Hedging Strategies

Using Futures

Instructor
Anirban Ghatak , PhD

Dr. Anirban Ghatak, IMCU 1

P1.T3. Hull,Chapter 3

Agenda
• Hull, Options, Futures, and
Other Derivatives (9th Edition)
– Chapter 3: Hedging Strategies Using Futures

Learning Objectives
1. Define and differentiate between short and long hedges and identify their
appropriate uses,
2. Describe the arguments for and against hedging and the potential impact of hedging
on firm profitability,
3. Define the basis and explain the various sources of basis risk, and explain how basis
risks arise when hedging with futures,
4. Define cross hedging, and compute and interpret the minimum variance hedge ratio
and hedge effectiveness,
5. Compute the optimal number of futures contracts needed to hedge an exposure, and
explain and calculate the “tailing the hedge” adjustment,
6. Explain how to use stock index futures contracts to change a stock portfolio’s beta,
7. Explain the term “rolling the hedge forward” and describe some of the risks that
arise from this strategy,.
2
 Hull,Chapter3:
Hedging Strategies Using Futures

3
P1.T3. Hull,Chapter 3:Hedging Strategies Using Futures

Define and differentiate between shortand long hedges and identify situations
where they are appropriate.

Long forward (or futures) hedge: A short forward (or futures) hedge:
agreement to buy in the future agreement to sell in the future
Hedger does not currently own the Hedger already owns the asset.
asset. Expects to purchase in the
future.
An airline depends on jet Farmer wants to lock in a sales
fuel. Enters into futures price to protect against a price
contract (a long hedge) to decline.
protect from exposure to high oil
prices

4
Describethe arguments forand against hedging and the potentialimpactof
hedging on firm profitability.
In favor of hedging
• Companies should focus on their
core business and minimize risks
arising from financialvariables and
marketvariables (e.g.,interest
rates,exchange rates)
Against hedging
• Shareholdersare diversifiedand
can make theirown hedging
decisions
• May increase riskto hedge when
competitors do not
• Explaining a loss on the hedge (if
gain on the underlying) can be
difficult
5
Define and compute the basis.

Basis =
$4.20
$4.00
Spot Price (S0) minus (–)
Futures Price (F0) $0.00
$0.20
= S0 – F0 $4.20
$3.80

Financial Assets:
Futures Price (F0) – Spot Price (S0)

6
P1.T3. Hull,Chapter 3:Hedging Strategies Using Futures

Define and compute the basis.

May-13 May-14
Spot $4.00 $4.20

Futures $3.80 $4.20 $4.20

$0.20 $0.00 $4.00

Basis
$0.00

Spot ($4.20) $0.20

$4.20
Futures (gain/loss) $0.40

$3.80
Total cost ($3.80)

Basis “weakens” (decreases) from $0.20 to $0

7
Refer : Hull Page 57
P1.T3. Hull,Chapter 3:Hedging Strategies Using Futures

Define the various sources ofbasisriskand explain how basis risksarisewhen

hedging w ith futures.

• Strengthening of the basis:

Spotpriceincreases by more than the futures price basisincreases.
– If unexpected,strengthening isfavorable fora shorthedge and
unfavorable fora long hedge

• Weakening of the basis:

Futures priceincreases by more than the spotprice basisdeclines
– If unexpected,w eakening isfavorable fora long hedge and unfavorable for
a shorthedge

9
P1.T3. Hull,Chapter 3:Hedging Strategies Using Futures

Define the various sources ofbasisriskand explain how basis risksarisewhen

hedging w ith futures.

• But basis riskarisesbecause often the characteristics of the futures contract

differ from the underlying position.
– Contract≠ Commodity.
– Contractisstandardized (e.g.,WTI oilfutures)
– Commodities are notexactly commodities(e.g.,hedger has a position in
different grade of oil)

Liquidity Trade-off Basis risk

(exchange)

10
P1.T3. Hull,Chapter 3:Hedging Strategies Using Futures

Define cross hedging.

• Cross hedge: When asset underlying hedge isdifferent from asset being hedged

Hedging purchase Not futures for jet fuel

of jet fuel so use heating oil

11
P1.T3. Hull,Chapter 3:Hedging Strategies Using Futures

Define,compute and interpret the minimum variance

hedge ratioand hedge effectiveness.

• The optimal hedge ratio(a.k.a.,minim u m variance hedge ratio)isthe ratioof

futures position relative to the spot position thatminimizes the variance ofthe
position.

h*  
 S N* 
h * QA
F QF
σS standard deviation of ΔS, change in spot
σ F standard deviation of ΔF, change in futures
ρ is the coefficient of correlation between Δ S and Δ F.

12
 Example: Minimum variance hedge ratio

Suppose a currency trader computed the correlation

between the spot and futures to be 0.923, the annual
standard deviation of the spot price to be $0.10, and the
annual standard deviation of the futures price to be
$0,125. Compute the hedge ratio.
Refer : Hull Page 61
P1.T3.Hull,Chapter3:Hedging Strategies Using Futures

Define,com pute and interpretthe m inim um variance hedge ratio and hedge
effectiveness.

Regressing Spot on Forward

 Spot

 Forward

15
P1.T3.Hull,Chapter3:Hedging Strategies Using Futures

Define,com pute and interpretthe m inim um variance

hedge ratio and hedge effectiveness.

(heating oil (jet fuel

futures) spot)
Standard Dev $3.13 $2.63
Correlation 0.928
(MV) Hedge ratio 0.78
h*  
 S  (0.928)
2.63
F 3.13
Airline will purchase 2,000,000
NYMEX oil futures (gallons) 42,000
Number of contracts 37.01
h * QA 0.78  2,000,000
N*  
QF 42,000

16 16
P1.T3.Hull,Chapter3:Hedging Strategies Using Futures

Define, com pute and interpret the optim al num ber of futures contracts
needed to hedge an exposure …

• Forexam ple,ifthe volatility ofthe spotprice is 20% ,the volatility ofthe

futures price is 10% ,and theircorrelation is 0.4,then:

h*  
 20%
S
h*  (0.4)  0.8
F 10%
Number of h * NA
contracts
N* 
QF
17
P1.T3.Hull,Chapter3:Hedging Strategies Using Futures

… including a “tailing the hedge” adjustm ent.

Tailing the hedge:

• Replace units w ith values:

h * QA h * VA
N*  N* 
QF VF
• The neteffectis to m ultiply the originalhedge ratio by the ratio of[spot
price/futures price]

18
P1.T3.Hull,Chapter3:Hedging Strategies Using Futures

Dem onstrate how stock index futures contracts can be used to change a stock
portfolio’s beta.

• Given
– a portfolio beta (),
– Currentvalue ofthe portfolio (P),and
– Value ofstocks underlying one futures contract(A),

• The num berofstock index futures contracts (i.e.,m inim izesthe portfolio
variance)is given by:

P
N 
A
19
P1.T3.Hull,Chapter3:Hedging Strategies Using Futures

Dem onstrate how stock index futures contracts can be used to change a stock
portfolio’s beta.

• W hen the goalis to shiftportfolio beta from ()to a targetbeta (*),the

num berofcontracts required is given by:

P
N  ( *  )
A
20
P1.T3.Hull,Chapter3:Hedging Strategies Using Futures

Demonstrate how stock index futures contracts can be used to change a stock
portfolio’s beta.

• Assum e:
– Value ofportfolio is $10 m illion
– S&P 500 Futures Price = 1240
– Portfolio beta ()is 1.5
– Contract= $250 × Index
– Target beta = 1.2

P $10,000,000
N  (  *   )  (1.2  1.5)  9.7
A (1240)(250)
We short ~ 9.7 contracts.
(-) = short
(+) = long

21
 Example: Hedging with stock index futures
You are a portfolio manager with a $20 million growth
portfolio that has a beta of 1.4, relative to the S&P 500. The
S&P 500 futures are trading at 1,150, and the multiplier is
250. You would like to hedge your exposure to market risk
over the next few months. Identify whether a long or short
hedge is appropriate, and determine the number of S&P 500
contracts you need to implement the hedge.
 Tailing the Hedge

• A hedger may actually over-hedge the underlying

exposure if daily settlement is not properly
accounted for.
• To correct for the possibility of over-hedging, a
hedger can implement a tailing the hedge strategy.
• The extra step needed to carry out this strategy is to
multiply the hedge ratio by the daily spot price to
futures price ratio.
• In practice, it is not efficient to adjust the hedge for
every daily change in the spot-to-futures ratio.
 Example: Tailing the hedge
Suppose that you would like to make a tailing the hedge
adjustment to the number of contracts needed in the
previous example. Assume that when evaluating the next
daily settlement period you find that the S&P 300 spot price
is 1,095 and the futures price is now 1,160. Determine the
number o f S&P 500 contracts needed after making a tailing
the hedge adjustment.
P1.T3.Hull,Chapter3:Hedging Strategies Using Futures

Describe w hatis m eantby “rolling the hedge forw ard”and discusssom e ofthe
risks thatarise from such a strategy.

• W hen the delivery date ofthe futures contractoccurs prior to the expiration
date ofthe hedge,the hedgercan rollforw ard the hedge:close outa futures
contractand take the sam e position on a new futures contractw ith a later
delivery date.
• Exposed to:
– Basisrisk (originalhedge)
– Basisrisk (each new hedge)= “rolloverbasisrisk”

25
 Concept Checkers

An equity portfolio is worth $100 million with the benchmark of the Dow Jones
Industrial Average. The Dow is currently at 10,000, and the corresponding
portfolio beta is 1.2. The futures multiplier for the Dow is 10. Which of the
following is the closest to the number of contracts needed to double the portfolio
beta?
A. 1,100.
B. 1,168.
C. 1,188.
D. 1,200.

Dr. Anirban Ghatak, IMCU 2

6
 Concept Checkers

An equity portfolio is worth $100 million with the benchmark of

the Dow Jones Industrial Average. The Dow is currently at 10,000,
and the corresponding portfolio beta is 1.2. The futures multiplier
for the Dow is 10. To cut the beta in half, the correct trade is:
A. long 600 contracts.
B. short 600 contracts.
C. long 1,200 contracts.
D. short 1,200 contracts.

Dr. Anirban Ghatak, IMCU 2

7
 Concept Checkers

The standard deviation of price changes in a wheat futures contract is 0.6, while the
standard deviation of changes in the price of wheat is 0.75. The covariance between the
spot price changes and the futures price changes is 0.3825. Which of the following is
closest to the optimal hedge ratio?
A. 0.478.
B. 0.850.
C. 1.063.
D. 1.250.

Dr. Anirban Ghatak, IMCU 2

8
 Concept Checkers

Which o f the following situations describe a hedger with exposure to basis risk?
I. A portfolio manager for a large-cap growth fund knows he will be receiving a significant
cash investment from a client within the next month and wants to pre-invest the cash
using stock index futures.
II. A farmer has a large crop of corn he is looking to sell before June 30. The farmer uses a
June futures contract to lock in his sales price.
A. I only.
B. II only.
C. Both I and II.
D. Neither I nor II.
C Both of these situations describe exposure to basis risk—the risk that the difference
between the spot price and futures delivery price will change. The portfolio manager using
futures to pre-invest the cash does not know the exact date he will receive the cash and
may need to sell or hold the futures contract for a longer time period than intended. The
farmer may need to sell his June futures contract early if he sells his corn earlier than the
June futures expiration date.

Dr. Anirban Ghatak, IMCU 2

9
 Concept Checkers

A large-cap value equity manager has a $6,500,000 equity portfolio

with a beta of 0.92. An S&P 500 futures contract is available with a
current value of 1,175 and a multiplier of 250. What position should
the manager take to completely hedge the portfolio’s market risk?
A. Short 20 contracts.
B. Short 22 contracts.
C. Short 24 contracts.
D. Long 22 contracts.

Dr. Anirban Ghatak, IMCU 3

0