Hedging Fundamentals

Functions of futures markets

 Hedging
 Speculation
A B

State 1 2 6

State 2 3 4

 Motive for hedging

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Hedging cannot…
 Guarantee the best outcome

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What risks?
 Price risk
 Quantity risk

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Defns..

 A Short (or selling) Hedge: Occurs when a firm holds a long

cash position and then sells futures/forward contracts for

protection against downward price exposure in the cash
market.
 A Long (or buying) Hedge: Occurs when a firm holds a

short cash position and then buys futures/forward

contracts for protection against upward price exposure in
the cash market. Also known as an anticipatory hedge.

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Defns..
 A Cross Hedge: Occurs when the asset underlying the
futures/forward contract differs from the product in the cash
position.

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Hedge position?
 Hedging typically involves taking a position in a futures market
that is opposite to the position already held in a cash market.
 Why opposite position?

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When will a short hedge be beneficial?
 When the spot prices fall by the maturity date of the future
contract

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When will a long hedge be beneficial?
 When the spot prices rise by the maturity date of the future
contract

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Classic example of hedging
A cotton farmer expects 5000 kg of harvest in early January
 spot price (1 kg) Rs. 2.30
 futures price is Rs. 2.50
 Delivery after 3 months
Problem: Farmer doesn’t know what will be the price of cotton
when his crop arrives to the market and the total value of the
harvest.
Can Futures market help him???

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Example contd..

 Hedge using futures:

• What position should farmer take (long or short)?

 To find out, answer the following question:

• What is the farmer’s concern? (price rise or decline?)

 Take a position that earns a profit when prices move

against the entity.
• Contract size = 1,000 kg.
• long or short? 5 futures contracts.

 Loss on spot transaction (receivable) is offset by gain on

futures transaction (and vice versa).
• Enables the seller to lock in a fixed price for wheat.

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Example contd..
Spot declines to Rs. 2.15
 What is the farmer’s revenue?
(1) Spot market transaction:
• Rs. 10750 revenue (2.15*5000)
(2) Futures market transaction:
• A gain of Rs.1,750 {(2.50-2.15)*5000}.

Total revenue = 10750+1750 = Rs.12500

Exactly the same as reflected in the futures prices of early Jan

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Example contd..
Spot prices rise to Rs. 2.65
 What is his revenue?
(1) Spot market transaction:
• Rs. 13250 (2.65*5000)
(2) Futures market transaction:
• Loss of Rs. 750{(2.50-2.65)*5000}.

Total revenue = 13250-750 = Rs. 12500

Revenue = Rs. 12,500

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Hedge outcome

The farmer’s position in the futures market completely removed

price risk come what may he is assured of a price of Rs.2.50/kg

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Perfect hedges

The farmer’s position in the futures market completely removed

price risk but rarely we will find such perfect hedges.

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Perfect Hedge is to be found…
 …Japanese Garden
 The underlying to be hedged may not have a futures contract
trading
 The hedger is not sure of the date on which hedge will be lifted

Therefore in practice hedges eliminate some, but not all of the

price risk and this leads to basis risk

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Basis
Basist = cash pricet - futures pricet
bt = St - Ft

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 Basis for 29 Jul 2006 Nifty future's contract

100
80
Niftyindexpoints

60
40 basis
20
0
-2024- 13- 3-May- 23- 12- 2-Jul-
Mar-06 Apr-06 06 May-06 Jun-06 06

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 The power of basis

• What will be the gain/loss of a hedger’s position:

Total Gain / Loss  ( S1  S 0 )  ( F1  F0 )

Gain/Loss on Gain/Loss on
spot position futures
Shuffling a bit position

Total Gain / Loss  ( S1  F1 )  ( S0  F0 )

Basis at t = 1 Basis at t = 0
Total Gain / Loss  b1  b0
b1 is a random
b0 is known
variable

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 • Suppose a firm places a hedge at t = 0, when:
• S0 = Rs. 45
• F0 = Rs. 42
• We don’t know S1 and F1 since they are unknown.
• The gain/loss from the hedge will be:
payoff  ( S1  S0 )  ( F1  F0 )
 ( S1  45)  ( F1  42)
 b1  3

If this were a perfect hedge then b1 = 3 and gain/loss = 0

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To summarize

 At expiration b = 0
 prior to expiration the basis changes randomly (random
variable).
 Uncertainty around basis is lesser than that around the prices

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Hedging strategies

Current status Risk Hedge

Hold the asset Asset price may fall Short

About to buy the asset Asset price may rise Long

Short sold the asset Asset price may rise Long

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Hedging decisions
 Choice of underlying asset:
• Choose the underlying asset that has high correlation with the asset being
hedged.
• Best possible hedge occurs when underlying asset is same as the asset being
hedged (not always possible).
 Choice of contract maturity:
• The futures with maturity closest to but after the hedge termination date
subject to the suggestion not to be in a contract in its expiration month

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Hedging decisions contd..
 Hedge position

 No. of contracts to trade

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Hedging decisions contd..

NA = spot position in qty

QF = futures contract size (# units per contract).

NF* = optimal number of futures

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No. of contracts

S
 Optimal # of futures N  N A
*
F
F
*
 Define N
h*  F
NA

 We now have the minimum-variance hedge ratio (MVHR):

S
h*  
F

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No. of contracts

S
h 
*

F
 If r = 1.00 and sF = sS, then h* = 1.00
• F and S move in perfect unison.
• Magnitude of change in S = magnitude of change in F.

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Example

Microsoft Excel
Worksheet

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Hedge effectiveness

• Hedge effectiveness is defined as the percentage of the spot price variance

that has been removed by the hedge.
• Hedging effectiveness, e, is calculated as:

e  2 (0  e  1.00)

The higher the correlation between the spot and futures price, the more
risk that is eliminated!

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Illustration contd….

• Hedging effectiveness would be:

e    0.652
2
 0.4225

 What can we infer?

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