short hedge
2. Hedge ratio of an equity portfolio
3. Equity portfolio hedging example
4. Hedge ratio of a fixed-income portfolio
5. Bond portfolio hedging example

214 Tie Su -- FIN617 @ UM

 A long hedge: buy futures and sell/short spot:
Scenario:
On January 15, a cable company knows it will require 100,000
pounds of copper on May 15 to meet a certain contract. The
spot price of copper is $2.55 per pound.
May futures price is $2.70 per pound (Contango! Cost of carry =
$0.15/lb). The size of copper futures contract is 25,000 pounds.

Hedging strategy:
January 15: buy four May futures contracts on copper (long
hedge)
May 15: close out futures position.

215 Tie Su -- FIN617 @ UM

 A long hedge: buy futures and sell/short spot:
(cont.)
Result:
The company locks in a price of $2.70 per pound of copper.

Case 1:
Cost of copper on May 15 is $2.90 per pound
The company gains 20 cents per pound from the futures
contract.

Case 2:
Cost of copper on May 15 is $2.35 per pound
The company loses 35 cents per pound from the futures contract.

In the U.S., crude oil and copper futures are traded on the New York
Mercantile Exchange. Visit its website for current crude oil and copper
futures prices: http://www.cmegroup.com/.

216 Tie Su -- FIN617 @ UM

 A short hedge: sell futures and buy spot:
Scenario:
On May 15, XOM has negotiated a contract to sell 5,000,000 barrels of oil.
The price in the sales contract is the spot oil price on August 15.
One contract of oil futures calls for 1,000 barrels of oil. Price quotes are
given below:
Spot price of crude oil: $85.60 per barrel
August oil futures price: $88.75 per barrel (contango or backwardation?)

Hedging strategy:
May 15: sell 5,000 August futures contracts on crude oil (short
hedge)
August 15: close out futures position.

217 Tie Su -- FIN617 @ UM

 A short hedge: sell futures and buy spot: (cont.)
Result:
The company locks in a price of $88.75 per barrel.

Case 1:
Oil price on August 15 is $30.00 per barrel:
XOM receives $30.00 per barrel under the sales contract.
XOM gains $58.75 per barrel from the futures contract.
Case 2:
Oil price on August 15 is $100.00 per barrel:
XOM receives $100.00 per barrel under the sales contract.
XOM loses $11.25 per barrel from the futures contract.

218 Tie Su -- FIN617 @ UM

 Four questions to ask when designing a
hedging (speculative) strategy:
1. What futures contract?
2. Buy or sell?
3. Which maturity?
first available futures maturity after expected
transaction date
4. How many contracts? (Nf)

219 Tie Su -- FIN617 @ UM

 Hedge ratio (Nf) for an equity portfolio S + f × N f :
Price change of a hedged position = ∆S + ∆f × N f
Find the optimal Nf to minimize the variance of ∆S + ∆f × N f :
cov ( ∆S , ∆f )
arg min Var ( ∆S + ∆f × N f ) = N *f = −
var ( ∆f )
Recall Ordinary Least Squares (OLS) regression in Statistics 101:
 cov ( x, y )
y =α + β x + ε ; β =
var ( x )
 ∆S ∆f 
cov  ,  Sf
N *f =
−
cov ( ∆S , ∆f ) =
−  S f  = −
cov ( rs , rm ) S
= −βs
S
var ( ∆f )  ∆f  2 var ( rm ) f f
var   f
 f 
∆S
∆S S dr S ∂r / ∂r S β S S
Alternatively, N *f =
− − S
= =
− s =
− s m =
− s = −βs
∆f ∆f f drf f ∂rf / ∂rm f 1 f f
f
This formula is particularly useful if the portfolio β is known. The futures
contract is generally a market-stock index futures, such as the S&P 500
Index futures. The formula is commonly applied to diversified stock
portfolios.
220 Tie Su -- FIN617 @ UM
 Example 1: Stock portfolio
Scenario: On April 10, a portfolio manager is
concerned about the market over the next four
months. The portfolio has accumulated an impressive
profit, which the manager wishes to protect over the
period ending August 10. The prices, number of
shares, and betas are given below.

221 Tie Su -- FIN617 @ UM

 Example 1: Stock portfolio (cont.)
Price Market Price Market
Stock (4/10) # of Shares Value Weight Beta (8/10) Value
Amgen 68.80 9,000 $619,200 0.210 1.48 0.311 70.53 $634,770
Bristol-Myers 27.59 8,000 $220,720 0.075 1.12 0.084 24.88 $199,040
Citigroup 53.71 3,500 $187,985 0.064 0.42 0.027 50.12 $175,420
Dow Chemical 42.70 5,400 $230,580 0.078 1.21 0.095 38.25 $206,550
eBay 32.85 10,500 $344,925 0.117 3.94 0.461 34.23 $359,415
Ford Motor 8.45 14,400 $121,680 0.041 1.95 0.080 7.58 $109,152
Goldman Sachs 212.60 2,500 $531,500 0.180 1.14 0.205 195.78 $489,450
Home Depot 41.76 16,600 $693,216 0.235 1.30 0.306 40.69 $675,454
Sum $2,949,806 1.568 $2,849,251

222 Tie Su -- FIN617 @ UM

 Example 1: Stock portfolio (cont.)
Portfolio beta = 1.568

S&P 500 September futures contract:

Price on April 10: 1452.60
Multiplier: $250
Price of one contract: $250(1452.60) = $363,150

Optimal number of futures contracts:

Nf = –1.568×[2,949,806/363,150] = –12.7366
Sell 13 contracts

223 Tie Su -- FIN617 @ UM

 Example 1: Stock portfolio (cont.)
Four months later, on August 10:

S&P 500 September futures contract:

Price on August 10: 1422.04
Price of one contract: $250(1422.04) = $355,510
Buy 13 contracts

224 Tie Su -- FIN617 @ UM

 Example 1: Stock portfolio (cont.)
Analysis: The market value of the stock portfolio
declined by
$2,949,806 – $2,849,251 = $100,555, a loss of 3.41
percent.

The profit on the futures contracts was

13($363,150) (sale price of
futures)
-13($355,510) (purchase price of
futures)
$99,320 (profit on futures)
(1452.60 – 1422.04) × 250 × 13 = $99,320
Tie Su -- FIN617 @ UM
225
Thus, the overall loss on the portfolio was effectively
 Hedge ratio (Nf) for a fixed-income portfolio S + f × N f :
Price change of a hedged position = ∆S + ∆f × N f
Find the optimal Nf to minimize the variance of ∆S + ∆f × N f :
arg min Var ( ∆S + ∆f × N f ) = N *f

∆S DSModified S DSMacaulay / (1 + yS ) S
Nf *
=− =− Modified × =− Macaulay ×
∆f Df f Df / (1 + y f ) f

D: duration of a fixed-income security.

y: yield to maturity of a security;

This formula is used to hedge fixed-income securities, such as a

bond portfolio.

226 Tie Su -- FIN617 @ UM

 Example 2: Anticipatory hedge of a future commercial paper issue
Scenario: On April 6, a corporate treasurer learns that on July 20 the firm will have to issue $10 million face value
of 180-day commercial paper.

Date Spot Market Futures Market

April 6
A local commercial bank agrees September Eurodollar futures IMM Index is at 88.23.
to purchase the whole issue at Price per $100 face value:
an effective forward yield of 11.40%. 100-(100-88.23)(90/360)= 97.0575
Price per contract: $970,575
Implied yield:
(100/97.0575)365/90-1 = 0.1288
Appropriate number of contracts:
9, 481,532.46 180 / 365 1.1288
Nf = − × × =
−19.80
970,575 90 / 365 1.1140

Sell 20 contracts

July 20
$10 million face value of commercial September Eurodollar futures IMM index is at 87.47
paper is issued at the effective spot rate
of 12.5653% Buy 20 contracts
000, 000 (1.125653)
−180 / 365
PV 10, = $9, 433, 000

227 Tie Su -- FIN617 @ UM

 Example 2: Anticipatory hedge of a future commercial paper issue

Analysis: When the $10,000,000 face value of commercial paper

is issued on July 20, the firm will receive $9,433,000, which
implies a rate of 12.5653 percent, which is much higher than the
11.40 percent implied forward rate in effect at the time the hedge
was initiated. The profit on the futures transaction is:
20($970,575)(sale price of futures)
-20($968,675)(purchase price of futures)
$38,000(profit on futures)

(8823 – 8747)×25×20 = $38,000 profit on futures

228 Tie Su -- FIN617 @ UM

 Example 2: Anticipatory hedge of a future commercial paper issue

The profit on the futures can be considered as an

increase in the proceeds received from issuing the
paper. This effectively changes the proceeds to
$9,433,000 +$38,000=$9,471,000. Thus, the firm
effectively received $9,471,000 for $10,000,000 face
value of commercial paper. This implies a rate of

($10,000,000/$9,471,000)365/180 – 1 = 0.1165.

Thus, the effective rate paid on the commercial paper

after accounting for the hedge is 11.65 percent, which
is reasonably close to the 11.40 percent implied
forward rate.

229 Tie Su -- FIN617 @ UM

 Example 2: Anticipatory hedge of a future commercial paper issue

Conclusion:
No hedge: 12.5653%
Forward hedge: 11.40%
Futures hedge: 11.65%

230 Tie Su -- FIN617 @ UM