LECTURE 2:

HEDGING
STRATEGIES
USING FUTURES
CONTRACTS
 LEARNING OBJECTIVES
1) Understand the concept of “hedging”. The intentions
to use Futures market instrument.
2) Taking a position in the Futures market: either a “Long
Hedge” or “Short Hedge” position.
3) Differentiate between “Long Futures hedge” and
“Short Futures hedge” and its purpose.
4) To devise hedging strategies using Futures contracts.
5) The concept of “Perfect Hedge” and “Imperfect
Hedge”
6) Correcting the “basis risk”. When hedged asset is
different from hedging contract.
7) Cross hedging and Optimum Hedge Ratio (OHR).
FIN3074 RISK MANAGEMENT APPLICATIONS OF
DERIVATIVES BY RAFF
LEARNING STRUCTURE
 Definition of “hedging”.
 Taking a Hedge position in the Futures market.
 Issues in hedging using futures
 Types of hedge structures.
 The Basis and Basis risk.

 The optimal hedge ratio (OHR), optimal number of hedging contracts and
hedging effectiveness.
 Is the perfect hedging possible?

FIN3074 RISK MANAGEMENT APPLICATIONS OF DERIVATIVES BY RAFF

TWO MARKETS INVOLVED IN HEDGING WITH FUTURES
Cash or Physical Market (Spot Price)
 This is where the real physical asset exist for
a purchase or sale in the future date.
 A trader can purchase or sell a physical
product e.g. a commodity like Gold or Silver,
Crude Palm Oil, Equity Stock of a company or
a Stock Index.
 Physical goods or products exist to be taken
delivery on an intended date of purchase or
sale on a spot price that floats every minute.
 This asset is what to be hedged on a future
date delivery.
FIN3074 RISK MANAGEMENT APPLICATIONS OF DERIVATIVES BY RAFF
Futures Contract Market (Futures Price)
 This is where the Futures Contracts are being
traded for various maturity dates.
 A trader can go long or short on any Futures
Contract on an underlying asset e.g. Gold
Futures or Silver Futures, Crude Palm Oil
Futures , Single equity Stock Futures or Stock
Index Futures.
 Paper Contract that written on an underlying
asset that exist and traded in Cash / Physical
market on a Futures Price indicator that floats
on daily basis.
 This is the hedging contract according to future
date maturity.
 WHAT IS HEDGING ?
 A hedge is an investment position intended to offset potential losses that may be incurred by an
existing investment in a future date. Hedging is about reducing the volatility (risk) of future cash
flows associated with existing commitments in cash / physical market. There should be an
exposure in the physical market.

 Commitments in cash/physical market means existing positions in some instruments/commodities

or equities or planning to buy or sell any of these in the future time in physical market. [physical
market is also referred as the spot market or cash market].
 The concept is to take some position in derivative contracts that neutralizes the risk as much as
possible. (if you lose in cash market, you will gain in derivative market, and vis a vis)
 In most of cases, hedging involves the use of some financial derivatives like Futures or Options
contracts.
 Hedgers identify the risk factor in the cash market and take a position in a derivative such as to
benefits from the adverse movements in the asset prices.
 TAKING A POSITION IN THE FUTURES MARKET

 There are only two alternative positions available:

Trader / Investor

Short Position Long Position

Short Hedge Long Hedge

Intending to sell something in the Intending to buy something in the
Physical market in a future date. Physical market in a future date.

Main concern is that the price of Main concern is that the price of
that something may drop in the that something may increase in
future intended time. the future intended time.
Action
FIN3074 RISK in the
MANAGEMENT Futures
APPLICATIONS market:BY RAFF
OF DERIVATIVES Action in the Futures market:
Sell now and buy back later Buy now and sell later
 LONG & SHORT FUTURES HEDGES

 A Short Futures hedge is appropriate when you want to sell an underlying asset in a
future date and intend to neutralize the risk of drop in price of that underlying asset by
taking a short position in the Futures market. (Short Futures hedge when asset price
may fall in a future time). Therefore, through selling now at a high price per contract and
buying back at a lower price per contract can gain the difference in the future market that
can be used to offset the loss in the physical market due to the drop in price.

 A Long Futures hedge is appropriate when you want to purchase an asset in the future
date and intend to neutralize the risk of increase in price of the asset by taking a long
position in the Futures market. (Long Futures hedge when asset price may rise at future
time). Therefore, through buying now at a lower price per contract and selling higher in
the future date can gain the difference in the futures market that can be used to offset the
loss due to increased price in the physical market.
FIN3074 RISK MANAGEMENT APPLICATIONS OF DERIVATIVES BY RAFF
BASIC PRINCIPLE OF HEDGING

 Hedging is not to make a target profit through futures market.

 Hedging is to neutralize the losses as much as possible.
 For example:
 The company may lose $10,000 if the commodity price (which it intends to sell in 3-months)
drop by $1.00 per unit in the physical market.
 Alternatively the company may gain $10,000 if the commodity price (which it intends to sell in
3-months) increases by $1.00 per unit in the physical market.

FIN3074 RISK MANAGEMENT APPLICATIONS OF DERIVATIVES BY RAFF

BASIC PRINCIPLE OF HEDGING
 The big issue here is how would the company treasurer maintain a neutral position or maintain
certainty in cash flow at the end of 3 months?????
 By taking a short hedge position in the futures market, the treasurer can short sell a certain number of
this futures contract for 3-months. (The opposite happens for Long Hedge Position).
 At the end of 3-months if the commodity price do drop by $1.00, he / she will lose $10,000 in physical
market, but will gain the $10,000 in the futures market (through buying back the contracts that he sold
earlier at $1.00 lower price that will gain $10,000). This will neutralize the loss. [Loss $10,000 in the
physical market but gained $10,000 in the futures market = 0 ]
 If at the end of 3-months the commodity price increases by $1.00, he / she will gain $10,000 in the
physical market but will loose $10,000 in the futures market (through buying back the contracts that he
sold earlier.
 In either way. The treasurer can maintain a neutral position through hedging. His cash flow is not altered.
FIN3074 RISK MANAGEMENT APPLICATIONS OF DERIVATIVES BY RAFF
 AN EXAMPLE ON LONG FUTURES HEDGE

 Assuming it is March 2023 now, and a gold-bullion manufacturer anticipates a need for 1,000 grams of raw gold in December 2023. His downside risk is that the
gold price may increase by December 2023.
 Currently Gold is priced at $990 / gram in physical market, and the December 2023 Gold Futures are priced at $1000 / gram.
 Each Gold Futures contract for all delivery months is 100 grams. (total Dec futures contract = $1,000,000)
 The gold-bullion manufacturer can hedge the possible increase in price of raw gold by going long in Ten December Gold Futures Contracts:
CASH/PHYSICAL
Case 1: Gold PriceMARKET GOLD
in December 2023 is $900 FUTURES MARKET
/ gram CASH/PHYSICAL
Case 2: Gold Price in DecemberMARKET GOLD FUTURES MARKET
2023 is $1200/ grams
Now in March 2023 Now in March 2023 Now in March 2023 Now in March 2023
Long 10 December Gold Futures Long 10 December Gold Futures
Do nothing Contracts @ $100,000 /contract Do nothing Contracts @ $100,000 /contract
Total Contract Value $1 million Total Contract Value $1 million

In December 2023 In December 2023 In December 2023 In December 2023

Buy 1,000 grams of gold @ $900 / Short the 10 December Gold Futures Buy 1,000 grams of gold @ Short the 10 December Gold Futures
gram Contract @ $90,000 / contract $1,200/gram Contract @ $120,000 / contract
Total purchase value $900,000 Total Sales value $900,000 Total purchase value $1.2 million Total Sales value $1.2 million
Cash outflow $ 900,000 Cash Flow in Futures 900 k – 1m = - Cash outflow = $ 1.2 mill Cash Flow in Futures 1.2 – 1 = $200,000
Offset Futures Loss $ 100,000 $100,000 Offset Futures gain - $ 0. 2 mill
Total cost $1 mill   Total cost $1 mill  

FIN3074 RISK MANAGEMENT APPLICATIONS OF DERIVATIVES BY RAFF

 AN EXAMPLE ON SHORT FUTURES HEDGE
 Assuming it is March 2023 now, and a Crude Palm Oil (CPO) producer anticipates to Sell for 1,000 metric tons
(Mt) of CPO in December 2023. His downside risk is that the CPO price may fall by December 2022.
 Currently CPO is priced at $1,200 / Mt in physical market, and the December 2023 CPO are priced at $1,150 /
Mt.
 Each CPO contract for all delivery months is 25 Mts. (so need 40 contracts) (total Dec futures contract =
$1,150,000)
 The CPO producer can hedge the possible decrease in price by going short in Forty December CPO Futures
Contracts:
Case 1: CPO Price in December 2023 is $1,000 / Mt Case 2: CPO in December 2023 is $1300/Mt
CASH/PHYSICAL MARKET CPO FUTURES MARKET CASH/PHYSICAL MARKET CPO FUTURES MARKET
Now in March 2022 Now in March 2023 Now in March 2023 Now in March 2023
Short 40 December CPO Futures Short 40 December CPO Futures Contracts
Do nothing Contracts @ $28,750 /contract Do nothing @ $28,750 /contract
Total Contract Value $1,150,000 Total Contract Value $1,150,000

In December 2023 In December 2023 In December 2023 In December 2023

Sell 1,000 Mts of CPO @ $1,000 / Long the 40 December CPO Futures Sell 1,000 Mts of CPO @ $1,300 Long the 40 December CPO Futures
Mt Total Sale value $1,000,000 Contract @ $25,000 / contract / Mt Total Sale value $1,300,000 Contract @ $32,500 / contract
Total purchase value $1,000,000 Total purchase value $1,300,000
Cash in flow $ 1,000,000 Cash Flow in Futures 1.15m – 1m = $ Cash in flow $ Cash Flow in Futures 1.15m – 1.3m = -
150,000 1,300,000 150,000
Offset
FIN3074 Futures Gain $ APPLICATIONS
RISK MANAGEMENT 150,000 OF DERIVATIVES BY RAFF Offset Futures Loss ($
Total Revenue $ 1,150,000   150,000)
Total Revenue  
$1,150,000
A Motivating Example (Outcome)
 Alternative explanation: consider the outcomes from 2 different scenarios in December 2023

Scenario 1: ST = FT = Scenario 2: ST = FT =1200

900
Price paid for gold in the spot 1,000 x 900 = $900,000 1,000 x 1200 = $1.2M
market in December 2023

Less payoff from futures

(You short in December 1,000(FT - F) 1,000(FT - F)
2023) =1,000 (900 - 1000) =1,000(1200 - 1000)
= loss $100,000 = Gain $200,000
Net price paid for gold
By offsetting the gain/loss in 900k + 100k = $1M 1.2M – 200k = $1M
futures market

 Try again with any ST value, you always get the total outflow as $1M.

 Why?
 Well, any gain (loss) from the spot transaction is exactly matched by loss (gain) from the futures transaction,
as long as S = F . This “exactness” makes the hedge perfect, which may not be the case in real world.
T T
FIN3074 RISK MANAGEMENT APPLICATIONS OF DERIVATIVES BY RAFF
IS HEDGING REALLY NECESSARY?
 Arguments in favor of hedging
 Most of the companies are involved skillfully in the business of manufacturing,
wholesaling, retailing or providing professional services. They don’t have the expertise to
predict variable and volatilities of commodity prices, interest rates or foreign exchange
rates.
 Therefore, they should hedge risks associated to these variations in physical market
prices and focus on their core activities of the business.
 To avoid unpleasant surprises such as a sharp increase or decrease in physical market
prices.

FIN3074 RISK MANAGEMENT APPLICATIONS OF DERIVATIVES BY RAFF

IS HEDGING REALLY NECESSARY?
 Arguments against hedging
 Hedging and Shareholders: Assuming that the shareholders are very informed on the risks
and have well diversified their portfolio of shares in various industries, hedging is not
necessary at the company level.
 Hedging and Competitors: If hedging is not a norm in the industry, then single firm in the
industry need not hedge. Again in perfect competition market you may have high flexibility
to pass on the price variations to the customer easily as all the competitors would increase
or decrease the retail price at the same time. Therefore, hedging is not necessary.
 Hedging and its outcome: Must analyze the cost and benefit of hedging. If it costs large
amount to save a small amount of benefit then why hedge. Besides that, not always
hedging can be beneficial, in case of missing a huge gain due to hedge position, it is going
to be very difficult to justify.
FIN3074 RISK MANAGEMENT APPLICATIONS OF DERIVATIVES BY RAFF
 THE CONCEPT OF BASIS RISK
 Basis is usually defined as the difference between spot price and futures price of an asset at any
point in time during the hedge period.
 Basis = Spot price of asset to be hedged – Futures price of the contract used is non zero
= ST – FT is non-zero at the end of the contract reversal
 It represents the “uncertain” component in the outcome of a hedge using futures.
 Basis risk therefore, refers to the uncertainty of the price difference between the spot and futures
price during the contract is closed out.
 Hedging effectively transforms a price risk into basis risk, the latter is smaller.
 Due to the converging of the spot and futures prices, the basis risk should be zero at the maturity
date of a Future contract.

Basis Risk

FIN3074 RISK MANAGEMENT APPLICATIONS OF DERIVATIVES BY RAFF

 REASONS FOR BASIS RISK TO PERSIST
 The term basis refers to the difference between the Spot price of the asset to be hedged minus Futures price of the
contract being used in the hedging period : S0 – F0 to be non zero

 The "perfectness" of the hedge depends on the time-T basis being zero with certainty.

 Basis risk arises when there is uncertainty or volatility about the time –T basis: FT - ST ≠ 0

 At least tree reasons why, in general, the basis may be risky and non-zero at the expiration of a futures contract.
1. Commodity mismatch: The type of the commodity underlying the futures contract may not be the one being hedged.
E.g. Jet fuel and Heating oil; Portfolio of stocks and the stock market index; Gold and Silver Futures
 This is commodity basis risk.
2. Delivery mismatch: The standardized delivery dates of the futures contract may not match the desired delivery dates
(e.g., there is no gold contract expiring in April; there is no CPO contract delivering in June).
This is delivery basis risk.
3. Contract Size mismatch: The Future Contract Size is more than or less that Physical market underlying asset
requirement. (e.g. CPO Futures is 25 Metric tons per contract and the physical CPO requirement is 40 or 90 tons,
which is not divisible as a whole contract. It will be either a CPO futures of 50 tons or 100 tons as for 2 contracts or 4
FIN3074 RISK MANAGEMENT APPLICATIONS OF DERIVATIVES BY RAFF
contracts respectively.) This is contract size basis risk
 In the presence of basis risk, a perfect hedge is impossible.
 UNCERTAINTIES ASSOCIATED WITH BASIS
 Changes in the basis can lead to an improvement or worsening of a hedgers position over the life span of a hedge contract.

 Basis can be viewed as a gap between the spot price and the futures prices of an underlying throughout the hedge contract
period.
 The gap between these two prices can either become broader (strengthening) or thinner (weakening) from the inception
time until the expiry of a futures contract.
 Generally, when the asset to be hedged and the underlying in the futures contract is same (e.g. Jet Fuel is hedged with Jet
Fuel futures) the spot price and the futures price should converge at the maturity of the contract (i.e. Spot price = Futures
price of same underlying) so that the futures broker can buy the asset in the physical market to deliver to the Short position
party to take delivery.
 However, if the asset to be hedged is different from the futures underlying (case of commodity mismatch, e.g. Jet Fuel
hedged with Heating oil futures) the gap between these both prices will not converge at the maturity, leading to a presence
of basis risk.
 Strengthening of basis is evident when either the asset price increases or the futures price decreases, or both happens,
and the gap becomes larger. This is called the strengthening of a basis.
 Weakening of basis is evident when either the asset price decreases or the futures price increases, or both happens at the
same time and the gap becomes closer. This is called the weakening of a basis.
 STRENGTHENING AND WEAKENING OF BASIS
The two below graphs illustrates the strengthening and Weakening of Basis.

FP FP

SP SP

t0
Time
When the Futures Price is above the Spot Price
Increase in FP or Decrease in SP can Strengthen
the basis at the contract expiry time.
T Time t0 T
When the Futures Price is above the Spot Price
Decrease in FP or Increase in SP can Weaken
The basis at the contract expiry time.

The above both illustrations are assuming the Futures Price is above than Spot Price throughout the life of the hedge period. If they
were in reverse order (i.e. Spot Price higher than Futures Price), the effect of basis strengthening and weakening will be in the
opposite outcomes .
FIN3074 RISK MANAGEMENT APPLICATIONS OF DERIVATIVES BY RAFF
UNCERTAINTIES ASSOCIATED WITH BASIS

 Basis changes can lead to an improvement or a worsening in the hedgers position:

 For a short hedge(sell now to buy back later in futures market); if the basis strengthens
unexpectedly, (spot price in the physical market decreased, or futures contract price
increased) the hedgers position worsens as he will get a smaller difference in gain (either buy
back the futures at a higher-than-expected price or sell his asset at lower-than-expected price
in the physical market at the intended time). It is the opposite if the basis weakens.
 For a long hedge (buy now to sell latter in futures market); if the basis weakens
unexpectedly, (spot price in the physical market increased, or futures contract price
decreased) the hedgers position worsens as he will get a smaller difference in the gain (either
sell the futures at lower-than-expected price or buy the intended asset at higher-than-expected
BASIS
price in the physical market SHORT
at the intended time). It isLONG POSITION
the opposite if the basis strengthens.
POSITION
Strengthened Worse off Better off
Weakened
FIN3074 RISK MANAGEMENT APPLICATIONS OF DERIVATIVES BY RAFF Better off Worse off
 THE CONCEPT OF PERFECT HEDGE

 A “perfect” hedge would be possible when the hedger is able to:

1) identify the exact date when an underlying asset will be sold/bought,
2) trade the Futures contract written on the same specified underlying asset,
3) with Futures contract delivery date matching the hedging horizon.
 If that is the case, the net amount received by (paid by) the short (long) hedger is
FT – ST = 0 : No basis risk = Perfect Hedge
 The gain (loss) in the futures market can exactly match the loss (gain) in the cash
market, where it will end as a zero-sum game.
 A Note: In reality due to market imperfections and frictions such as transaction costs,
early close outs and commodity mismatch a perfect hedge is rarely possible.
 E.g. Gold jeweler enters a June 2022 Gold Futures contract and closes out on the exact
FIN3074 RISK MANAGEMENT APPLICATIONS OF DERIVATIVES BY RAFF

contract expiry date to take delivery of intended quantity of Gold.

HANDLING BASIS RISK: THE IDEA
 The question: What do we mean by the "best" hedging strategy?
 The answer: the one that minimizes cash-flow variance at time T
 Don’t underestimate how insightful this answer actually is!
 Similar to the mean-variance optimization in Markovitz’s portfolio theory.
 Cross hedging between highly correlated underlying futures asset and the asset
being hedged is one of the best possible strategy to overcome or to reduce basis risk.
 To cross hedge the pair of different assets (the physical and futures underlying) we
must identify the appropriate proportion (numbers) of futures contact to have an
effective hedge outcome.
 The effective hedge outcome is the “Optimum Hedge Ratio (OHR)” that can reduce as
much possible variance between the two price movements during the period of
FIN3074 RISK MANAGEMENT APPLICATIONS OF DERIVATIVES BY RAFF
analysis.
CHOICES OF HEDGING AND BASIS RISK
1) The choice and availability of underlying asset in Futures contract affects basis risk.
2) The Futures contract maturity time and the physical asset delivery time also affects basis risk.
 When there is no futures contract on the asset being hedged, choose the contract whose futures
price change that is highly correlated with the asset price change. This is known as Cross -hedging.
 In some cases, the choice could be obviously different
 Use crude oil futures to hedge jet oil
 Use S&P index futures to hedge diversified Australian stock portfolios
 In others, a decision has to be made
 Different grades of wool, wheat, coffee or corn futures against cotton, crude oil, tea or heating oil as
the asset price to be hedged.
 Government bond futures to hedge a corporate bond portfolio
FIN3074 RISK MANAGEMENT APPLICATIONS OF DERIVATIVES BY RAFF
 In all the above cases the next issue is the choice of the delivery month.
CROSS HEDGING
Cross hedging occurs when the change in the asset price that being hedged is not
exactly the same as the change in the underlying asset price of the futures contract.
 E.g. (1) Crude oil futures used to hedge Jet Fuel price in an intended future time, (2) Crude Palm Oil
futures (FCPO) is used to hedge the Heating Oil price in an intended future time.
 When a pair of hedging assets are different, their daily price changes will not be same over a period.
i.e. the daily change in the spot price is not same as the daily price change of the futures price. ∆SP
≠ ∆FP
 Therefore, their standard deviations also will not be same.
 Since the two assets are different, their prices will not be perfectly correlated.
 Most importantly their price correlation will never be 1.00. Therefore we should identify the pair that
has the highest correlation nearing to 1.00 e.g. 0.8 or 0.9 correlation coefficient.
FIN3074 RISK MANAGEMENT APPLICATIONS OF DERIVATIVES BY RAFF

 Need to determine the Optimum Hedge Ratio (OHR), to reduce the variance between the price
changes, i.e. how many futures contracts to use, given the amount of physical asset to hedge.
 CHOICE OF HEDGING CONTRACT DELIVERY MONTHS
 Choice of delivery month also affects basis risk.
 Basis risk increases as the time gap between hedge expiration and delivery month increases
 Rule of thumb: choose the contract whose delivery month is as close as possible to, but later
than, hedge expiration.
 The best choice of cross-hedge in underlying is to identify:
 The optimal hedge ratio (OHR), optimal number of hedging contracts and hedging
effectiveness.
 E.g. If you intending to take delivery of 1000 Metric tones of CPO on 15th May 2023, you
should hedge it by going long in (1000 / 25) = 40 June FCPO contracts. (assuming there are
no May 2023 FCPO contract expiry).

FIN3074 RISK MANAGEMENT APPLICATIONS OF DERIVATIVES BY RAFF

 CROSS HEDGING AND OPTIMAL HEDGE RATIO (OHR)
 Optimal Hedge Ratio:
 Proportion of the exposure that should optimally be hedged is:

Where:

 h* is the OHR
 σS is the standard deviation of DSp, the change in the spot price during a retrospective period of time.

 σF is the standard deviation of DFp, the change in the futures price during the same retrospective
period of time.

 ρ is the coefficient of correlation between DSp and DFp

 When ρ = 1 and DSp = DFp ; then h*

FIN3074 RISK MANAGEMENT APPLICATIONS OF DERIVATIVES BY RAFF
= 1. Which is what you would expect if the futures underlying asset and the
physical asset are the same.
 OPTIMAL HEDGING: SOME ISSUES
Optimal Number of Contracts for increasing the hedge effectiveness
 Size of asset being hedged (units)

 )
 )

Optimal number of contracts without Optimal number of contracts with

tailing adjustment: tailing adjustment:

* Tailing is taking into account of the daily price settlement in the futures market due to M2M
FIN3074 RISK MANAGEMENT APPLICATIONS OF DERIVATIVES BY RAFF
CROSS HEDGING NUMERICAL EXAMPLE
 Example: An airline company expects to purchase two million gallons of Jet fuel in one
month time and decides to use Heating Oil futures for hedging. (Assuming there are no Jet
Fuel Futures listed in the Futures market). Using data on ΔSP and ΔFP over 15 previous
months, it is calculated that:
 σΔSp = 0.0263 and σΔFp = 0.0313, and ρ = 0.928.
 What is the value of the Optimal hedge ratio h*?
 The solution is:

 What does this mean?

 The airline should use the number of futures contracts such that the underlying value of the
heating oil in the contracts is 78% of the value of the physical jet fuel to be hedged.
FIN3074 RISK MANAGEMENT APPLICATIONS OF DERIVATIVES BY RAFF
 CROSS HEDGING

 Optimal number of contracts to be hedged in futures market

 The number of futures contracts should be on h*QA units of the asset.

 Heating oil Futures contracts traded on NYMEX is 42,000 gallons per contract (QF ).

 The physical jet fuel to be hedged is 2 million gallons (QA ) .

 Optimal number of heating oil futures contracts is…

≈ 37 contracts
FIN3074 RISK MANAGEMENT APPLICATIONS OF DERIVATIVES BY RAFF
 CROSS HEDGING
 When incorporating the effects of daily settlement, the optimal contracts becomes: *=
 Where
 VA is the dollar value of the physical asset to be hedged

 VF is the dollar value of the underlying asset in one contract.

 Therefore, continuing with the airline example…
 If the heating oil futures price Ft = $1.99/gallon, and the jet fuel spot price is St =
$1.94/gallon, then the optimal number of contracts at time t is

FIN3074 RISK MANAGEMENT APPLICATIONS OF DERIVATIVES BY RAFF

STOCK INDEX FUTURES
 Stock Market Index (SMI) – Is an Index representing the stock market performance based on a
number of selected stocks in the stock market. The stock market index can be 100, 200 or even 500
stocks representing in the market.
 SMI is available in the futures market as Stock Index Futures. In Malaysia we have the Kuala Lumpur
Composite Index Futures (FKLI). The underlying asset of this FKLI is FBM KLCI based on the
weighted average of 100 stocks in the main market.
 FKLCI has a multiplier of RM50.00 to each Index point.
 E.g. As on 19th July 2021 the FBM KLCI closed at 1,519.97 points. These points have a RM value of
1,519.97 x 50 = RM 75,998.50. This Index is available in the Futures as FKLI
 FKLI is a Ringgit Malaysia (“MYR”) denominated FTSE Bursa Malaysia Kuala Lumpur Composite Index (FBM
KLCI) Futures Contract traded on Bursa Malaysia Derivatives ("BMD") providing market participants exposure to
the underlying FBM KLCI constituents. It is actively used by both institutional and retail investors in their respective
trading portfolios.
Contract Months Spot month, the next month and the next two calendar quarterly months. The calendar
quarterly months are March, June, September and December.

 https://www.bursamalaysia.com/trade/our_products_services/derivatives/equity_derivatives/
ftse_bursa_malaysia_klci_futures
FIN3074 RISK MANAGEMENT APPLICATIONS OF DERIVATIVES BY RAFF
HEDGING EQUITY
A fund manager PORTFOLIOS
can have a USING
portfolio of equity fund made upSTOCK
of either allINDEX FUTURES
similar stocks of the Stock Index
components (market portfolio with a Beta of 1.000) or made up mostly of the stock index components (well
diversified portfolio). Sometimes it could be a mix of randomly selected stocks in the stock market
(diversified portfolio).
 A market portfolio is said to be mimicking or mirroring the market index and its Index futures. Which means
the correlation coefficient should be almost 1.00. However, most of the time an equity fund portfolio may
have a diversified stocks almost mimicking the market index but not exactly. In such cases, we need to
identify the optimum number of index futures contracts.
 The downside risk of any equity portfolio is that the total value of the portfolio may drop beyond the
expected limit if the market index falls.
 In a equity portfolio fund that mirrors the market index, the percentage changes in the stock index over a
small interval is set to be equal to the increase or decrease in the value of the hypothetical equity portfolio.
 Therefore, always short hedge the Market Index Futures to protect the drop in total value of an equity
portfolio.
 Dividends received are usually not included in the calculation, so the index tracks the capital gain/loss
from investing in the portfolio.
FIN3074 RISK MANAGEMENT APPLICATIONS OF DERIVATIVES BY RAFF
HEDGING USING STOCK INDEX FUTURES
 Hedging using Index Futures:
 To hedge the risk (drop in value) in a portfolio a number of contracts that should be shorted is

 where
 VA is the current dollar value of the investors portfolio (Size of the portfolio)
 β is the investor’s portfolio beta, and
 VF is the current dollar value of one stock index futures contract (size of one Index Futures)
(i.e. Index futures price × contract size)

The beta coefficient β is a measure of the portfolio combined risk against the market risk.
When the β = 1.00, the portfolio risk is as the same as the market risk (the undiversifiable risk). When the
β < 1.00 than, the portfolio risk is less than the market risk.
When the β > 1.00 than, the portfolio risk is more than the market risk
HEDGING USING STOCK INDEX FUTURES
 The β is the same as h*.
 The β is from the Capital Asset Pricing Model (CAPM).
 The β of an asset, or a portfolio of assets, is the slope of the ‘best fit’ line when the
return of the asset, or portfolio of assets, is regressed against the return of a well
diversified stock index.
 When β =1.00, the return on the portfolio tends to mimic the return on the stock
index.
 When β =2, (β=0.5) the return on the portfolio tends to twice (half) as great as that of
the return on the stock index.
 The β plays the same role of the correlation coefficient ρ in the OHR
FIN3074 RISK MANAGEMENT APPLICATIONS OF DERIVATIVES BY RAFF
HEDGING USING STOCK INDEX FUTURES
 Why might an equity portfolio manager use Stock Index futures contracts to hedge their
portfolio position?
 Equity portfolio managers generally would use Stock Index Futures to protect the value
of a portfolio from falling during bear trend times. Portfolio managers would like to hold a
certain well diversified portfolio for a longer term but may want to hedge the value of the
portfolio against short-term fluctuation in the Stock Index Futures rather than constantly
change their portfolio by selling and buying back in the stock market.
 Why not just exit the market by selling the portfolio?
Hedging on the SIF is much be cheaper than selling the portfolio and buying it back.
 Hedge can remove systematic risk, by constantly doing dynamic changes in the
number of optimum contracts to safeguard the value of their portfolio at any point in
time of the portfolio asset holding.
FIN3074 RISK MANAGEMENT APPLICATIONS OF DERIVATIVES BY RAFF
 A NUMERICAL EXAMPLE
 An Example:
 Input Data:
 S&P 500 stock index = 1,000 points.
 Current S&P 500 stock index futures price =1,010 points
 Each index point is worth $250 (or a multiplier of 250 times)
 Value of equity portfolio = $5,050,000. (VA)

 Risk free interest rates = 4% p.a. (1% per quarter)

 Dividend yield on S&P 500 = 1% p.a. (0.25% per quarter)
 Beta (β) of equity portfolio = 1.5
FIN3074 RISK MANAGEMENT APPLICATIONS OF DERIVATIVES BY RAFF

 Hedge period = 3 months.

EXAMPLE
 Example continued:
 Current value of one Stock Index Futures contract = $250 × the S&P Futures Price
 = $250 x 1,010 = $252,500 (VF)

 Value of equity portfolio is $5,050,000 (VA)

 β is 1.5

The outcome is:

 N* = 1.5 x ($5,050,000/$252,500) = 30 contracts.
 In order to hedge the physical equity portfolio, the fund manager should go ‘short’ on 30 S&P stock index
futures contracts.
 By hedging on 30 stock index futures, the fund manager fully eliminates the market risk that could reduce
the equity portfolio value in the short term due to the drop in the index futures.
FIN3074 RISK MANAGEMENT APPLICATIONS OF DERIVATIVES BY RAFF
 CHANGING THE BETA
Based on the previous example:
When the β was 1.5 and you hedge on 30 index futures contract.
The market momentum could change in the short term and during bear trend season you may not want your
portfolio value to fall in tandem with the market index, you would want reduce the β to a lesser point e.g. less
than β of 1.0, so that you would short smaller number of Index Futures contracts.

 What position is necessary to reduce the beta of the portfolio from 1.5 to 0.75?
 β = 1.5 to β* = 0.75. Since β*< β (that is to reduce the beta)

 We would go short on 15 index futures contracts, not short 30 as in the earlier example.
 To decrease
FIN3074 the beta
RISK MANAGEMENT we go
APPLICATIONS short onBYindex
OF DERIVATIVES RAFF futures contracts
 CHANGING THE BETA

What position is necessary to increase the beta of the portfolio from 1.5 to 2.0?
 When market momentum could change in the short term and during bull trend season you may want
your portfolio value to increase higher than the market index, you would want increase the β to a larger
point e.g. more than β of 1.0, so that you would long lower number of Index Futures contracts.

 β = 1.5 to β* = 2.0. Since β*> β ( that is to increase the beta)

We would go long 10 contracts, not short 30 as in the earlier example.

FIN3074 RISK MANAGEMENT APPLICATIONS OF DERIVATIVES BY RAFF

To increase the beta we go long on index futures contracts.

 LECTURE SUMMARY
 Futures can be used to hedge the risk of asset price falling or rising.
 Outcome in a futures hedging is the net of the outcome in the spot transaction and the outcome in
the futures transaction at the maturity date.
 Futures hedging effectively transfers the price risk to basis risk.
 In a portfolio context, stock index futures provides a low cost strategy to alter the systematic risk of
the portfolio for a given period of time.
 However, you must understand that hedging with the futures market instruments can reduce your
lose in the physical / cash market, but it could also reduce your gain in the physical / cash market.
 The hedging process in the futures market instruments works in an inverse direction of the cash
market.
 I.e. a loss in the cash market is offset by the gain in the futures market and a gain in the cash
market is offset by the loss in the futures market. Thus, the main objective is just to neutralize the
future cash flow and not to count on profit or loss.
 REMEMBER:::::: A perfect hedge is impossible in the real-world hedge transactions.
FIN3074 RISK MANAGEMENT APPLICATIONS OF DERIVATIVES BY RAFF
THANK YOU