P1.T3. Financial Markets & Products Chapter 8. Using Futures For Hedging Bionic Turtle FRM Study Notes

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P1.T3. Financial Markets & Products
Chapter 8. Using Futures for Hedging
Bionic Turtle FRM Study Notes


DEFINE AND DIFFERENTIATE BETWEEN SHORT AND LONG HEDGES AND IDENTIFY THEIR
APPROPRIATE USE. ................................................................................................................. 3
DESCRIBE THE ARGUMENTS FOR AND AGAINST HEDGING AND THE POTENTIAL IMPACT OF HEDGING
ON FIRM PROFITABILITY ........................................................................................................... 4
DEFINE THE BASIS AND THE VARIOUS SOURCES OF BASIS RISK, AND EXPLAIN HOW BASIS RISKS
ARISE WHEN HEDGING WITH FUTURES. ..................................................................................... 5
CALCULATE THE PROFIT AND LOSS ON A SHORT OR LONG HEDGE ............................................. 10
DEFINE CROSS HEDGING, AND COMPUTE AND INTERPRET THE MINIMUM VARIANCE HEDGE RATIO
AND HEDGE EFFECTIVENESS .................................................................................................. 11
COMPUTE THE OPTIMAL NUMBER OF FUTURES CONTRACTS NEEDED TO HEDGE AN EXPOSURE AND
EXPLAIN AND CALCULATE THE “TAILING THE HEDGE” ADJUSTMENT. ........................................... 14
EXPLAIN HOW TO USE STOCK INDEX FUTURES CONTRACTS TO CHANGE A STOCK PORTFOLIO’S
BETA .................................................................................................................................... 16
EXPLAIN HOW TO USE STOCK INDEX FUTURES CONTRACTS TO LOCK IN THE BENEFIT OF A STOCK
SELECTION. .......................................................................................................................... 18
EXPLAIN HOW TO CREATE A LONG-TERM HEDGE USING A “STACK AND ROLL” STRATEGY AND
DESCRIBE SOME OF THE RISKS THAT ARISE FROM THIS STRATEGY. ........................................... 19
CHAPTER SUMMARY ............................................................................................................. 21
PRACTICE QUESTIONS & ANSWERS: ...................................................................................... 22
2

 Define and differentiate between short and long hedges and identify their
appropriate use.
 Describe the arguments for and against hedging and the potential impact of
hedging on firm profitability.
 Define the basis and 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.
 Calculate the profit and loss on a short or long hedge
 Compute the optimal number of futures contracts needed to hedge an exposure

and explain and calculate the “tailing the hedge” adjustment.
 Explain how to use stock index futures contracts to change a stock portfolio’s
beta.
 Explain how to create a long-term hedge using a “stack and roll” strategy and
describe some of the risks that arise from this strategy.
Define and differentiate between short and long hedges and

identify their appropriate use.
Short hedge
A short forward or futures hedge is an agreement to sell in the future and is suitable for a
hedger who owns (or will own) an asset that needs to be sold in the future. The classic
example is a farmer who wants to lock in the sales price of a crop, for example, corn, so as
to protect against its price decline. By owning the crop, the farmer effectively has a long
position in corn. To offset the exposure or risk in this long position, the farmer enters into a
corresponding short position, which is exactly what a short hedge accomplishes.
Long Hedge
A long forward or futures hedge is an agreement to buy in the future and is suitable for a
hedger who does not currently own the asset but expects to purchase it in the future.
An example is an airline company, which depends on future consumption of jet fuel and
enters into a forward or futures contract (a long hedge) to lock in the price of oil in order to
protect itself from exposure to high prices.
A long forward (or futures) hedge is an A short forward (or futures) hedge is
agreement to buy in the future an agreement to sell in the future
Hedger does not currently own the asset Hedger already owns (or will own) the
but expects to purchase it in the future. asset which needs to be sold in the
future.
Example: An airline depending on jet fuel Example: A farmer owning a crop
locks in the purchase price of oil to protect locks in the sales price for the crop to
from rising prices. protect against a price decline.
3
A key difference: is the future price predetermined?

Consider a coffee producer who plans to sell 100 pounds of coffee on a future date under
two different scenarios:
1. To a key customer, the coffee producer promises to sell 100 pounds, on a date one
year in the future, at $3.00 per pound.
2. To a key customer, the coffee producer promises to sell 100 pounds, on a date one
year in the future, at the future spot price (which is obviously unknown today)
If the coffee producer wants to hedge with coffee futures, the hedge differs depending on the
scenario:
1. In the first scenario, the producer is exposed to a future spot price increase, such that
the appropriate hedge is a long position in coffee futures contracts. Because the
sales price of $3.00 is predetermined, the underlying exposure is effectively a short
position, such that the hedge instrument is a long position to offset.
2. In the second scenario, the producer is exposed to a future spot price decrease, such
that the appropriate hedge is a short position in coffee futures contracts. In this
case, as the future sale price is not predetermined, the underlying exposure is
effectively a long position such that the hedge instrument is a short position.
This concept is fundamental but not always obvious. For elaboration, see the following forum
discussion thread(s):
 David’s summary and response https://www.bionicturtle.com/forum/threads/short-
hedge-long-hedge.22341/post-75291
Describe the arguments for and against hedging and the potential
impact of hedging on firm profitability
Arguments in favor of hedging
Hedging is a way of reducing risk. Rather than focus on market forces, over which a firm has
no control, and financial instruments, over which they have little knowledge, focus should be
on their primary business, where they do have specialized knowledge. The firm should take
steps to minimize risks arising from changes in market variables (exchange rates, interest
rates, commodity prices, etc.) by hedging them. As hedging potentially decreases the
fluctuations in a firm’s earnings, it makes the firm more appealing to investors.
Arguments against hedging:

 In theory, there is no reason for the firm to try to minimize risk by hedging since
shareholders can construct their own well-diversified portfolios and can make their
own hedging decisions. In practice, owning the market portfolio has frictions and
transaction costs. Also, shareholders have less information regarding the risks that
the company will encounter than the management.
 Hedging may increase risks when competitors do not hedge. 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 “overpaying” for the jet fuel.
 In some industries, profit margins stay roughly the same because the cost of inputs
can be passed on to consumers in the form of higher prices. When the firm hedges,
its margins can either get squeezed, or conversely, the margins may expand. This
sort of hedging may be perceived as more akin to price speculation than actual
hedging. In this case, hedging increases the risks rather than decreasing them.
4
 The person responsible for hedging may be unwilling to enter into a hedge when they
expect that prices will not move in their favor. Questions will be asked as to why the
company entered into the hedge when there is a loss. However, if there is a gain,
hedging might not be recognized as a problem. This informational asymmetry can
result in principal-agent problems, where management may choose the safer option
of not hedging, even though it may be optimal for the firm to hedge.
There are arguments both in favor of and against hedging. Sometimes hedging may
increase profits, whereas, at other times, it may reduce the profits, but the main purpose of
hedging is to decrease the variability in profits, so the outcome is more certain. So whatever
decision a firm may take with regards to hedging, i.e., whether to hedge or not, it should be
supported by management and communicated to shareholders, so the stakeholders are
clearly aware of the risks.
Define the basis and the various sources of basis risk, and explain
how basis risks arise when hedging with futures.
A perfect hedge may not be attained many times due to the following reasons:
 Difference between the asset to be hedged and the asset underlying the futures.
 Time differences between the buying or selling of the asset in the spot market and in
the futures market.
In the real world, hedges may not be perfect, which gives rise to basis risk.
Basis
We can represent basis as,1
= −
Financial commodities often express basis risk in reverse: Future price – Spot Price. The
direction of your subtraction is not critical: the basis is the difference in price.
Remember that the basis itself converges to zero over time when the asset is hedged, and
the asset underlying the futures are the same as the spot price converges toward the futures
price at the maturity of the futures contract. As the basis is the difference between the spot
price and the futures price, the basis can change due to changes to either the spot or the
futures price, or both. For example, knowing the spot price increases by itself does not tell us
whether the basis increased or decreased.
The following specific terms as defined by Hull are:1

 An increase in the basis is called a strengthening of the basis.
 A decrease in the basis is called a weakening of the basis.
1
Hull, C. John, “Options, Futures and Other Derivatives”, Ch: 3, “Hedging strategies using futures”, 10th Edition,
Pearson, 2018.
5
Sources of basis risk

Basis risk depends on the futures contract selected for hedging. This has two components:
 The asset underlying the futures contract: If the asset being hedged does not
match the asset underlying a futures contract, then basis risk arises. In that case, a
futures contract should be selected such that the futures prices of the underlying are
most closely correlated with the price of the asset being hedged.
 Delivery month: Basis risk increases as the time difference between the hedge
expiration and the delivery month of the futures contract increases. Therefore, it is
good to choose a delivery month that is closer to but later than the expiration of the
hedge. The selection of the delivery month is influenced by several factors.
o When the expiration of the hedge corresponds to a delivery month, the contract
with that delivery month can be chosen.
o But usually, a contract with later delivery months is chosen as futures prices
fluctuate during the delivery month. A long hedger has to take delivery of the
physical asset if the contract is held during the delivery month, which could be
costly and difficult.
o However, as liquidity tends to be highest in short-maturity futures contracts, the
hedger may want to use these contracts and roll them forward.
Basis risk when hedging with futures
Basis risk arises because the characteristics of the futures contract often differs from the
underlying position. In particular, basis risk is ensured if the asset to be hedged is not exactly
the same as the asset underlying the futures contract. This can be due to these factors:
 Standardized contracts: Futures contracts are standardized (e.g., WTI oil Futures)
 Differences in grade: Commodities are not exactly the same (they have different
qualities or grades)
 Uncertain timing: The hedger may be unsure about the date that the asset will be
purchased or sold.
 Timing uncertainty vis-a-vis futures contract: It may be necessary that the futures
contract is closed out prior to its month of delivery.
Basis risk may be sub-classified in various ways.

 For example, time-varying changes in the cost of carry model may induce basis risk.
 There is an inherent trade-off between liquidity and basis risk; to reduce basis risk is
to require a tailored hedge.
6
Basis risk is illustrated using the below notation and the following examples:2
 S : Spot price of asset hedged at time t ; S : Spot price of asset hedged at time t ;
S ∗ : Spot price of asset underlying futures at time t
 F : Futures price time t ; F : Futures price time t
 b : Basis at time t ; b : Basis at time t
Example:3 For a hedge placed at time t the spot price is $2.50, and the futures price is
$2.20. When the hedge is closed at time t , the spot price is $2.00, and the futures price is
$1.90.
By definition, the basis is calculated as: b = S − F , b = S − F
Therefore, b = 2.50 − 2.30 = $0.30; b = 2.00 − 1.90 = $0.10
Consider the two following scenarios:3
(i) The asset will be sold at time t , so the hedge is a short futures position at time t .
 The price realized for the asset is: S = $2.00
 The profit on the futures position is: F − F = 2.20 − 1.90 = $0.30
 The effective price of the asset considering hedging is: S + F − F = 2.00 +
0.30 = $2.30
 This effective price can be otherwise written as: F + b = 2.20 + 0.10 = $2.30
(ii) The asset will be bought at time t , so the hedge is a long futures position at time t .
 The price paid for the asset is: S = $2.00
 Loss on the futures position is: F − F = 2.20 − 1.90 = $0.30.
 The effective price paid for the asset considering hedging is: S + F − F = 2.00 +
0.30 = $2.30
 This effective price can be otherwise written as: F + b = 2.20 + 0.10 = 2.30
From the example, we see that price received for an asset when a short hedge is placed, it
is the same as the price paid when a long hedge is placed, i.e., equal to F + b . In both
these scenarios, while F is known at time t , b may not be known at that time, leading to
uncertainty related to hedging, which is represented by the basis risk.
2
All formulas in this section are consistent with notation in Hull, C. John, “Options, Futures and Other
Derivatives”, Ch: 3, “Hedging strategies using futures”, 10th Edition, Pearson, 2018.
3
Pearson, 2018.
7
Two more examples are shown below (a short hedge and a long hedge) for understanding
the basis risk.
Example (Hull Example 3.1):4 In March, a U.S. company expects to receive 50 million
Japanese yen by the end of July. The company shorts four September yen futures contracts
(one contract = 12.5 million yen) on March 1st to hedge its position. When the yen are
received at the end of July, the company closes out its position. The futures price in March is
1.0800, and that the spot and futures prices when the contract is closed out are 1.0200 and
1.0250, respectively (in cents per yen).
 The profit on the futures contract is: F − F = 1.0800 – 1.0250 = 0.0550 cents
per yen.
 The basis when the contract is closed is b = S − F = 1.0200 − 1.0250 =
− 0. 0050 cents per yen.
 The effective price received is the final spot price plus the profit on the futures:
S + F − F = 1.0200 + 0.0550 = 1.0750 cents per yen.
 This can otherwise be calculated as the initial futures price plus the final basis:
F + b = 1.0800 − 0.0050 = 1.0750
 The total amount received for 50 million yen is 50,000,000 * 0.01075 = $537,500
Example (Hull Example 3.2)4: Consider a company that on June 8th has plans to buy
20,000 barrels of crude oil on November 10th. The company employs a long hedge to buy
December 20th contracts (Contract size = 1,000 barrels). The futures price on June 8th is
$48.00 per barrel. The spot price and futures price on November 10th are $50.00 per barrel
and $49.10 per barrel.
 The profit on the futures position is: F − F = 49.10 – 48.00 = $1.10 per barrel.
 The basis at contract maturity is: b = S − F = 50.00 – 49.10 = $0.90 per barrel.
 The effective price paid is the final spot price minus the profit on the futures:
S + F − F = 50.00 – 1.10 = $48.90 per barrel.
 This result can otherwise be calculated as the initial futures price plus the final basis:
F + b = 48.00 + 0.90 = 48.90 per barrel.
 The total price paid for 20 contracts is 48.90 * 20,000 = $978,000.
Basis risk may also arise because of cross hedging, where the asset underlying the futures
contract is different from the actual asset that needs to be hedged.5
 By hedging, the price received or paid for the asset will be: S + F − F
 Using S ∗ , this equation can be otherwise written as: F + (S∗ − F )+ (S − S ∗ )
 The first term in brackets implies the basis risk when the hedged asset is the same
as the asset underlying the futures contract. The second term in brackets indicates
the basis resulting from the difference between these assets.
4
Pearson, 2018.
5
Formulas retrieved from Hull, C. John, “Options, Futures and Other Derivatives”, Ch: 3, “Hedging strategies
using futures”, 10th Edition, Pearson, 2018.
8
Basis Change
Unexpected basis change can be favorable or unfavorable to the hedger. Consider the
following, but keep in mind to focus on the impact of the unexpected change:
 When the spot price increases by more than the futures price, the basis
increases, and this is said to be a “strengthening of the basis.”
When the strengthening of basis is unexpected, for a short (long) hedge position,
it is favorable (unfavorable) to the hedger, as the price received (paid) for the asset
will be higher.
 When the futures price increases by more than the spot price, the basis declines,
and this is said to be a “weakening of the basis.”
When the weakening of basis is unexpected, for a short (long) hedge position, it is
unfavorable (favorable) to the hedger, as the price received (paid) for the asset will
be lower.
Example illustrating basis change: Consider a company that in March plans to buy 25,000
pounds (lbs.) of copper in December. The company employs a long hedge, i.e., a long
position in a futures contract. The March spot and December futures prices are $2.50 and
$2.70, respectively. In March, therefore, the basis is -$0.20.
The company hedges by taking a long position in one copper futures contract.
 In the exhibit below, observe the implication of three different scenarios, each
illustrating a possible state in December.
 In all three scenarios, the basis strengthens (increases) from -$0.20 to zero.
 The key point here is that the hedge is effective under each scenario. Specifically,
the net cost is the same $67,500, where net cost includes both the unhedged cost of
buying the copper and the futures gain/loss.
9
From the same exhibit, as seen on the right side, consider two different scenarios in
which the basis does not converge to zero.
 These scenarios show how the intended hedge, via unexpected basis weakening or
strengthening, can contribute to a profit or loss.
 If the expectation is basis convergence and the expectation is realized (as in the
case of the three scenarios above), the hedge works perfectly. However,
unexpected basis weakening or strengthening introduces variability in the net cost.
 In our example, when the basis weakens, the net cost is lesser at $66,000 compared
to when the basis converges and is favorable to the long hedge. However, when the
basis strengthens, the net cost increases to $69,000, which worsens the long
hedge’s position relative to the scenario in which the basis converges.
Calculate the profit and loss on a short or long hedge

Profit or loss on a short hedge
Example:6 On May 15th, an oil producer wants to hedge his exposure by selling 1 million
barrels of crude oil at the market price available on August 15th. So, he enters into a short
hedge position to sell 1000 futures contracts of oil (one contract = 1000 barrels). On May
15th, the spot price is $50 per barrel, and the crude oil futures price for August delivery is
$49 per barrel. Calculate the profit or loss on this short hedge position, considering two
scenarios:
(i) The spot price on August 15th is $45 per barrel (ii) The price of oil on August 15th is $55
per barrel.
Under the first scenario, when the spot price of oil on August 15th is $45 per barrel:
 The price received by the company for selling its oil in the spot market is:
45 * 1,000,000 = $45,000,000
 The profit made by the company through its short futures position is:
(49 – 45) * 1,000,000 = $4,000,000
 The effective price realized from the sales of oil and the futures position is:
45,000,000 + 4,000,000 = $49,000,000.
Under the second scenario, when the spot price of oil on August 15th is $55 per barrel:
 The price received by the company for selling its oil in the spot market is:
55 * 1,000,000 = $55,000,000
 The loss made by the company through its short futures position is:
(49 – 55) * 1,000,000 = -$6,000,000
 The effective price received from the sales of oil and the futures position is:
55,000,000 - 6,000,000 = $49,000,000.
In both cases, the company receives a price of $49 million from the sales of the 1 million
barrels of oil. So, whatever the spot price of oil is at the maturity of the futures contract, the
short hedge strategy locked in the price at the August 15th futures price of $49 per barrel.
6
Pearson, 2018.
10
Profit or loss on a long hedge

Example6: On January 15th, a copper fabricator knows it has to purchase 100,000 pounds
of copper on May 15th. The spot price in January is 340 cents per pound, and the futures
price for May delivery is 320 cents per pound. The fabricator enters into a long hedge
position in four May copper futures contracts (one contract = 25,000 pounds of copper).
Calculate the profit or loss on this long hedge position, considering two scenarios: (i) The
spot price on May 15th is 325 cents per pound (ii) The spot price on May 15th is 305 cents
per pound.
Under the first scenario, when the spot price of copper on May 15th is 325 cents per pound:
 The price paid for purchasing copper is: 3.25 * 100,000 = $325,000
 The profit on the futures position is: (3.25 -3.20) * 100,000 = $5,000
 The effective price paid for copper purchase is the price paid in the spot market less
the profit on the futures contract: 325,000 - 5,000 = $320,000.
Under the second scenario, when the spot price of copper on May 15th is 305 cents per
pound:
 The price paid for purchasing copper is: 3.05 * 100,000 = $305,000
 The loss on the futures position is: (3.05 -3.20) * 100,000 = -$15,000
 The effective price paid for copper purchase is the price paid in the spot market plus
the loss on the futures contract: 305,000 + 15,000 = $320,000.
In both cases, the company pays a price of 320 cents per pound for purchasing 100,000
pounds of copper. So, whatever be the spot price of copper at the maturity of the futures
contract, the long hedge strategy has locked in the price of copper at the May 15th futures
price of 320 cents per pound.
Define cross hedging, and compute and interpret the minimum

variance hedge ratio and hedge effectiveness
A cross hedge is a hedge wherein the asset underlying the hedge is different from the asset
being hedged.
 A classic cross-hedge example is that of an airline hedging the cost of jet fuel with
the highly correlated heating oil futures contracts. Cross-hedges are necessary in this
case because jet fuel futures, although available, are not actively traded on the
exchanges.
Compute and interpret the minimum variance hedge ratio and hedge effectiveness
The hedge ratio is the ratio of the size of the futures contracts used for hedging to the size of
the original exposure that needs to be hedged. When the asset underlying the futures
contract is the same as the asset being hedged, that is, if the spot and future positions are
perfectly correlated, then a 1:1 hedge ratio results in a perfect hedge. However, this is rarely
the case, and indeed, with cross-hedging, the optimal hedge ratio need not be equal to 1.0.
11
Rather the optimal hedge ratio is the ratio that minimizes the variance of our hedge.
This is the minimum variance hedge ratio (MVR) and is given by:7
∗
= ,
,
Please note the equivalence: = . ..
where σ is the standard deviation of the changes in the spot price(∆S) for the period of the
hedge, σ is the standard deviation of the changes in the futures prices(∆F) for the period of
the hedge and ρ , is the coefficient of correlation between the two price changes for the
period of the hedge.
Note that the MVR is equal to 1.0 when ρ , = 0.5 and σ = 2σ , for example. As a
corollary, while a perfect hedge implies a correlation equal to 1:1, in our example, the
correlation ρ , ≠1.0, yet the hedge is still optimal because it is the minimum variance ratio.
There is a subtle difference between a perfect hedge that implies a correlation of 1 and an
optimal hedge, which is the MVR and is the optimality criteria that the hedge typically wants
to satisfy.
IMPORTANT CONCEPT: The minimum variance ratio is the slope of the regression
line of ∆ against ∆ and is the optimal hedge ratio. Note that the correlation can take
on a range of different values and does not need to equal 1 in order for the hedge to
be optimal.
The hedge effectiveness, that is, just how good our hedge is, “is defined as the proportion
of the variance that is eliminated by hedging.”7 It can be measured by a regression of the
change in spot prices against the change in futures prices, typically using historical, non-
overlapping data.8 The resulting R = ρ , tells us how good our hedge is.
Example of minimum variance (optimal) hedge ratio

If the volatility of the spot price is 20%, the volatility of the futures price is 10%, and their
correlation is 0.40, then the optimal hedge ratio, h*, is given by:
σ 20%
h∗ = ρ , = 0.4 ∗ = 0.8
σ 10%
The optimal number of futures contracts is given by N ∗ when Q is the size of the position
being hedged and Q is the size of one futures contract.7
h∗Q
N∗ =
Q
7
Pearson, 2018.
8 FASB 133 accounting rules regarding Cash-Flow hedging requires that you regress 36 months of price changes
of your hedging instrument against the asset you wish to hedge, and that the beta-coefficient be between 0.85
and 1.2. You may choose the time interval (days, weeks, months) however, once chosen it cannot be changed.
This hedge effectiveness testing must be done both on a retrospective (historical) and prospective (future
expected) basis every month.
12
Cross-hedge example
In Hull’s example 3.3,8 an airline intends to purchase 2.0 million gallons of jet fuel in the
future (at the future spot price, which is currently unknowable) and decides to use heating oil
futures for hedging. The appropriate hedge is, therefore, a long position in heating oil
futures. Each heating oil contract traded by the CME Group is on 42,000 gallons of heating
oil.
The historical change in spot price (jet fuel) is regressed against the change in futures price
(heating oil futures), and the minimum variance hedge ratio is found. (Refer to the table and
graph below). The minimum variance hedge (MVH) ratio is calculated at 0.78, as shown.
σ 0.026
h∗ = ρ , = 0.928 × = 0.7777
σ 0.031
Using this MVH ratio and from Q = 2,000,000 and Q = 42,000, the optimal number of
futures contracts is approximately 37.
h∗Q 0.7777 × 2,000,000

N∗ = = = 37.03
Q 42,000
The results are illustrated in the diagram below.
Cross-hedging: Hull’s Example 3.3 and Fig 3.29
Note: The slope of the regression line equals the optimal hedge ratio.
9
Pearson, 2018.
13
Compute the optimal number of futures contracts needed to hedge

an exposure and explain and calculate the “tailing the hedge”
adjustment.
When futures contracts are used for hedging, daily settlement of futures means that the
hedge is not a one-time hedge but a series of one-day hedges. So when futures are used, a
small adjustment, known as tailing the hedge, allows for the impact of daily settlement, i.e.,
the hedge is adjusted as time elapses.
The only difference here is to replace the units (quantity) with values (quantity times price)
while calculating the optimal number of contracts. Instead of using quantities, that is, the size
of the position being hedged (QA ) and size of one futures contract(Q ) used in finding the
optimal number of futures contracts as shown here (which is appropriate for forward
contracts rather than futures),10
h∗ Q
∗
N =
Q
we use the dollar value (asset price times the quantity). If V is the dollar value of the
position being hedged and V is the dollar value of one futures contract, then:
hV
N∗ =
V
The dollar values are obtained by multiplying the original ratio of quantities Q /Q by the
ratio of S/F (spot price/futures price).
Here the hedge ratio h∗ is replaced by h
σ
h= ρ
σ
where σ : Standard deviation of percentage one-day changes in the spot price

σ : Standard deviation of percentage one-day changes in the futures price
ρ: Correlation between percentage one-day changes in the spot and futures
10
Formulas in this section retrieved from Hull, C. John, “Options, Futures and Other Derivatives”, Ch: 3,
“Hedging strategies using futures”, 10th Edition, Pearson, 2018.
14
Example:11 Consider the previous example again, where an airline tries to cross hedge its
future purchase of 2.0 million gallons of jet fuel with heating oil futures (one contract =
42,000 gallons). The spot price of jet fuel is $1.94 per gallon, and the futures price of the
heating oil is $1.99 per gallon. Calculate the optimal number of contracts used for tailing the
hedge if the hedge ratio is 0.75.
The optimal number of contracts for a one-day hedge is approximately 35 and calculated as:
hV 2,000,000 ∗ 1.94 3,880,000

N∗ = = 0.75 × = 0.75 × = 34.82
V 42,000 ∗ 1.99 83,580
Note: The discount factor should be applied to the series of one-day hedges to calculate the
interest earned over the remaining time period of the hedge. If an interest rate of r can be
earned during time period t, then between the time t and the maturity of the hedge, the
optimal number of contracts at time t should be divided by 1+r (=N ∗ /(1 + ) to take account
of this adjustment. This discount factor adjustment need not be made if the contracts are not
settled daily (e.g., forward contracts).
11
Pearson, 2018.
15
Explain how to use stock index futures contracts to change a stock

portfolio’s beta
Changing a stock portfolio’s beta using index futures
A portfolio of stocks can be created, and the returns on the market can be hedged through
stock index futures such that an investor is left with the excess return of the stocks in the
portfolio over the market return.
Given a portfolio beta (β), the current value of the portfolio (V ), and the value of stocks
underlying one futures contract (V ), the number of stock index futures contracts (i.e., which
minimizes the portfolio variance) to be hedged is given by:12
V
N∗ = β
V
The hedge ratio is the slope of the best-fit line when percentage one-day changes in the
portfolio are regressed against percentage one-day changes in the futures price of the index.
In the above equation, the hedge ratio is replaced by beta (β), which is the slope of the best-
fit line when the return from the portfolio is regressed against the return of the index.13
Example:13 Consider an investor who holds a portfolio of stocks worth $5,050,000. The
investor feels that the market will be very volatile in the next few months, but the well-
diversified stocks in the portfolio have a good chance of outperforming the market. The
investor uses the S&P 500 futures contract with a maturity of four months to hedge the
market’s return over the next three months. The index futures price is 1010 (one contract is
250 times the index). The beta of the portfolio is estimated at 1.5. In three months, the index
falls to 900, and the futures price falls to 902. The dividend yield is 0.25% for three months,
and the risk-free interest rate is 1% for three months.
The market returns can be hedged with the futures contract. Calculations are shown below.
 The number of futures contracts that should be shorted by the investor to hedge the
portfolio is:
V 5,050,000 5,050,000
N∗ = β = 1.5 ∗ = 1.5 ∗ = 30
V 1010 ∗ 250 252,500
 In three months, when the index futures price falls to 902, the gain made on the
futures position can be given by
30 * (1010 - 902) * 250= $810,000
 In three months, when the index falls to 900, the loss on the index in percentage
terms is 10%. Given that the dividend yield is 0.25%, the return on the index is
-10.0% +0.25% = -9.75%
12
Formulas in this section retrieved from Hull, C. John, “Options, Futures and Other Derivatives”, Ch: 3,
“Hedging strategies using futures”, 10th Edition, Pearson, 2018.
13
Pearson, 2018.
16
According to the CAPM model,15
= +[ ( − )]
 So expected portfolio return =1.0+ [1.5*(-9.75-1.0)] = -15.125%
 So, the value of the portfolio at the end of three months, using the expected return is,
5,050,000 * (1- 0.15125) = $ 4,286,187
 The total expected value of the investor’s position in three months, including the profit
made on futures, increases to:
4,286,187 + 810,000 = $5,096,187
The hedger’s expected return does not depend on the index’s value, as the portfolio is
hedged with the stock index futures. Hedging removes the market risk (β = 0), leaving the
investor exposed only to the performance of the stocks chosen in his portfolio. The investor’s
position, therefore, grows at the risk-free rate.
Now, by extension, when the goal is to shift portfolio beta to any value other than zero, i.e.,
from β to a target beta, β∗ , the optimal number of stock index futures contracts required for
hedging is given by:14
V
N∗ = (β∗ − β)
V
Example:15 Using the same assumptions as shown in the above example, where the index
futures price is at 1010, the value of the portfolio is $5,050,000, and the beta of the portfolio
is 1.5, instead of hedging the net beta to zero (i) increase the beta of the portfolio to 2.0. (ii)
reduce the beta of the portfolio to 0.75.
To increase the beta of the portfolio to 2.0:
V 5,050,000 5,050,000
N∗ = (β∗ − β) = (2.0 − 1.5) = 0.5 ∗ = 10
V (1010)(250) 252,500
The hedge trade here is to enter into a long position on 10 futures contracts.
Note we could have used (beta minus target beta), in which case the result would be
negative (-) 10. But in either case, we must buy (go long) futures contracts because we are
increasing the beta. If we are reducing the beta, then we should short futures.
To reduce the beta of the portfolio to 0.75, we should short futures:
V 5,050,000 5,050,000
N∗ = (β∗ − β) = (0.75 − 1.5) = −0.75 ∗ = −15
V (1010)(250) 252,500
Since the beta should be reduced, we should short about 15 futures contracts.
14
Formula retrieved from Hull, C. John, “Options, Futures and Other Derivatives”, Ch: 3, “Hedging strategies
15
Pearson, 2018.
17
Explain how to use stock index futures contracts to lock in the

benefit of a stock selection.
A smart investor who owns shares of a particular stock or a small stock portfolio and is
confident that its performance would be better than the market should short index futures
contracts.
The number of contracts needed for short hedging is given by:16
V
β
V
If the performance of investors’ portfolio is better than a portfolio that is well-diversified with
similar beta, then money can be made by shorting the futures contract, as shown in the
example below.
Example:17 In April, an investor owns 20,000 shares of a company at a share price of $100.
While market volatility is expected over the next three months, the stock portfolio is expected
to have a better performance than the market. So, the investor hedges the market risk using
the August futures contract on the Mini S&P 500 at a price of 2100 (one contract = 50 times
the index). The beta of the company’s stock is estimated at 1.1. If the stock price declines to
$90 and the futures price of the Mini S&P 500 drops to 1850, show how hedging locks in the
benefit of stock selection.
The investor takes a short hedge position in the futures contract.
Value of the portfolio is: V = 20,000 * 100 = $2,000,000

Value of the futures position is: V = 2,100 * 50 = $105,000
The number of contracts required for taking a short hedge position is approximately 21, as
calculated below:
V 2,000,000
N∗ = β = 1.1 ∗ = 20.95
V 105,000
Given that the company’s stock price declines to $90, the loss in the portfolio is:
20,000 * ($100 - $90) = $200,000
Given that the futures price drops to 1,850, the gain on the short futures position is:
21 * 50 * (2,100 - 1,850) = $ 262,500
The investor makes an overall gain because the selected stock did not fall as much as a
well-diversified portfolio with a beta of 1.1, and the market risk was hedged by the short
futures position. The gain made by the investor is: 262,500- 200,000 = $62,500. In case the
market prices had risen instead of falling, the investor would still have made profits as the
stock price would have increased by more than a well-diversified portfolio with a beta of 1.1.
16
Formula retrieved from Hull, C. John, “Options, Futures and Other Derivatives”, Ch: 3, “Hedging strategies
17
Pearson, 2018.
18
Explain how to create a long-term hedge using a “stack and roll”

strategy and describe some of the risks that arise from this
strategy.
When the delivery date of the futures contract occurs prior to the hedge’s expiration date, or
there is little liquidity except in the spot and prompt month, the hedger can roll forward the
hedge. This means that the hedger can initially enter into a short maturity futures position
and close out this position before delivery only to reinstate the equivalent position in another
new short maturity futures contract with a delivery date that is further into the future. This
process is repeated using short maturity futures contracts with increasingly later dates of
delivery until the expiration of the hedge.
This is also known as a stack and roll strategy as the hedgers usually have exposure to the
asset price every month rather than one future month. So, the hedger “stacks” contracts to
hedge the exposure in each future maturity month and then “rolls forward the contracts.”
Example:18 In April 2017, a company has plans to sell 100,000 barrels of oil in June 2018. It
wants to hedge its risk with a hedge ratio of 1.0. The current spot price is $49.00. Of the
futures contracts available, only the first six delivery months have adequate liquidity. The
company enters into a short hedge in 100 October 2017 contracts. Later, in September
2017, it rolls forward the hedge into the March 2018 contract, and again in February 2018, it
rolls forward the hedge into the July 2018 contract. The assumptions are given in the table.
Hull Table 3.5: Data on rolling forward the oil hedge19

Date April 2017 Sep 2017 Feb 2018 June 2018
Oct 2017 futures price $48.20 $47.40
Mar 2018 futures price $47.00 $46.50
July 2018 futures price $46.30 $45.90
Spot price $49.00 $46.00
18
Pearson, 2018.
19
The stack and roll hedge strategy for the given example is illustrated in the diagram below.
From the table,

 The hedger’s profit from entering into a short position in the October 2017 contract
and closing it out is: 48.20 - 47.40= $0.80 per barrel.
 The hedger’s profit from entering into a short position in the March 2018 contract and
closing it out is: 47.00 – 46.50 = $0.50 per barrel.
 The hedger’s profit from entering into a short position in the July 2018 contract and
closing it out is: 46.30 – 45.90 = $0.40 per barrel.
 The total profits from the short hedge position is: 0.80+0.50+0.40 = $1.70 per barrel.
 While the oil prices in the spot market decreased by $3.00 from $49.00 to $46.00, the
stack and roll strategy compensates the hedger with a profit of $1.70.
Although the fall in oil prices is not fully covered by the hedge in the above example, the
stack and roll strategy helps to secure the most favorable price.
Risks arising from a stack and roll strategy

 Rolling the hedge forward exposes the company or hedger to basis risk on the
original hedge and 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.
 Insufficient liquidity can cause major problems 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 usually employs the stack and roll strategy every month, it
can readily expect to buy futures and thus hedge its cost in the following months at a
lower price.
20
Chapter Summary
Hedging is a way of reducing risk. Exposure to the prices of any asset can be hedged by
taking a position in the futures markets.
 A short hedge is an agreement to sell in the future and is appropriate when the
hedger already owns the asset.
 A long hedge is an agreement to buy in the future and is appropriate when the
hedger does not currently own the asset but expects to purchase it in the future.
Rather than focus on market forces over which a firm has no control, and financial
instruments, over which they have little knowledge, companies should focus on the main
business they are in, where they do have specialized knowledge. In theory, there is no
reason for the firm to try to minimize risk by hedging since shareholders can make their
portfolios well diversified and can make their own hedging decisions. In practice, this can be
questioned due to frictions and transaction costs associated with owning the market
portfolio. Although hedging removes the uncertainty associated with asset prices, sometimes
it turns out to be unappealing when it results in a loss.
= −
Hull states that “basis arises from uncertainty as to what the basis will be at maturity of
the hedge.”19 This is not entirely satisfactory, however, as it begs the question as to what
drives this uncertainty in the first place. A more precise answer is that basis risk reduces to
one key fact: the asset being hedged is typically not identical to the commodity underlying
the futures contract. There is an inherent trade-off between liquidity and basis risk: to reduce
basis risk is to require a tailored hedge, which is why basis risk is not an issue when hedging
using forwards.
A cross hedge is a hedge wherein the asset underlying the hedge is different from the
asset being hedged. The hedge ratio is the futures position taken over the total exposure. A
correlation of 1 implies a perfect hedge. However, the criteria for optimality may be to reduce
the hedge’s variance, in which case the optimal hedge is the beta of regression of price
changes of the spot against price changes of the futures. This is the minimum variance
hedge ratio. The effectiveness of the hedge is measured by the aforementioned regression’s
.
When futures are used, a small adjustment, known as “tailing the hedge,” can be
made to allow for the impact of daily settlement. The only difference here is to replace
the position size with values. Instead of using quantities, we use the dollar value of the
position being hedged and the dollar value of one futures contract by multiplying the original
ratio that involves quantities by the ratio of spot price/futures price.
Stock index futures may be used to modify a stock portfolio’s beta by going long or short
stock index futures. It is also used to hedge the portfolio’s market risk.
If the delivery date of the futures contract occurs prior to the hedge’s expiration date, or there
is little liquidity except in the spot and prompt month, the hedger can use stack and roll
strategy to hedge long maturity exposures with a series of short-maturity futures contracts.
Going forward, the near maturity contracts are closed out before delivery and replaced with
late maturity contracts.
19
Pearson, 2018.
21
Practice Questions & Answers:

710.1. You are meeting with your FRM study group when one of the members of the group
says they are a bit unclear on the definition of the term "short hedge." The following
conversation ensues:
I. Albert says, "It's simple, if a company owns an asset but wants to hedge its plan to
sell the asset at the future spot price, a short hedge is appropriate"
II. Barbara says, "Yes, Albert that is true, but if the company plans to sell the
commodity in the future at a predetermined price, then a long hedge is appropriate!"
III. Chris says, "Barbara is correct because a short hedge is simply a hedge where a
short futures position is taken."
IV. Donald says, "Exactly true, Chris. And that means that a short hedge can also be a
cross-hedge; i.e., these terms are not mutually exclusive."
V. Erin says, "And I would like to add that the company does not need to own the asset
in order to conduct a short hedge."
VI. Fred says, "And I would like to add that a short hedge implies negative basis, just as
a long hedge implies positive basis."
Which of the statements is (are) accurate?
Only Donald and Erin are accurate
Only Albert, Chris, and Fred are accurate
All of the statements are accurate, except Barbara's
All of the statements are accurate, except Fred's
710.2. An industrial manufacturer of vehicle emissions control devices is heavily dependent

on platinum as an input, and the price of platinum has a significant impact on the company's
cost of goods sold (COGS). Among the following justifications, if true, which is the best
reason for the company to hedge the price risk of platinum?
a) The company's shareholders are well diversified
b) The company has no demonstrable skill in predicting the price of platinum, yet is
greatly exposed to it
c) Although the board does not understand hedging, most of the members will
understand the better outcomes
d) Hedging is not the norm in the highly competitive platinum industry where peer-
versus-peer profit margins are scrutinized by analysts
711.2. Each of the following statements is true about hedging and cross-hedging with futures
contracts EXCEPT which is not accurate?
a) If the correlation coefficient is zero, the optimal number of contracts is zero
b) Tailing the hedge refers to adjusting the number of futures contracts used to hedge in
order to reflect the impact daily settlement (by using to the commodity position value
rather than quantity of commodity position)
c) A stack and roll hedge takes a position in futures contracts with delivery dates (much)
earlier than the expiration date of the hedge, then closes out these contracts and
enters new short-term futures contracts
d) There is no theoretical reason or advantage for the owner of an equity portfolio to
fully neutralize beta (i.e., to achieve net beta of zero) by hedging with S&P 500
futures contracts because she could have instead invested in the risk-free asset with
less transaction cost
22
711.3. Sally the portfolio manager oversees a $9.0 million large-cap equities portfolio with a
beta of 1.30. She has decided the portfolio's beta is too high and calibrates a new target
beta of 0.70. If she employs S&P 500 index futures contracts to reduce the beta when the
index futures price is 2,400 (the contract size is $250 * S&P 500 index per the specification),
then which is nearest to the trade?
a) Short 9.0 contracts
b) Short 27.0 contracts
c) Short 54.0 contracts
d) Long 13.0 contracts
23
Answers
710.1. D. All of the statements are accurate, except Fred's, whose statement is false
because a short hedge is a hedge with a short position, per TRUE choice (C), such that the
basis could be either negative or positive.
710.2. B. True: The company has no demonstrable skill in predicting the price of
platinum yet is greatly exposed to it. This is a good reason to hedge.
 In regard to false (A), a well-diversified shareholder tends to be a partial (i.e., albeit
imperfect) argument against the need to hedge or to leave a risk unhedged. Hull
writes "One thing that shareholders can do far more easily than a corporation is
diversify risk. A shareholder with a well-diversified portfolio may be immune to many
of the risks faced by a corporation."20
 In regard to false (C), hedging can lead to a worse outcome: Hull illustrates the
problem of a Treasurer whose hedge lost money because it basically performed as
expected, but his President does not understand. He concludes, "It is easy to see
why many treasurers are reluctant to hedge! Hedging reduces risk for the company.
However, it may increase risk for the treasurer if others do not fully understand what
is being done."20
 In regard to false (D), this is more likely to be an argument against hedging. When
the industry norm is to avoid hedging, it may be entirely rational for the company to
act like its peers and similarly avoid hedging. For example, in such an industry,
investors are likely to make relative comparisons. Also, competition might inform the
cost of goods sold (COGS) which might tend to naturally stabilize profit margins.
Discuss in the forum here: https://www.bionicturtle.com/forum/threads/p1-t3-710-long-and-

short-hedges-hull-chapter-3.10546/
711.2. D. False. Neutralizing beta, in theory, merely eliminates the single-factor

systemic risk (i.e., exposure to the equity risk premium) such that the manager may
prefer alpha-based exposure.
An investor who expects positive alpha might hedge their portfolio’s beta in order to isolate
on the portfolio expected outperformance relative to the market. By hedging beta, the “stock
picker” could (in theory) earn positive alpha-based performance even during down markets.
Another rationale for neutralizing beta is timing: the investor may seek short-term protection
against volatility, even as she plans to hold the portfolio for the longer-run.
In regard to (A), (B), and (C), each is TRUE.

 In regard to true (A), because the minimum variance hedge ratio (MVH) =
ρ(ΔS,ΔF)*σ(S)/σ(F), if ρ(ΔS,ΔF) = 0 then the MVH equals zero
 In regard to true (B), "tailing the hedge" is a procedure for adjusting the number of
futures contracts used for hedging to reflect daily settlement. When tailing the hedge,
the optimal number of contracts is given by h(*)*V(A)/V(F) where V(A) is the value of
the exposed position and V(F) is the notional value of a futures contract; in this case,
V(F) = 42,000 * F(0). But the problem does not provide F(0).
 In regard to true (C), a "stack and roll" is a procedure where short-term futures
contracts are rolled forward to create long-term hedges.
20
John C. Hull, Options, Futures, and Other Derivatives, 9th Edition (New York: Pearson Prentice Hall, 2014)
24
711.3. A. Short 9.0 contracts
The value of the portfolio, V(A), is $9,000,000 and the value of one futures contract, V(F), is
2,400 * $250 = $600,000 such that number of contracts is given by N(*) = (β - β*)*V(A)/V(F)
= (1.30 - 0.70) * $9.0/$0.60 = 9.0 contracts. To reduce the beta, she should SHORT the
futures contracts.
Discuss in the forum here: https://www.bionicturtle.com/forum/threads/p1-t3-711-optimal-

cross-hedge-and-reducing-portfolio-beta-hull-chapter-3-continued.10566/
25

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P1.T3. Financial Markets & Products

Chapter 8. Using Futures for Hedging

Bionic Turtle FRM Study Notes

Chapter 8. Using Futures for Hedging

Chapter 8. Using Futures for Hedging

 Calculate the profit and loss on a short or long hedge

 Compute the optimal number of futures contracts needed to hedge an exposure

Define and differentiate between short and long hedges and

A key difference: is the future price predetermined?

Arguments against hedging:

The following specific terms as defined by Hull are:1

Sources of basis risk

Basis risk may be sub-classified in various ways.

By definition, the basis is calculated as: b = S − F , b = S − F

Therefore, b = 2.50 − 2.30 = $0.30; b = 2.00 − 1.90 = $0.10

Consider the two following scenarios:3

Calculate the profit and loss on a short or long hedge

Profit or loss on a long hedge

Define cross hedging, and compute and interpret the minimum

Example of minimum variance (optimal) hedge ratio

h∗Q 0.7777 × 2,000,000

The results are illustrated in the diagram below.

Cross-hedging: Hull’s Example 3.3 and Fig 3.29

Compute the optimal number of futures contracts needed to hedge

Here the hedge ratio h∗ is replaced by h

where σ : Standard deviation of percentage one-day changes in the spot price

hV 2,000,000 ∗ 1.94 3,880,000

Explain how to use stock index futures contracts to change a stock

According to the CAPM model,15

To increase the beta of the portfolio to 2.0:

To reduce the beta of the portfolio to 0.75, we should short futures:

Explain how to use stock index futures contracts to lock in the

The number of contracts needed for short hedging is given by:16

The investor takes a short hedge position in the futures contract.

Value of the portfolio is: V = 20,000 * 100 = $2,000,000

20,000 * ($100 - $90) = $200,000

21 * 50 * (2,100 - 1,850) = $ 262,500

Explain how to create a long-term hedge using a “stack and roll”

Hull Table 3.5: Data on rolling forward the oil hedge19

From the table,

Risks arising from a stack and roll strategy

Practice Questions & Answers:

710.2. An industrial manufacturer of vehicle emissions control devices is heavily dependent

Discuss in the forum here: https://www.bionicturtle.com/forum/threads/p1-t3-710-long-and-

711.2. D. False. Neutralizing beta, in theory, merely eliminates the single-factor

In regard to (A), (B), and (C), each is TRUE.

711.3. A. Short 9.0 contracts

Discuss in the forum here: https://www.bionicturtle.com/forum/threads/p1-t3-711-optimal-

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