Financial Markets and Products

Chapter 6:
Hedging Strategies Using Futures*

*Chapter 3 of Options, Futures and Other Derivatives, Ninth Edition, by John C Hull

Learning Objective
Define and differentiate between short and long hedges and identify their
appropriate uses.
Describe the arguments for and against hedging and the potential impact
of hedging on firm profitability.
Define the basis and explain the various sources of basis risk, and explain
how basis risks arise when hedging with futures.
Define cross-hedging and compute and interpret the minimum variance
hedge ratio and hedge effectiveness.
Compute the optimal number of futures contracts needed to hedge an
e posure, a d e plai a d al ulate the taili g the hedge adjust e t.
Explain how to use stock index futures contracts to change a stock
portfolios eta.
E plai the ter rolli g the hedge for ard a d des ri e so e of the
risks that arise from this strategy.

Define and differentiate between short and long hedges

and identify their appropriate uses.
Short Hedge

Long Hedge

Involves a short position in futures contracts.

Appropriate when the hedger already owns an
asset or is expected to own the asset in near
future and expects to sell it at some time in the
future
Protect against price decline
Long position in Asset + Short Position in
Future Contract cancels out the exposure and
locks in the price

Involves a long position in futures contracts.

Appropriate when the hedger knows it will
have to purchase a certain asset in the future
and intends to lock in the price
Protect against price increase
Short position in Asset + Long Position in
Future Contract cancels out the exposure and
locks in the price

A key difference: is the future price predetermined?

A producer promises to sell 100 kg, on a date A producer promises to sell 100 kg, on a date
one year in the future, at the future spot price
one year in the future, @ $3.00 / kg.
The future sale price is not predetermined The sales price of $3.00 is predetermined,
hence the producer is exposed to a future spot
hence the producer is exposed to a future spot
price decrease, such that the appropriate
price increase, such that the appropriate hedge
hedge is a short position in futures contracts.
is a long position in futures contracts
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Describe the arguments for and against hedging and the

potential impact of hedging on firm profitability
Advantages of Hedging
Reduce or eliminate price risk
Companies should focus on the main business they are in and take steps to minimize risks arising
from interest rates, exchange rates, and other market variables
Disadvantages of Hedging
Shareholders are usually well diversified and can make their own hedging decisions. In practice
though, this can be questioned due to frictions and transaction costs associated with owning the
market portfolio
It may increase risk to hedge when competitors do not. . For example, if you are an airline and you
hedge your exposure to jet fuel while your competitors do not and the price of jet fuel drops, you
are stuck with o erpa i g for the jet fuel.
In some industries margins stay roughly the same because the cost of inputs can be passed on
directly to consumers in the form of higher prices. In that case one can easily end up in a situation
where your margins get squeezed if you entered into a hedge and prices move against you.
Explaining a situation where there is a loss on the hedge and a gain on the underlying can be
difficult
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Define the basis and the various sources of basis risk, and
explain how basis risks arise when hedging with Futures
Basis
Basis is defined as the spot price minus the futures price
Basis risk arises because of the uncertainty about the basis when the hedge is closed out
If the asset to be hedged and the asset underlying the futures contract are the same, the basis
should be zero at the expiration of the futures contract. Prior to expiration, the basis may be
positive or negative.
As time passes, the spot price and the futures price for a particular month do not necessarily
change by the same amount. As a result, the basis changes.
An increase in the basis is referred to as a strengthening of the basis,
A decrease in the basis is referred to as a weakening of the basis.
Figure alongside illustrates how a basis might change over time in a
situation where the basis is positive prior to expiration of the futures
contract.

Define the basis and the various sources of basis risk, and
explain how basis risks arise when hedging with Futures
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

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

Cost of asset

S2

Price of asset

S2

Gain on Futures

F2 F1

Gain on Futures

F1 F2

Net amount paid

S2 (F2 F1) =F1 + b2

Net amount received

S2 + (F1 F2) =F1 + b2

Sources of Basis Risk

The asset whose price is to be hedged may not be exactly the same as the asset underlying the
futures contract.
The hedger may be uncertain as to the exact date when the asset will be bought or sold.
The hedge may require the futures contract to be closed out before its delivery month.
Changes in the cost of carry (storage, interest, insurance).
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Define cross hedging, and compute and interpret the

minimum variance hedge ratio and hedge effectiveness
Cross Hedging
Cross hedging occurs when the two assets are different. A cross hedge is when the asset underlying
the hedge is different from the asset being hedged.
Example: An airline that is concerned about the future price of jet fuel, might choose to use heating
oil futures contracts to hedge its exposure, because jet fuel futures are not actively traded, it
Hedge Ratio
The hedge ratio is the ratio of the size of the position taken in futures contracts to the size of the
exposure. When the asset underlying the futures contract is the same as the asset being hedged, it is
natural to use a hedge ratio of 1.0.
with cross-hedging the optimal hedge ratio need not equal 1.0. The optimal hedge ratio is the ratio
that minimizes the variance of our hedge that is the minimum variance hedge ratio (MVR)
The minimum variance hedge ratio depends on the relationship between changes in the spot price
and changes in the futures price
S
*
Proportion of the exposure that should optimally be hedged is h
F
where
S is the standard deviation of S, the change in the spot price during the hedging period,
F is the standard deviation of F, the change in the futures price during the hedging period
is the coefficient of correlation between S and F.
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Define cross hedging, and compute and interpret the

minimum variance hedge ratio and hedge effectiveness
Hedge Ratio
Airline will purchase 2 million gallons of jet fuel in one month and hedges using heating oil futures
From historical data F =0.0313, S =0.0263, and = 0.928

h* 0.928

0.0263
0.78
0.0313

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) so that

V A 1.94 2,000,000 3,880,000

VF 1.99 42,000 83,580
Optimal number of contracts is N *=

0.78 2, 000, 000 42, 000

h *Q A
QF

which rounds to 37

Define, compute and interpret the optimal number of

Futures contracts needed to hedge an exposure, and
explain and calculate the taili g the hedge adjustment
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

adjustment for daily settlement

h *Q A

QF

Optimal number of contracts after

taili g adjust e t to allo or dail
settlement of futures

hV
A

VF

When Futures are used, a small adjustment, known as taili g the hedge can be made to
allow for the impact of daily settlement. The only difference here is to replace the units with
values
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Explain how to use stock index Futures contracts to

change a stock portfolios beta
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,
is its beta, and
VA F is the value of one futures contract
Eg. 1
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?
to reduce the beta of the portfolio to 0.75?
to increase the beta of the portfolio to 2.0?

A 4 month futures contract is used to hedge the

value of a portfolio over the next 3 months.
Value of S&P 500 index = 1,000
S&P 500 futures price = 1,010
Value of portfolio = $5,050,000
Risk-free interest rate = 4% per annum
Divided yield on index = 1% per annum
p= 1.5;
Index Multiple: 250
a. Calculate value of S&P 500 futures price of 4
month maturity
b. How many futures contracts should be
bought or sold for hedging the portfolio for 3
months
c. After 3 months, value of S&P 500 index = 900
Calculate gain/loss on squaring off futures.
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Describe what rolli g the hedge for ard means and

describe some of the risks that arise from such a strategy
When the delivery date of the Futures contract occurs prior to the expiration date of the hedge, or
there is little liquidity but in the spot and prompt month, the hedger can roll forward the hedge: close
out a Futures contract and take the same position on a new Futures contract with a later delivery
date. This is also known as a stack and roll strategy.
Risk arising from a stack and roll strategy
Rolling the hedge forward exposes the company, or hedger to basis risk on the original hedge.
Further, it exposes the hedger to basis risk on each new hedge; a.k.a., rollover basis risk. If the price
of the asset we are long declines, such that there are margin calls, or at least cash outflows in the
near-term the firm might experience a liquidity squeeze. With insufficient liquidity this can cause
major problems. This is largely due to unfortunate timing: in the short run we have cash outflows due
to the loss on the Futures contract, however, since the firm employs the stack and roll strategy every
month, it can readily expect to buy Futures, and thus hedge its cost, the following months at a lower
price.

Summary
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 an replace them with new contract reflect the new exposure
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