Hedging Strategies Using Futures

Thota Nagaraju
Dept of Econ & Fin
BITS-Pilani Hyd Campus
Derivatives and Risk Management
Chapter-3: Hedging Strategies Using Futures

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Why should we discuss about the Hedging Strategies Using Futures?
Many of the participants in futures markets are hedgers. Their aim is to use futures
markets to reduce a particular risk that they face. This risk might relate to
fluctuations in the price of oil, a foreign exchange rate, the level of the stock
market, or some other variable.
So, a study of hedging using futures contracts is a study of the ways in which
hedges can be constructed so that they perform as close to perfect as possible.
Learning Outcomes this chapter

When is a short futures position appropriate?

When is a long futures position appropriate?
Which futures contract should be used? What is the optimal size of the futures
position for reducing risk?
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Basic Assumption of this Chapter

In general investors try to change the hedging position based on the market
conditions but, in this chapter, we assume that no attempt is made to adjust the
hedge once it has been put in place.
that means
The hedger simply takes a futures position at the beginning of the life of the hedge
and closes out the position at the end of the life of the hedge.

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Long & Short Hedges

A long futures hedge is appropriate when you know you will purchase an asset in
the future and want to lock in the price
Ex. Bread manufactures hedging on wheat prices.
A short futures hedge is appropriate when you know you will sell an asset in the
future and want to lock in the price.
Ex. Wheat Producer

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Arguments in Favor of Hedging

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

Arguments against Hedging

Shareholders are usually well diversified and can make their own hedging
decisions
It may increase risk to hedge when competitors do not
Explaining a situation where there is a loss on the hedge and a gain on the
underlying can be difficult

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Basis Risk
In practice, hedging is often not quite as straightforward as this. Some of the
reasons are as follows:
1. The asset whose price is to be hedged may not be exactly the same as the asset
underlying the futures contract.
2. The hedger may be uncertain as to the exact date when the asset will be bought or sold.
3. The hedge may require the futures contract to be closed out before its delivery month.
These problems give rise to what is termed basis risk.
Basis is usually defined as the spot price minus the futures price
Over the time, the spot and futures prices do not change by same amount then it
leads
strengthening of the basis.
weakening of the basis.

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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

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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

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Choice of Contract

Choose a delivery month that is as close as possible to, but later than, the end of
the life of the hedge.

When there is no futures contract on the asset being hedged, choose the
contract whose futures price is most highly correlated with the asset price. This is
known as cross hedging.

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Optimal Hedge Ratio

Proportion of the exposure that should optimally be hedged is

sS
h r
*

sF
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.

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Optimal Number of Contracts-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

0.0263
h 0.928
*
0.7777
0.0313

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Optimal Number of Contracts

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Optimal Number of Contracts-Example
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
VA 1.94 2,000,000 3,880,000
VF 1.99 42,000 83,580
Optimal number of contracts assuming no daily settlement
0.7777 2,000,000 42,000 37.03

Optimal number of contracts after tailing

0.7777 3,880,000 83,580 36.10

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Hedging Using Index Futures
To hedge the risk in a portfolio the number of contracts that should be
shorted is
VA
b
VF
where VA is the value of the portfolio, b is its beta, and VF is the value
of one futures contract
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?

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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?

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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
Suppose stocks in your portfolio have an average beta of 1.0, but you feel they
have been chosen well and will outperform the market in both good and bad
times. Hedging ensures that the return you earn is the risk-free return plus the
excess return of your portfolio over the market.

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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 an replace them with new
contract reflect the new exposure etc.

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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 (elaborated discussion will be
done through the HBR case at the time of group presentations)
which sold long term fixed-price contracts on heating oil and gasoline
and hedged using stack and roll

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Capital Asset Pricing Model
The capital asset pricing model (CAPM) is a model that can be used to calculate the
expected return from an asset during a period in terms of the risk of the return.
= + ( )
where is the return on the portfolio of all available investments, is the return
on a risk-free investment, and (the Greek letter beta) is a parameter measuring
systematic risk.
When =0, an assets returns are not sensitive to returns from the market. In this case, it
has no systematic risk and equation shows that its expected return is the risk-free rate;
when = 0:5, the excess return on the asset over the risk-free rate is on average half of the
excess return of the market over the risk-free rate; when = 1, the expected return on the
asset equals to the return on the market; and so on.

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