Hedging Strategies using

Futures
Minimum Variance Hedge Ratio

• Hedge ratio is the size of the position taken in

futures contract to the size of the exposure.

• Hedge Ratio = Number of futures contracts required

* Size of one Futures contract (Units)/ Size of
position being Hedged

• Optimal number of futures contract required = HR *

Size of position being hedged/Size of one futures
contract (units)
• An airline expects to purchase two million
gallons of jet fuel. Decides to hedge by
purchasing heating oil futures.
• Heating Oil contract traded on NYMEX is
42,000 gallons
• How many contracts should the airline
buy.
Month Change in futures (X) Change in Jet fuel price (Y)
1 0.021 0.029
2 0.035 0.02
3 -0.046 -0.044
4 0.001 0.008
5 0.044 0.026
6 -0.029 -0.019
7 -0.026 -0.01
8 -0.029 -0.007
9 0.048 0.043
10 -0.006 0.011
11 -0.036 -0.036
12 -0.011 -0.018
13 0.019 0.009
14 -0.027 -0.032
15 0.029 0.023
 Solution
• Slope or beta or hedge ratio =.78

• Optimal Number of futures contracts = .

78*2,000,000/42,000 = 37.14 =37
 Stock Index Futures
• If a portfolio mirrors index then hedge ratio
is 1

• Optimal number of future contracts =

Current value of portfolio (P)/ Current
value of stock underlying one futures
contract (F)
• EX: portfolio of 1 Million mirror CNX S&P 500. if
the current value of the index is 4000.
• Each futures contract is 100 times the index.
• P= 1 million
• F =100*4000 = 400,000.
• So 2.5 futures should be shorted to hedge the
portfolio.
• N = P/F = 1,000,000/400,000 = 2.5
What if the portfolio does not mirror
the Index?
• We can use the Beta from CAPM to determine the
appropriate hedge ratio.

• When Beta =1 for the portfolio then the portfolio mirrors

the return of the market (because beta of the market is
always 1)

• If portfolio beta=2 then the excess return on portfolio

tends to be twice as great as excess return on market.
•
• Similarly when portfolio beta=0.5 then it is half as great
as market.
• Optimal number of futures contract = Beta *P/F

• Example:
• Value of S&P 500 index =4000
• Value of portfolio = 8 millions
• Risk free interest rate =10%
• Dividend yield on index =4% p.a ( for 3 months the yield is 1%)
• Beta of portfolio = 1.5
• Assume Cost of carry model holds
• Trader wants to hedge the portfolio for three months.
• Futures Price of index expiring in 4 months available for 4080 is
shorted for the purpose of hedge.

• Optimal number of futures contract = 1.5*8000,000/400,000 = 30

contracts
 Scenario 1
• If the index turns out to be 3600 after three months
• Futures price of index expiring in next month =
• 3600*exp ((.10-.04)*30/365)= 3617.8
• = 3600*exp (.06*30/365)= 3617.8

• Return of the market = -400/4000 = -.10 +.01(Dividend

Yeild for 3M) = -.09 =-9%

• Expected return on portfolio

• =Risk free rate + 1.5( Return of the market – Risk free
rate)
• =.025 + 1.5(-.09 -.025) = - 14.75%
 Futures( December
Date Spot contract)

Now 4000 4080 (Actual Price)

3 months Later 3600 3617(COC Model)

 Pay off
Profit in the futures market = (4080 – 3617.8)*100*30 = 1,385,670

Expected value of portfolio after three months = 8000,000*(1-.1475)

=6,820,000

Total value of the position after 3 months = 6,820,000 + 1,385,670

=8,205,670
Value of Index Right
Now 4,000 4,000 4,000 4,000 4,000
Valuf of index after three
months 3,200 3,600 4,000 4,400 4,800
Futures Price NOW
(Futures Price of
Index Expring in 4
months )Cost of
carry model 4,080 4,080 4,080 4,080 4,080
Futures price of Index
after three months
(cost of carry) 3,216 3,618 4,020 4,422 4,824

Total Gain or loss in 2,591, 1,385, 179,7 (1,026, (2,232,

futures 603 671 38 194) 127)
Expected Return -29.75% -14.75% 0.25% 15.25% 30.25%

Value of Portfolio 5,620, 6,820, 8,020, 9,220, 10,420,

including dividends 000 000 000 000 000

Total Value of Position in 8,211, 8,205, 8,199, 8,193, 8,187,8

Three months 603 671 738 806 73
 Reasons for Hedging Equity
Portfolio
• The above is an example where the beta has
been reduced to Zero.
• To protect from short term Uncertainties
• If you are confident that the stocks in your
portfolio outperforms the market.
– Then a hedge using index futures removes the risk
arising from market moves and leaves the hedger
exposed on to the performance of portfolio relative to
market.
• Beta Management
 Changing Beta
• In the above example to reduce the beta
from 1.5 to .75, the number of contracts
shorted should be 15 rather than 30.

• Similarly to increase the beta to 2.0 a long

position of 10 contracts should be taken so
on..
• If you want to reduce the beta say 1.5 to .
75

• Then you need to short

– (1.5-.75)*8,000,000/4,000,000 =.75*20 = 15

• If you want to increase the beta to say 2

– Then you need to go long on
• (2-1.5)*20 = 10 Contracts
Problems In Hedging causing basis
risk
• The asset to be hedged may not exactly
be same as asset underlying the futures
contract.

• The hedger is uncertain when the asset

will be exactly bought or sold.

• The hedger may require to close the

position well before the maturity date
 Key factors affecting basis risk
• Choice of underlying asset
• Choice of the delivery month

– In general the basis risk increases as the time

difference between hedge expiration and
delivery month increases
– A good rule of thumb is to choose a delivery
month that is as close as possible but later
than expiration of the hedge
• Example: if delivery months are march,
June, September and December for a
particular contract.
• Then
– For hedge expirations in April and May
– June contracts will be chosen.
 Rolling the Hedge Forward
• In practice, greatest liquidity is for short
term futures contract.

• If there is no liquidity in far month

contracts or if you need to hedge for one
year and the contracts available are for
the next three months.
 Ex
• In April 2002 a company realized it will have
100,000 barrels of oil to sell in June 2003 and
decides to hedge the risk with HR of 1.0. the
current spot price is $19. Although crude oil
futures are traded in New York mercantile stock
exchange with maturities up to six years,
company thinks that only the first six month
contracts have enough liquidity.
• Crude dropped from $19 to $16 during the
period
 One scenario

Apr-02 Short October 2002 futures Oct-02 18.2

Sep-02 Rollover Buy 17.4 0.8

Take a fresh short position on March
Sep-02 2003 Mar-03 17

Feb-03 Rollover Buy 16.5 0.5

Feb-03 Take a fresh short position on July 2003 Jul-03 16.3

Jun-03 Buy back 15.9 0.4

Total Profit/Loss 1.7

• In the above example the firm faces three
basis risks along with two rollover basis.