Hedging with FUTURES

LONG Hedge
Spot Market: asset will be bought (lose when price increases); Futures Market: LONG position (gain when price increases).

SHORT Hedge
Spot Market: asset will be sold (lose when price decreases); Futures Market: SHORT position (gain when price decreases).

3 things we need to know

1.

Risk Factor
Variable that determines the possible loss

2.

Position on Risk Factor (spot market)

When do we lose?

When price increases? When price decreases?

3.

Position on hedging contract (F market)

LONG (if you lose on spot market when price increases) SHORT (if you lose on spot market when price decreases)

Example short hedge

May 15:

SELL 1 mil. Barrels crude oil at August 15

SM15=$19 FM15=$18.75

SHORT 1000 barrels August FUTURES and lock in a price of $18.75

August 15 (possibility 1)
Spot market:

SA15 = $17.50 which means + $17.5 mil. FA15 = $17.50 ~ close to the spot price because August is the delivery month

Futures market:

Profit: $18.75 - $17.50 = $1,25 / barrel i.e. + $1.25 mil. from the Futures position Result: $18.75 mil.

August 15 (possibility 2)
Spot market:

SA15 = $19.50 which means + $19.5 mil. FA15 = $19.50 ~ close to the spot price because August is the delivery month

Futures market:

Loss: $18.75 - $19.50 = $0.75 / barrel i.e. - $0.75 mil. from the Futures position Result: $18.75 mil.

Roll over the hedge

To undertake a one-year hedge transaction, an investor must sell oneyear futures. This is often difficult because a futures contract with this maturity tends to be illiquid. One alternative is to hedge forward using more liquid, shorter maturity contracts.

Arguments in Favor of Hedging

Prediction is expensive;

Usually companies make no prediction of market variables they need their cash flow to be certain.

They hedge to avoid unpleasant price movements; Thus they focus on their main activities.

Arguments against Hedging

Shareholders are usually well diversified and can make their own hedging decisions;

(Ex. build portfolio of copper producer and copper user companies.) However hedging might be more expensive for shareholders.

It may increase risk to hedge when competitors do not hedging becomes risky Explaining a situation where there is a loss on the hedge and a gain on the underlying can be difficult hedging strategies should be set by a companys board of directors and clearly communicated to companys management and shareholders.

BASIS = Spot price Futures price

$2.50 Spot price

b1
$2.20 $2.00 $1.90 Futures price

b2

t1

t2

Basis risk - Long Hedge

Suppose that F1 : Initial Futures Price F2 : Final Futures Price S2 : Final Asset Price You hedge the future purchase of an asset by entering into a long futures contract Cost of Asset = S2 (F2 F1) = F1 + b2
If basis weakens hedgers position improves The lower the basis the better

Basis risk - Short Hedge

Suppose that: F1 : Initial Futures Price; F2 : Final Futures Price; S2 : Final Asset Price; You hedge the future sale of an asset by entering into a short futures contract Price Realized = S2+ (F1 F2) = F1 + b2
If basis strengthens hedgers position improves

Basis risk (contd)

Investment assets vs. consumption assets; The case of different asset in the hedging contract S2 + F1 F2 F1 + (S*2 F2) + (S2 S*2)
Basis if the asset being hedged were the underlying asset Basis from the difference between the 2 assets

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. When the correlation is different from 1 we have the 2 components of basis.

Optimal Hedge Ratio

Payoff

The payoff of Futures on another asset

+
The payoff of S i.e. the hedged asset

S0-S

S0
S0+S S Price of underlying

Optimal Hedge Ratio (contd)

Long hedge Short hedge

Spot Market
Futures Market

- (S2 S1) - S

+ (S2 S1) + S

+ h(F2 F1) + F - h(F2 F1) - F h F - S S - h F

Hedgers payoff

We need to make the hedgers payoff as certain as possible i.e. we need to minimize its variance.

Optimal Hedge Ratio (contd)

Proportion of the exposure that should optimally be hedged is:

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.

sS hr sF

Optimal Hedge Ratio (contd)

h* = regression coefficient of S on F; Hedge effectiveness; Parameters are estimated from historical data; Ideally the length of each time interval is the same as the length of the time interval for which the hedge is in effect (we should have previous realizations of the change we try to estimate).

Optimal number of contracts

NA size of position being hedged (units); QF size of one futures contract (units); N* optimal number of futures contracts for * hedging hN *

QF

Hedging Using Index Futures

If we have a portfolio that mirrors the index (we are long on the stocks that are in the index with the same weights) then the number of contracts that should be shorted is

P N A
*

value of the portfolio

The hedge ratio is 1!

value of the assets underlying one futures contract

Hedging Using Index Futures

To hedge the risk in a portfolio that does not mirror the index, the number of contracts that should be shorted is

where P is the value of the portfolio, b is its beta, and A is the value of the assets underlying one futures contract

P N b A
*

21

Example
Value of S&P 500 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?

Reasons for Hedging an Equity Portfolio

1.

Desire to be out of the market for a short period of time. (Hedging may be cheaper than selling the portfolio and buying it back). Desire to hedge systematic risk (Appropriate when you feel that you have picked stocks that will outperform the market.) Can do the same with a single stock when the investor feels the stock will outperform the market or an investment bank wants to protect its new issue against market moves.

2.

3.

Changing Beta - reducing

Until now we used the futures contract to reduce the Beta to 0. What position is necessary to reduce the beta of the portfolio? ( > *)
Short this to reduce beta to 0

P * P N b b A A
*

Long this to increase beta to *

Short N* to obtain the new * for your portfolio

Changing Beta - increasing

What position is necessary to increase the beta of the portfolio? (* > )
Long this to increase beta to * Short this to reduce beta to 0

P P N b b A A
* *

Long N* to obtain the new * for your portfolio

Rolling The Hedge Forward

We can use a series of futures contracts to increase the life of a hedge;

Each time we switch from 1 futures contract to another we incur a type of basis risk (rollover basis).

Can postpone the rollover in the hope the basis will improve.

Rolling The Hedge Forward - Ex.

April 2002 Sept. 2002 Oct. 2002 SA=$19 Short: FO=$18.20 FO=$17.40 Feb. 2003 March 2003 FM=$16.50 June 2003 July 2003 SJune=$16 FJul.=$16.50 Close: +$0.50

Close:
+$0.80 Short: FM=$17.00 +$1.70 for a loss of $3

Close:
+$0.50 Short: FJul.=$16.30

Price of INPUT decreases

Price of INPUT increases

Profit margin

Price of OUTPUT decreases

Unhedged company

Price of OUTPUT increases

Hedged company

Price of output