Mechanics of Futures and

the hedging strategies

Chapter 2&3
Geng Niu

1
Future Contracts
 Available on a wide range of assets
 Exchange traded
 Specifications need to be defined:
 What can be delivered,
 Where it can be delivered, &
 When it can be delivered
 Settled daily
Corn futures contract in CME
 On March 5 a trader in NY call a broker to
buy 5,000 bushels of corn for July delivery
 The broker immediately issue instructions to
a trader to buy one July corn contract
 Another trader in Kansa instruct a broker to
sell 5,000 bushels for July delivery.
 The broker then issues instructions to sell
 A price would be set and the deal would be
done

3
Closing Out Positions

 Most futures contracts do not lead to delivery

 Closing out: enter into the opposite trade to
the original one before the delivery
 E.g. On Apr 20, the NY investor closed out
his position by selling (shorting) one July corn
futures.
 E.g On May 25, the Kansas investor closed
out his position by buying one July contract.

4
Specification of a futures contract
 The asset: which asset should be delivered on maturity
 The contract size: amount that has to be delivered under
one contract
 Delivery arrangements: place where delivery will be
made
 Delivery Month: when the delivery can be made
 Last trading day
 Price quotes: how to understand the listed prices
 Price limits and position limits

5
Sample futures contracts
specification
 http://
www.cmegroup.com/trading/agricultural/grain
-and-oilseed/corn_contract_specifications.ht
ml
 Corn futures contract traded in CME group
 http://
www.dce.com.cn/portal/cate?cid=111458645
2100
 Corn futures contract traded in Dalian
commodity exchange
Wulin Suo 6
Convergence of Futures to Spot

Futures
Price Spot Price

Spot Price "according to market prices"Futures

at the end of
each day Price

Time Time

(a) (b)

What if the Future price does not equal to the Spot price?
Understand daily settlement

 Daily settlement (mark-to-market)

determinants the “ market values” of
futures contracts at the end of each day.
 It is used to calculate the profit or loss
status of the two parties in a futures
transaction every day.

8
Understand daily settlement
 Suppose trade A longed 1 December Lumber futures
contracts on March 1st for a price of $ 100 per contract
 On March 2nd, the news said that new Lumber mills will
be completed earlier than expected, indicating a Lumber
supply increase.
 Dec Lumber futures price decreased to $90 per contract.
 Compared to people who longed Lumber futures on
March 2nd , A is better off or worse off?
 Or, if on March 2nd A sold 1 Dec Lumber futures and
hold the two contracts together, is A better off?
Understand daily settlement
 A is worse off:
 If A waited for one more day and longed the futures on
Mar 2nd, A is able to buy Lumber on Dec for $90 per
contract instead of $100.
 If A sold 1 Dec Lumber futures on 2nd March, and also
hold the 1 contract bought on 1st March, the current cost
is zero, but he will buy Lumber on Dec for 100 and sell
Lumber for 90.
 This futures price decrease is shown as a loss of $10 in
the daily settlement for long traders.

10
Understand daily settlement
 Suppose trade B longed 1 December Lumber
futures contracts on March 2nd for a price of $ 90
per contract
 On March 3th , the news said that more people
are willing to build houses in the future.
 Dec Lumber futures price increased to $110 per
contract.
 B is better off or worse off?
 An increase in futures price is recorded as a gain
for long traders.
Margins
 Risk of futures contracts:
 -- one party may regret
-- may not have the money to honor the agreement
 A margin is cash or marketable securities deposited
by an investor with his or her broker
 The balance in the margin account is adjusted to
reflect daily settlement.
 Margins minimize the possibility of a loss through a
default on a contract
Margins
 An investor contacts his broker to buy two
December gold futures
 Current future price ： 1,250 per oz.
 Contract size : 100 ounces.
 The broker will require the investor to deposit
funds in a margin account
 Initial margin: the amount must be deposited
at the beginning; suppose it’s $ 6000 per
contract
 Initial balance in the margin: 2*6000=12,000
13
Margins

 Daily settlement or marking to market: margin

account is adjusted a the end of each trading
day to reflect market values of futures contract.
 By the end of the first day, futures price dropped
to 1,241
 The investor has a loss of 1,800 (200*9)
 New balance in the margin account: 12000-
1800=10,200

14
Margins

 The investor’s broker pays the 1,800 to the

exchange
 The exchange passes the money on to a
broker of an investor of a short position
 This is because the investor with a short
position gains from price decline.

Wulin Suo 15
Margins

 The investor can withdraw any balance in the

margin account in excess of the initial margin

16
Margins

 If price keep declining (increasing), long

(short) position investors may have negative
balance in margin account
 To avoid this, a maintenance margin is set.
 If balance < maintenance margin, the
investor receives a margin call: top up the
margin account to the initial margin level by
the end of the next day
 If not, the broker closes out the position.
17
A Possible Outcome
Day Trade Settle Daily Gain Cumul. Margin Margin
Price ($) Price ($) ($) Gain ($) Balance ($) Call ($)
1 1,250.00 12,000
1 1,241.00 −1,800 − 1,800 10,200
2 1,238.30 −540 −2,340 9,660
….. ….. ….. ….. ……
6 1,236.20 −780 −2,760 9,240
7 1,229.90 −1,260 −4,020 7,980 4,020
8 1,230.80 180 −3,840 12,180
….. ….. ….. ….. ……
15 1223.00 1,380 -5,400 14,400
16 1,226.90 780 −4,620 15,180
Margin Cash Flows When Futures Price
Increases

Clearing House

Clearing House Clearing House

Member Member

Broker Broker

Long Trader Short Trader

Margin Cash Flows When Futures Price
Decreases

Clearing House

Clearing House Clearing House

Member Member

Broker Broker

Long Trader Short Trader

Collateralization in OTC Markets
 It is becoming increasingly common for transactions
to be collateralized in OTC markets
 Consider transactions between companies A and B
 These might be governed by an ISDA Master
agreement with a credit support annex (CSA)
 The CSA might require A to post collateral with B
equal to the value of its outstanding transactions
with B when this value is positive.
 If A defaults, B is entitled to take possession of the
collateral
 The transactions are not settled daily and interest is
paid on cash collateral
Clearing Houses and OTC Markets
 Traditionally transactions have been cleared
bilaterally in OTC markets
 Following the 2007-2009 crisis, the has been a
requirement for most standardized OTC derivatives
transactions to be cleared centrally though clearing
houses.
Clearing Houses and OTC Markets

 An OTC transaction is negotiated between A

and B to a clearing house
 It is then presented to a clearing house
 If the clearing house accepts the transaction,
it becomes the counterparty to both A and B.
 The clearing house takes on the credit risk of
both A and B.
 The clearing house then require margins from
A and B.
Wulin Suo 23
Bilateral Clearing vs Central Clearing
House
Crude Oil Trading on May 26, 2010
Open High Low Settle Change Volume Open Int
Jul 2010 70.06 71.70 69.21 71.51 2.76 6,315 388,902
Aug 2010 71.25 72.77 70.42 72.54 2.44 3,746 115,305
Dec 2010 74.00 75.34 73.17 75.23 2.19 5,055 196,033
Dec 2011 77.01 78.59 76.51 78.53 2.00 4,175 100,674
Dec 2012 78.50 80.21 78.50 80.18 1.86 1,258 70,126
Some Terminology
 Open interest: the total number of contracts
outstanding
 equal to number of long positions or number of short
positions
 Settlement price: the price just before the final bell
each day
 used for the daily settlement process, not the closing price.
Why?
 Volume of trading: the number of trades that have
changed hands in one day
Volume

 Total amount of purchases or sales during a

trading session
 Not purchases and sales together
 Client A buys one contract of Jan wheat and
Client B sells one contract of Jan wheat, the
volume of trading between them is one.

27
Open interest
 Total number of futures contracts that remain
open at the end of a trading session
 Include those contracts not yet liquidated by
either an offsetting futures market transaction or
delivery.
 Client A buys one contract of Jan wheat from
Client B, and neither client started with a position
in Jan wheat, one futures contract will be
created and open interest will increase by one.

28
Open interest
 For seller of a contract there must be a buyer
 One new buyer and one new seller: open
interest + 1
 One old buyer sells to one old seller: open
interest -1
 One old buyer sells to one new buyer: open
interest not change

29
Open interest: suppose before Jan 1 no
trade had any futures positions.
Time Trading Activities Open Interests
Jan 1 A buys 1 futures and B 1
sells 1 futures
Jan 2 C buys 5 futures and D 6
sells 5 futures
Jan 3 A sells 1 futures and D 5
buys 1 futures
Jan 4 E buys 5 futures from C 5
who sells 5 futures
contracts

30
Open interest

 On January 1, A buys one futures contract ,

which leaves an open interest and also
creates trading volume of 1.
 On January 2, C and D create a trading
volume of 5, and there are also five more
options left open.

31
Open interest
 On January 3, A takes an offsetting position,
open interest is reduced by 1, and trading
volume is 1.

 On January 4, E simply replaces C, open

interest does not change, and trading volume
increases by 5.

32
Operation of the Clearinghouse
100 oz GOLD Contract
Time Buyer Seller Contract Cl. House Open Open Open
Value Position Longs Shots Interests
1 A B $46,000 A’s Seller A B 1
B’s Buyer
2 C A $47,000 C’ Seller C B ?
A’s Buyer
3 B C $46,500 B’ Seller - - ?
C’s Buyer
4 A C $48,000 A’s Seller A C ?
C’s Buyer
Questions
 When a new trade is completed what are the
possible effects on the open interest?
 Can the volume of trading in a day be greater than
the open interest?
Delivery
 If a futures contract is not closed out before maturity,
it is usually settled by delivering the assets
underlying the contract. When there are alternatives
about what is delivered, where it is delivered, and
when it is delivered, the party with the short position
chooses.
 A few contracts (for example, those on stock
indices and Eurodollars) are settled in cash
Key points about Futures
 They are settled daily
 Closing out a futures position involves entering into
an offsetting trade
 Most contracts are closed out before maturity
Forward Contracts vs Futures Contracts

FORWARDS FUTURES
Private contract between 2 parties Exchange traded

Non-standard contract Standard contract

Usually 1 specified delivery date Range of delivery dates

Settled at end of contract Settled daily

Delivery or final cash

Usually closed out
settlement usually occurs
prior to maturity
Some credit risk Virtually no credit risk
Accounting

 A company, with a Dec year end buys a

March 2012 corn futures in Sep 2011, and
closes out the position in Feb 2012. The
contract is for the delivery of 5000 bushels.
 Futures price in Sep 2011: 250 cents/bushel
 Futures price in Sep 2011: 270 cents/bushel
 Futures price in Sep 2011: 280 cents/bushel

38
Accounting

 (a) not qualified as a hedge. Accounting gain:

 2011: 5000*(2.7-2.5)=$1000
 2012: 5000*(2.8-2.7)=$500
 (b) hedge the purchase of 5000 bushels of
corn in Feb 2012. Accounting gain:
 2012: 5000*(2.8-2.5)=$1500

39
Hedging Strategies Using
Futures
Long & Short Hedges

 A long hedge: long position in futures contracts

 A short hedge: short position in futures contracts
 If you know you will purchase an asset in the future
and want to lock in the price, which one is
appropriate?
 If you know you will sell an asset in the future and
want to lock in the price, , which one is appropriate?
Basis Risk
 Perfect hedge: reduce all the risk arising from the
price of the asset
 In reality:
 The asset whose price is to be hedged is not exactly
the same as the asset underlying the futures
contract
 The exact date when the asset will be bought or
sold is uncertain
 The hedge may require the contract to be closed out
before delivery month
Examples:
 An airline company has to purchase jet fuel in
the future. Only heating oil futures are
available.
 A company needs to purchase 20,000
barrels of crude oil at some time in October
or November.
 A US company will receive 50 million yen in
July. Yen futures contracts have delivery
months of March, June, September, and
December
43
Basis

 Basis= Spot price of asset to be hedged –

Futures price of contract used
 Basis Risk: The risk to a hedger arising from
uncertainty about the basis at a future time
 If asset to be hedged and asset underlying
futures contract are the same, basis=0 at the
expiration data: no basis risk
 Prior to expiration, the basis can be positive
or negative.
Basis

Futures
Price Spot Price

Spot Price Futures

Price

Time Time

(a) (b)
Long Hedge for Purchase of an asset

 Define
F1 : Futures price at time hedge is set up
F2 : Futures price at time asset is purchased
S2 : Asset price at time of purchase
b2 : Basis at time of purchase

Cost of asset S2
Gain on Futures F2 −F1
Net amount paid S2 − (F2 −F1) =F1 + b2
Short Hedge for Sale of an Asset

 Define
 F1 : Futures price at time hedge is set up
 F2 : Futures price at time asset is sold
 S2 : Asset price at time of sale
 b2 : Basis at time of sale

Price of asset S2
Gain on Futures F1 −F2
Net amount received S2 + (F1 −F2) =F1 + b2
Strong or Weak Basis

 Basis=spot price-futures price

 If the basis increase (spot price increases, or
futures price decreases, or both), we say the
basis has strengthened.
 If the basis decreases (spot price decreases,
or futures price increases, or both), we say
the basis has weakened.
Basis Risk

 Basis will have strengthened or weakened

from the time the hedge is implemented to
the time when the hedge is removed.
 Basis also varies from one location to the
next.
 Hedgers are exposed to basis risk and are
said to have a position in the basis.
Basis example: grain futures basis

 When there is a shortage of grain in some

area, the local spot price increases relative to
the futures price: a strengthening basis
 Spot price is relatively lower in places further
away from areas where grain is used or
exported: a weakening basis

50
Corn prices: spot and futures

51
Basis Risk

 Short hedges gain from a strengthening

basis. Short hedges have a long basis
position.
 Long hedges gain from a weakening basis.
Long hedges have a short basis position.
Basis and the short hedge
 It is march and you plan to sell your wheat in Mid-Jun.
 July wheat futures price is $6.5/bushel
 Cash price in your area in Mid-Jun is normally about 35
under Jul futures price
 What is the net-selling price by short hedging if the basis
is 35 under in Mid-Jun?
 What is the net-selling price if the basis in Mid-Jun had
turn out to be 40 under? 25 under?
 Example source: Self-Study Guide to Hedging with Grain and Oilseed Futures and
Options
 http://
www.cmegroup.com/trading/agricultural/self-study-guide-to-hedging-with-grain-and-oil
seed-futures-and-options.html

53
Basis and the short hedge: basis
unchanged

54
Basis and the short hedge: weaker-
than-expected basis

55
Basis and the short hedge: stronger-
than-expected basis

56
Basis and the short hedge

 That is, as a short hedger, if you like the current

futures price and expect the basis to strengthen,
you should consider hedging a portion of your
crop or inventory.

 If you expect the basis to weaken and would

benefit from today’s prices, you might consider
selling your commodity now.

57
Cross hedge
size of futures position
hedge ratio 
size of the exposure

 Expect to purchase 20,000 barrels of

crude oil in the future: size of the
exposure=20,000
 Crude oil futures contract size: 1,000
 How many contracts to long: 20,000/1,000
 Size of futures position= 20,000
 Hedge ratio=1
58
Cross hedge

 If the asset underlying the futures contract is

the same as the asset being hedged, it is
easy: use a hedge ratio of 1.0
 What if the two assets are different?
 E.g.: air company has to purchase jet fuel,
but only heating oil futures are available.
 Use how many heating oil futures contracts?
 In other words: how to choose the hedge
ratio
Optimal Hedge Ratio
Proportion of the exposure that should optimally be hedged is

* S
h 
F
where
sS is the standard deviation of DS, the change in the spot price
during the hedging period,
sF is the standard deviation of DF, the change in the futures price
during the hedging period
r is the coefficient of correlation between DS and DF.
h* is the minimum variance hedge ratio
Optimal Number of Contracts
QA Size of position being hedged (units)
QF Size of one futures contract (units)
VA Value of position being hedged (=spot price time QA)
VF Value of one futures contract (=futures price times QF)

Optimal number of contracts if Optimal number of contracts after tailing

no tailing adjustment adjustment to allow or daily settlement of
futures

h *Q A
 h *V A
QF 
VF
Example
 Airline will purchase 2 million gallons of jet fuel in
one month and hedges using heating oil futures
 From historical data sF =0.0313, sS =0.0263, and r=
0.928

 The size of one heating oil contract is 42,000

gallons
 The spot price is 1.94 and the futures price is 1.99
(both dollars per gallon)
 h = 0.928* 0.0263/0.0313=0.7777
 QA= 2,000,000; QF= 42,000
 VA= 2,000,000*1.94=3,880,000
VF= 42,000*1.99=83,580
 Without tailing:
N= 0.777*2,000,000/42,000=37.03
 With tailing:

 N=0.777*3,880,000/83,580=36.10

Wulin Suo 63
Hedging Using Index Futures

To hedge the risk in a portfolio the number of contracts that

should be shorted is

VA

VF
where VA is the value of the portfolio, b is its beta, and VF is
the value of one futures contract
Hedging Using Index Futures
 CAPM:
 E(ri ) = rf + βi(E(rm ) – rf )
 βi= cov(ri , rm ) / var(rm )
= [cov(ri , rm ) /( var (ri ) * var (rm ) ) ] *
var (ri )/var (rm )
= ρim * σi / σm
=h

Wulin Suo 65
Example

S&P 500 futures price is 1,000

Value of Portfolio is $5 million
Beta of portfolio is 1.5

What position in futures contracts on the S&P 500 is

necessary to hedge the portfolio?
Changing Beta

 To change the beta of the portfolio from β to

β*:
 reduce exposure to market risk (If β> β* ):
a short position in (β- β* )* VA / VF
 Increase exposure to market risk (If β< β* ):
a long position in (β* - β )* VA / VF

Wulin Suo 67
Changing Beta
 What position is necessary to reduce the beta of the
portfolio to 0.75?
 What position is necessary to increase the beta of
the portfolio to 2.0?
Why Hedge Equity Returns
 May want to be out of the market for a while.
Hedging avoids the costs of selling and
repurchasing the portfolio

 Preserve alphas.
Stack and Roll
 We can roll futures contracts forward to hedge future
exposures
 Initially we enter into futures contracts to hedge
exposures up to a time horizon
 Just before maturity we close them out and replace
them with new contract reflect the new exposure
 etc
Liquidity Issues
 In any hedging situation there is a danger that
losses will be realized on the hedge while the gains
on the underlying exposure are unrealized
 This can create liquidity problems
 One example is Metallgesellschaft which sold long
term fixed-price contracts on heating oil and
gasoline and hedged using stack and roll
 The price of oil fell.....