HEDGING STRATEGIES USING

FUTURES

Sankarshan Basu
Professor of Finance
Indian Institute of Management Bangalore
Hedging

• Hedging implies elimination of price risk.

• Perfect hedge completely eliminates the price

risk.

• As perfect hedges are rare using futures

contracts, hedges are constructed to perform
close to perfect hedge.
2
Long Hedge

• Long hedge is undertaken when a trader

anticipates the need to buy an asset in future
and wants to lock in a price.
• The trader undertakes a long futures contract
when he anticipates the need to buy in future.
Later he shorts the same contract on the date
when he buys in the spot market.

3
Long Hedge – Example
• On May 15, a petroleum product producer has
negotiated a contract to buy 1 million barrels of
crude oil. The price that will apply in the contract is
market price on Sep 15.
• Spot price on May 15 is $100 per barrel
• September crude oil futures price on the NYMEX is
$105 per barrel
• Each futures contract on NYMEX is for the delivery of
1,000 barrels
– The company can hedge its exposure by going long on
1,000 September futures contracts

4
Long Hedge – Example
Case 1: Let spot price of oil on Sep 15 be $110 > futures contract price
• The company buys oil in spot by paying $110
• Because Sep. is the delivery month for futures contract, the futures price on Sep.
15 should be very close to spot, say $111
• On that date co’s gain from futures position = $111 - $105 = $6 (by closing the long
futures contract)
• Then, the net cost of buying oil = $110 - $6 = $104

Case 2: Let spot price of oil on Sep 15 be $103 < futures contract price
• The company buys oil in spot by paying $103
• Because Sep. is the delivery month for futures contract, the futures price on Sep.
15 should be very close to spot, say $104.
• On that date co’s loss from futures position = $105 - $104 = $1
• Then, the net cost of buying oil = $103 + $1 = $104

5
Short Hedge

• Short hedge is undertaken when a trader

anticipates the need to sell an asset in future
and wants to lock in a price.
• The trader undertakes a short futures contract
when he anticipates the need to sell in future.
Later he goes long on the same contract on
the date when he sells in the spot market.

6
Short Hedge – Example
• On May 15, a petroleum product producer has
negotiated a contract to sell 1 million barrels of
crude oil. The price that will apply in the contract is
market price on Sep 15.
• Spot price on May 15 is $100 per barrel
• September crude oil futures price on the NYMEX is
$105 per barrel
• Each futures contract on NYMEX is for the delivery of
1,000 barrels
– The company can hedge its exposure by going short on
1,000 September futures contracts

7
Short Hedge – Example
Case 1: Let spot price of oil on Sep 15 be $110 > futures contract price
• The company sells oil in spot at $110
• Because Sep. is the delivery month for futures contract, the futures price on Sep.
15 should be very close to spot, say $111
• On that date co’s loss from futures position = $111 - $105 = $6 (by closing the
short futures contract)
• Then, the net price realized by selling oil is $110 - $6 = $104

Case 2: Let spot price of oil on Sep 15 be $103 < futures contract price
• The company sells oil in spot at $103
• Because Sep. is the delivery month for futures contract, the futures price on Sep.
15 should be very close to spot, say $104.
• On that date co’s gain from futures position = $105 - $104 = $1
• Then, the net price realized by selling oil
= $103 + $1 = $104

8
Basis

• Basis = Spot price of asset to be hedged

– Futures price of the contract used

• If the asset and asset underlying futures contract are same

then the basis should be zero at the expiration of the futures
contract.

• Strengthening of the basis: If the spot price increases by

more than futures price, the basis increases
• Weakening of the basis: If the futures price increases more
than the spot price, the basis declines

9
Variation of Basis Over Time

Contango Market Backwardation Market

30 December 2021 Sankarshan Basu, IIM Bangalore 10

Basis Risk

Basis risk implies the uncertainty in the

amount of basis when the futures contract is
closed out in a hedge.

11
Impact of Basis on Net Buying / Selling Price

Notations:
S1 = Spot Price at time t1
S2 = Spot Price at time t2
F1 = Futures Price at time t1
F2 = Futures Price at time t2
b1 = Basis at time t1
b2 = Basis at time t2

12
Impact of Basis on Net Buying / Selling Price – contd.

• Assume a hedge is put in place at time t1 and closed

out at time t2
• The effective price obtained with hedging is
= Price realized/ paid + profit/ loss on hedge
= S2 + F1 – F2 = F1 + b2
• F1 is known at time t1
• The hedging risk is the uncertainty associated with
b2 and known as Basis Risk

13
Basis Risk and Hedging

• For a short hedge if basis strengthens

unexpectedly the hedger’s position improves
or vice-versa.

• For a long hedge if basis strengthens

unexpectedly the hedger’s position worsens
or vice-versa.

14
Cross Hedging
• Cross hedging: when two assets in the spot
and futures contracts are different
• Example:
– An airline wants to hedge against future price of
jet fuel, which has no futures contract
– It may use heating oil futures contract.

15
Cross Hedging and Basis Risk
• Consider S2* as the price of the asset underlying
futures contract at time t2 and S2 being the price of
the asset in the spot market
• By hedging the price paid/received by the company
is
= S2 + F1 – F2
= F1 + (S2* – F2) + (S2 – S2*)
• S2* – F2 is the part of the basis if asset hedged and
asset underlying futures were same
• S2 – S2* is the part of the basis due to difference
between two assets

16
Choice of Futures Contract

• The choice of futures contract for hedging affects

basis risk.
• If the asset being hedged does not exactly match the
asset underlying
– Analysis is required to find the asset having futures price
most closely correlated with the price of the asset being
hedged and cross-hedging results.

17
Choice of Futures Contract – Delivery
Month
• A contract with a later than spot transaction date delivery
month is chosen because
– A long hedger can avoid taking delivery of physical asset which can be
expensive and inconvenient
– A short hedger can avoid giving delivery of physical asset which can be
expensive and inconvenient

• Basis risk increases as the time difference between hedge

expiration and delivery month increases.

• Rule of Thumb: choose a delivery month that is as close as

possible to, but later than, the expiration of the Hedge.

18
Hedge Ratio

Hedge Ratio
= (The size of the position taken in futures contract)
/ (The size of the exposure)

19
Minimum Variance Hedge Ratio

Notations:
• ΔS = Change in Spot price, S, during the life of the
hedge
• ΔF = Change in Futures price, F, during the life of the
hedge
• σS = Standard deviation of ΔS
• σF = Standard deviation of ΔF
• ρ = Coefficient of correlation between ΔS and ΔF
• h = hedge ratio that minimizes the variance of
hedger’s position

20
Minimum Variance Hedge Ratio – contd.
S
• h
F

• Dependence of variance of hedger’s position on

hedge ratio
Variance of
Position

Hedge Ratio, h
h

21
The Hedge Effectiveness

 2

• The Hedge Effectiveness  h2 F2

S

• The parameters ρ, σS, σF in the above

equation are usually estimated from historical
data on ΔS and ΔF
• Assumption:
– Futures prices will be like in the past.

22
Optimal Number of Contracts

Notations:
• NA = Size of positions being hedged
• QF = Size of one Futures contract
• N = Optimal no. of Futures contracts for hedging

h NA
N
QF

23
Reasons for Hedging an Equity Portfolio

• 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.

24
Hedging an Equity Portfolio

To hedge the risk in a portfolio the number of contracts

that should be shorted is
P

A
where
P = The value of the portfolio
 = Its beta
A = The value of the assets underlying one futures
contract

25
Hedging an Equity Portfolio – Example

• Value of S&P 500 index = 1,000

• Value of portfolio = $5,000,000
• Risk-free interest rate = 4% per annum
• Dividend yield on index = 1% per annum
• Beta of portfolio = 1.5
• A futures contract on the S&P 500 with four months
to maturity is used to hedge the value of the
portfolio over the next three months
• One futures contract is for delivery of $250 times the
index

26
Hedging an Equity Portfolio – Example

• Current future price

= 1000*e(.04 - .01)*(4/12) = 1010
• The number of futures contracts that should be shorted to
hedge the portfolio
= 1.5*(5,000,000/250,000) = 30
• Suppose the index turns out to be 900 in three months
• After 3 months of hedge period, 1 month will remain.
• Future price then
= 900*e(.04 - .01)*(1/12) = 902
• The gain from the short futures position
= 30*(1010-902)*250 = $810,000

27
Hedging an Equity Portfolio – Example

• The loss on the index is 10%

• The index pays a dividend of 1% per annum, or 0.25% per
three months
• When dividends are taken into account, an investor in the
index would therefore earn -9.75% in the three-month period
• The risk-free interest rate is 1% for three months
• Because the portfolio has a β of 1.5,
• Expected return on portfolio — Risk-free interest rate
= β x (Return on index — Risk-free interest rate)
• It follows that the expected return (%) on the portfolio during
3 months
• 1 + [1.5 x (-9.75 - 1)] = -15.125

28
Hedging an Equity Portfolio – Example

• The expected value of the portfolio (inclusive of

dividends) at the end of the three months is
therefore
= $5,000,000 * (1 - 0.15125) = $4,243,750

• It follows that the expected value of the hedger's

position, including the gain on the hedge, is
= $4,243,750 + $810,000 = $5,053,750

29
Changing The Beta of A Portfolio

• To reduce the beta of the portfolio from 1.5 to 0.75,

the number of contracts shorted should be 15 rather
than 30
• To increase the beta of the portfolio to 2.0, a long
position in 10 contracts should be taken
• When we change beta from β to β*:
– If β > β*
• Short position in (β – β*).(P/A) contracts
– If β < β*
• Long position in (β* – β).(P/A) contracts

30
Rolling The Hedge Forward

• Sometimes the expiration date of the hedge is later

than the delivery dates of all the futures contracts
that can be used
• The hedger must then roll the hedge forward by
closing out one futures contract and taking the same
position in a futures contract with a later delivery
date.

• Consider a company that wishes to use a short hedge

to reduce the risk associated with the price to be
received for an asset at time T.
31
Rolling The Hedge Forward – Strategy

• Time t1: Short futures contract 1

• Time t2: Close out futures contract 1
Short futures contract 2
• Time t3: Close out futures contract 2
Short futures contract 3
…………………………………………………………
• Time tn: Close out futures contract n — 1.
Short futures contract n.
• Time T: Close out futures contract n.

t1 t2 t3 t4 tn T

32
Problem No. - 1

Is the following statement TRUE or FALSE?

A perfect hedge always succeeds in locking in

the current spot price of an asset for a future
transaction.

33
Problem No. – 1 (Ans.)
• Answer: FALSE
• Explanation:
• Consider for example the use of forward
contract to hedge a known cash inflow in a
foreign currency.
• The forward contract locks in the forward
exchange rate – which is in general different
from the spot exchange rate

34
Problem No. - 2

Is the following statement TRUE or FALSE?

If the minimum variance hedge ratio is

calculated as 1.0, the hedge must be perfect.

35
Problem No.– 2 (Ans.)
• Answer: FALSE
• Explanation:
• The minimum variance hedge ratio is
• ρ(σS/σF)
• It is 1.0 when ρ = 0.5 and σS= 2σF
• Since ρ < 1.0, the hedge is not perfect

36
Problem No. - 3

Is the following statement TRUE or FALSE?

If there is no basis risk, the minimum variance

hedge ratio is always 1.0.

37
Problem No.– 3 (Ans.)
• Answer: TRUE
• Explanation:
• If the hedge ratio is 1.0 the hedger locks in a
price of F1 + b2.
• Since both F1 and b2 are known , this has a
variance of zero and must be the best hedge

38
Problem No. 4

Suppose that the standard deviation of

quarterly changes in the prices of a
commodity is $0.65, the standard deviation of
quarterly changes in a futures price on the
commodity is $0.81, and the coefficient of
correlation between the two changes is 0.8.
What is the optimal hedge ratio for a three-
month contract? What does it mean?

39
Problem No. 4 (Ans. & Explanation)
• All standard deviations are on quarterly basis
• Optimal hedge ratio in 3-month contract
= 0.8*(0.65/0.81) = 0.642
• Meaning:
– The size of the futures position should be 64.2% of
the size of the company’s exposure in a 3-month
hedge.

40
Problem No. 5

A company has a $20 million portfolio with a

beta of 1.2. It would like to use futures
contracts on the S&P 500 to hedge its risk. The
index is currently standing at 1080, and each
contract is for delivery of $250 times the
index.
a. What is the hedge that minimizes risk?
b. What should the company do if it wants to reduce
the beta of the portfolio to 0.6?
41
Problem No. 5 (Ans. & Explanation)
a. 89 contracts should be shorted.
b. A short position in 44 contracts is required.

a. The no. of contracts should be shorted

20 , 000 , 000
 1 .2   88 . 9
1080  250
Rounding to the nearest whole number,
89 contracts should be shorted.

b. To reduce beta from 1.2 to 0.6,

half of this position
 44 contracts should be shorted

42
 Thank You!

Indian Institute of Management Bangalore

Bannerghatta Road, Bangalore – 560 076, INDIA

www.iimb.ac.in