Hedging Strategies Using Futures

LECTURE 3

Futures
y A futures contract is an agreement to buy (if you

are long) or sell (if you are short) something in the future, at an agreed price (the futures price). y Futures exist on financial assets (debt instruments, currencies, stock indexes), and real assets (gold, crude oil, wheat, cattle, cotton, etc.) y Note that a futures contract is like a portfolio of forward contracts (time series).

Margin Requirements
y Default risks y Margin is a crucial aspect of futures transactions and

has played vital roles in managing counter party risk and market volume. y Initial Margin: The initial margin is the money a trader must deposit into a trading account (margin account) when establishing a futures position.

Margin Requirements
y Each futures exchange is responsible for setting the

minimum initial margin requirements for their futures contracts y Most computer algorithms to set IM is called SPAN (Standard Portfolio ANalysis of risk). y An exchange can change the required margin anytime. y Initial Margin will increase if price volatility increases, or if the price of the underlying commodity rises substantially.

The Operation of Margin
y If the equity in the account falls to, or below, the

maintenance margin level, additional funds must be deposited to restore the account balance to the initial margin level. y The margin that is deposited in order to meet margin calls is called variation margin. If the trader does not promptly meet the margin call, the position will be forced to liquidated. y Marking-to-Market

Example
y At 10am, 7th May 2009, John sold one gold future

contract (100 oz) for delivery in August 2009 at the future price of £285/oz. The initial margin is £1000 and maintenance margin is set at £750.

Example (Cont.)
On all subsequent days, the account is marked o market. If the futures price falls, your equity rises. If the futures price rises, your equity declines. Maintenance margin calls will have to be met if your account equity falls to a level equal to or below £750.
Gold Cash Begin. Price Flow Equity 285.00 1000 286.40 (140) 860 620 288.80 (240) 289.00 (20) 980 288.60 40 1020 290.70 (210) 810 292.80 (210) 600 292.80 0 1000 Maint. Margin Ending Call Equity 0 380 0 0 0 400 0 860 1000 980 1020 810 1000 1000

Date 05/7 05/7 (end) 05/8 05/9 05/10 05/11 05/12 05/13

Long & Short Hedges
y A long futures hedge is appropriate when you

know you will purchase an asset in the future and want to lock in the price y A short futures hedge is appropriate when you know you will sell an asset in the future & want to lock in the price

Examples
y A manufacturer of gold jewellery knows it will

require 1000 ounces of gold to meet a certain contract in 6 months. The manufacturer expects the price of gold will increase in 6 months. y A firm is expecting to receive $30m 3 months later from its exporting goods to US. The firm thinks the dollar will devalue further in 3 months.

Choice of Contract
y Choose a delivery month that is as close as possible

to, but later than, the end of the life of the hedge y When there is no futures contract on the asset being hedged, choose the contract whose futures price is most highly correlated with the asset price. This is known as cross hedging.

Optimal Hedge Ratio
3.11

Consider a position which is long in an asset but short in future. S: change in spot price S over length of hedge ( s) F: change in future price F over length of Hedge ( F) h: hedge ratio

Optimal Hedge Ratio
Proportion of the exposure that should optimally be hedged is W V S WF where WS is the standard deviation of (S, the change in the spot price during the hedging period, WF is the standard deviation of (F, the change in the futures price during the hedging period V is the coefficient of correlation between (S and (F.

Optimal number of Contracts

NA N* ! h * QF
NA: Size of position being hedged QF: Size of one futures contract N*: Optimal number of futures contracts for hedging
3.13

Hedging an Equity Portfolio
y Stock Index Futures y To hedge the risk in a portfolio the number of

contracts that should be shorted is
F

A

where P is the value of the portfolio, Fis its beta, and A is the value of the assets underlying one futures contract

Example
Consider the value of S&P 500 is currently 1,000. An investor wants to use the future to hedge the value of the portfolio $5m over the next 3 months. One future contract is for delivery of $250 times the index and currently priced at $1010. The beta of the portfolio is 1.5. What position in futures contracts on the S&P 500 is necessary to hedge the portfolio?

Payoff of Hedging
y What is the total payoff from this hedging strategy

when the index future value becomes 902 in 3 months and the portfolio value fell to $4.2m. y What is the total payoff from this hedging strategy when the index value becomes 1050 in 3 months and the portfolio value increases to $5.3m.

Changing Beta

y What position is necessary to reduce the beta of the

portfolio to 0.75?

Hedging Price of an Individual Stock
y Similar to hedging a portfolio y Does not work well because only the systematic risk

is hedged y The unsystematic risk that is unique to the stock is not hedged

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