Introduction to Options and Futures

Options
(& others)
Hedging
Financial with…
markets and
Swaps
corporate
applications
Pricing…
Forwards
and Futures
 Introduction to hedging

 Hedging with futures

 Perfect and imperfect hedging

 Case: 2012 Fuel Hedging at JetBlue Airways

 Hedging risk of equity portfolios

 Hedger: Uses  How?
futures to reduce or
eliminate price risk ▪ Build a strategy, i.e.,
of an asset a combination of
your asset and
forwards/futures,
free of risk
 Hedger: Uses  Who?
futures to reduce or ▪ Corporate treasurer
eliminate price risk E.g., oil producer is
of an asset exposed to oil price
fluctuations
▪ Portfolio manager
E.g., fund is exposed
to S&P500
▪ …
 Hedger: Uses  What?
futures to reduce or
eliminate price risk
of an asset
 % of firms “material” risk
75%

60%

45%

30%

15%

0%
Interest rate Foreign Energy Commodity Credit Geopolitical
exchange
Source: Bodnar et al. (2011)
 Hedger: Uses  What?
futures to reduce or ▪ Many kinds of risk
eliminate price risk out there
of an asset ▪ Are derivatives
flexible enough to
address all of them?
 Firms managing material risk
95%
Derivatives
Operations
76%

57%

38%

19%

0%
Interest rate Foreign Energy Commodity Credit Geopolitical
exchange
Source: Bodnar et al. (2011)
 Firms managing material risk
95%
Derivatives
Operations
76%

57%

38%

19%

0%
Interest rate Foreign Energy Commodity Credit Geopolitical
exchange
Source: Bodnar et al. (2011)
 Hedger: Uses  Hedge-and-forget:
futures to reduce or set up the hedge,
eliminate price risk and make no further
of an asset attempt to adjust it

 Dynamic hedging:
hedge is monitored,
and adjustments
can be made
 P&L
 Hedger: Uses
futures to reduce or
eliminate price risk
of an asset

 How much can you 𝑆𝑇

gain/lose on a
futures position?
 Hedger: Uses  When is a long futures
futures to reduce or hedge appropriate?
eliminate price risk Short asset
of an asset  When is a short futures
hedge appropriate?
 How much can you Long asset
gain/lose on a
futures position?
  Ex: Long the asset, short the futures
Position on Position on Hedged
underlying futures position
If asset price =0
increases…
If asset price
decreases…
=0
Only with a
perfect hedge!
 Convergence of futures Price
to spot: Futures

𝐹𝑇 ≈ 𝑆𝑇

 Basis risk: The basis

𝑆𝑡 − 𝐹𝑡 can fluctuate a Spot
lot!

 E.g., compare positions

𝑡
closed at 𝑡2 and 𝑇 𝑡1 𝑡2 𝑇
 Basis risk: Uncertainty about the basis when
the hedge is closed
 Where does it originate from?
▪ Previous example: Calendar difference
▪ Difference in quality
▪ Difference in location
▪…
 Given: 𝐹1 (futures price when hedge is entered), 𝐹2
(futures price when hedge is closed), 𝑆2 (asset price at
closing)
 Basis = 𝑆2 − 𝐹2
 Long hedge:
Cost of asset = 𝑆2 − 𝐹2 − 𝐹1 = 𝐹1 + Basis
 Short hedge:
Price realized = 𝑆2 + 𝐹1 − 𝐹2 = 𝐹1 + Basis
 At 𝑡0 = March, US firm to receive ¥50m at
𝑇 = July. Yen/USD futures are available:
▪ Contract size: ¥12.5m

▪ Maturities: Mar, Jun, Sept, Dec

 Exposure: Long on ¥50m in July
 Hedge: Short ¥50m (4) Sep futures contracts,
𝐹0 = $0.0078/¥
 Scenario 1: ¥ spot price 𝑆𝑇 = 0.720¢; Sept ¥ futures
price 𝐹𝑇 = 0.725¢. Basis = −0.005¢
 Without hedging:
. Revenues =
 Result of hedging:
. Sell ¥5om, revenues =
. Profit from short futures =
. Hedged position =
 Scenario 2: ¥ spot price 𝑆𝑇 = 0.800¢; Sept ¥ futures
price 𝐹𝑇 = 0.810¢. Basis = −0.010¢
 Without hedging:
. Revenues =
 Result of hedging:
. Sell ¥5om, revenues =
. Profit from short futures =
. Hedged position =
 Hedging imperfect because of the basis at
𝑇 = July.
 Price realized = 𝐹0 + Basis
▪ Scenario 1 (𝑆𝑇 = 0.72,Basis= -0.005): Price=0.775¢
▪ Scenario 2 (𝑆𝑇 = 0.80,Basis= -0.01): Price=0.77¢
 If there existed a July futures, we’d have
perfect hedging, because basis should always
be 0 at maturity!
 Jan. 2012: You are evaluating the impact of
fuel price risk on JetBlue

 Public since 2002,

JetBlue has been
actively hedging jet
fuel prices since
2005
100% $4.00

Arab spring; civil war

75% $3.00
in Libya; Chinese
demand growth
50% $2.00

25% $1.00

Cumulative ret. in excess of S&P500 (left)

Jet fuel price per gallon (right)
0% $0.00
Jan '08 Jul '08 Jan '09 Jul '09 Jan '10 Jul '10 Jan '11 Jul '11

Source: CRSP; Matos (2012)

 What is the main source of risk for JetBlue?

 How can the firm hedge it?

 Could investors hedge it “on their own”?

 Same intuition as Modigliani-Miller

 No financial markets frictions? Don’t hedge!

 Also: Shareholder can (and should) diversify

 Same intuition as Modigliani-Miller

 Potential weaknesses in this argument

▪ Do shareholders have the same information as
managers? (Should they?)
▪ Size of the typical futures contract relative to the
size of the typical shareholder’s portfolio?
▪…
  Progressive corporate taxes
Income bracket Tax rate
Up to $1M 5%
65%
Above $1M and up to $50M 35%
Above $50M 65%

Tax bill = 35%

5% × $1M
+35% × $ 50 − 1 M 5%
+65% × $ 75 − 50 M
$1M $50M $75M
= $33.5M
 Progressive corporate taxes
Firm A Firm B
Taxable After-tax Taxable After-tax
Year income income Tax bill income income Tax bill
1 20.0 13.3 6.7 35.0 23.1 12.0
2 60.0 36.3 23.7 40.0 26.3 13.7
3 5.0 3.6 1.5 10.0 6.8 3.2
4 100.0 50.3 49.7 75.0 41.6 33.5
5 10.0 6.8 3.2 35.0 23.1 12.0
Mean 39.0 22.1 17.0 39.0 24.2 14.9
St. dev. 40.4 23.3
 Information asymmetries
▪ Firm knows and understands risks better than
investors

▪ Hedging can make the firm more transparent and

limit scope for agency costs (e.g., “pay for luck”)
 Transaction costs
 Competition
▪ If your competitors do not hedge, why bear extra
costs compared to them?
▪ More subtle
▪ Market power can mean that input and output prices
move together
▪ Under these conditions, hedging can make corporate
profits more, not less, volatile
 Competition
▪ Example: Jewelers

Effect on Effect on Effect on

Change in
price of gold profits of profits of
gold price
jewelery non-hedger hedger

Increase Increase None Increase

Decrease Decrease None Decrease
Profit volatility: Low High
 So how about we increase ticket prices
instead of hedging – pros & cons?
 Inelastic demand Elastic demand

P P

P1

P0

D D

Q1 Q0 Q Q1 Q0 Q
 How about we increase ticket prices instead
of hedging – pros & cons?

 JetBlue’s core competency not in forecasting

fuel prices
 Hedging can lead to worse outcome
 Suppose you hedge against oil price increase
by going long oil forward.
A. Oil price rises ☺
B. Oil price drops 
 Same hedging strategy can lead to trouble
with your boss, if (s)he doesn’t understand
how futures work
 CFO Perceptions
0% 10% 20% 30% 40% 50%

Avoid large losses from unexpected price movements

Shareholders expect us to manage risk
Increase firm value
Increase expected future cash flows
Improve or maintain credit rating
Ability to pursue opportunities in difficult times
Increase reported earnings predictability
Improve corporate decision making environment
Reduce operating cash flow volatility
Reduce cost of debt
Reduce cost of equity
Very important
Decrease volatility of share price
Increase the amunt we can borrow
Most important

Source: Bodnar et al. (2011)

 JetBlue has been hedging its exposure to jet
fuel prices using crude oil derivatives

 JetBlue’s current choice: West Texas

Intermediate (WTI)

 Most liquid alternative: Brent

 Cross-hedging: Optimal hedging when there
is no futures contract written on exactly the
asset we want to hedge

 Intuitively: What do we need for cross-

hedging to work?
4.5

1.5

0
Jan-07 Jul-07 Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 Jul-10 Jan-11 Jul-11
Jet fuel WTI Oil Brent Oil

Source: Matos (2012)

1.2
Basis vs. WTI Oil
(per gallon, 1 barrel = 42 gallons)
1.0
Basis vs. Brent Oil
(per gallon, 1 barrel = 42 gallons)
0.8

0.6

0.4

0.2

0.0
Jan-10 Apr-10 Jul-10 Oct-10 Jan-11 Apr-11 Jul-11 Oct-11
Source: Matos (2012)
 JetBlue has been hedging its exposure to jet
fuel prices using WTI derivatives

 Due to an oil glut in Cushing, Oklahoma, in

2011 WTI started trading at a discount
relative to Brent oil
 Estimate the relation between change in the
asset price 𝑃 and related futures price 𝐹:
Δ𝑃 = 𝑎 + ℎΔ𝐹 + 𝑒
 Cases:
▪ ℎ = 0 ⇒ No hedging possible
▪ ℎ > 0 ⇒ Hedge a drop in 𝑃 by shorting 𝐹
▪ ℎ < 0 ⇒ Hedge a drop in 𝑃 by going long 𝐹
  Can estimate ℎ with a linear regression
Δ𝑃 = 𝑎 + ℎΔ𝐹 + 𝑒
𝐸 Δ𝑃 = 𝑎 + ℎ𝐸 Δ𝐹
𝐸 Δ𝑃 − 𝐸 Δ𝑃 × Δ𝐹 − 𝐸 Δ𝐹 = cov Δ𝑃, Δ𝐹
2
𝐸 Δ𝐹 − 𝐸 Δ𝐹
ℎ𝐸 + 𝐸 𝑒 Δ𝐹 − 𝐸 Δ𝐹
var Δ𝐹
∗
cov Δ𝑃, Δ𝐹 𝜎𝑆
ℎ = =𝜌
var Δ𝐹 𝜎𝐹
  ℎ∗ minimizes the variance of the value of the
hedger’s position
var
 Prove this by:
min var Δ𝑃 − ℎΔ𝐹
ℎ

equivalently:
2
min 𝐸 Δ𝑃 − ℎΔ𝐹
ℎ
ℎ∗ Hedge
ratio
 Number of futures contracts to hold per
number of assets we want to hedge
 Need to take into account the size of each
futures contract
 Need futures on ℎ∗ 𝑄𝐴 units of the asset,
where 𝑄𝐴 = exposure
 Therefore: 𝑁 ∗ = ℎ∗ 𝑄𝐴 /𝑄𝐹 (𝑄𝐹 = futures size)
 JetBlue has been hedging its exposure to jet
fuel prices using WTI derivatives

 Would it make sense to switch to Brent?

ΔJet Fuel Price𝑡 = 𝑎 + ℎΔ𝐹𝑡 + 𝑒𝑡

 Δ𝐹𝑡 : change in the price of the hedging

instrument
 Jet Fuel vs. WTI
0.50

ΔJet Fuel Price𝑡 =

0.00 𝑎 + ℎΔ𝐹𝑡 + 𝑒𝑡
-1.00 -0.50 0.00 0.50

-0.50 𝑎ො = 0.00
ℎ෠ = 1.02
-1.00
𝑅2 = 85%

Source: Matos (2012)

 Jet Fuel vs. Brent
0.50

ΔJet Fuel Price𝑡 =

0.00 𝑎 + ℎΔ𝐹𝑡 + 𝑒𝑡
-1.00 -0.50 0.00 0.50

-0.50 𝑎ො = 0.00
ℎ෠ = 1.05
-1.00
𝑅2 = 90%

Source: Matos (2012)

 What contract delivers the most effective
hedge?
 Intuitively: We want Δ𝐹 (WTI or Brent) to
move as closely as possible to Δ𝑃 (jet fuel
prices)
 Would like to sum this up with a simple
number
 Decompose the variance of jet fuel prices:
var Δ𝑃 = ෠
var 𝑎ො + ℎΔ𝐹 +𝑒
= var 𝑎ො + 𝑏Δ𝐹෠ + var 𝑒
 Therefore:
෠
var 𝑎ො + ℎΔ𝐹 var 𝑒
+ = 100%
var Δ𝑃 var Δ𝑃

𝑅2
ΔJet Fuel Price𝑡 = ΔJet Fuel Price𝑡 =
𝑎 + ℎΔWTI𝑡 + 𝑒𝑡 𝑎 + ℎΔBrent 𝑡 + 𝑒𝑡

𝑎ො = 0.00 𝑎ො = 0.00
ℎ෠ = 1.02 ℎ෠ = 1.05
𝑅2 = 85% 𝑅2 = 90%
 Check with a (baby) simulation in Excel
 Steps:
1. Need 20M gallons of fuel

2. Use fuel, WTI, and Brent price data to compute

P&L under no hedge, WTI hedge, and Brent
hedge scenarios
3. Use solver to determine optimal hedge ratios:
How to minimize P&L volatility?
 WTI still most liquid, and Cushing glut might
dissipate
 Alternative strategies:
▪ Heating oil?

▪ Jet fuel OTC contracts?

▪ Buy a refinery?
 Stock index: Tracks the changes in value of a
hypothetical portfolio
 Returns on the index:
𝑅𝑡 = σ𝑖 𝑤𝑖𝑡 𝑅𝑖𝑡
 Weights 𝑤𝑖 𝑖 adjusted (typically)
proportionally to the market cap of
constituent stocks
 Futures are traded on:
▪ Dow Jones Industrial Average (DJIA)

▪ Standard & Poor’s 500 (S&P500)

▪ Nasdaq 100

▪ Russell 1000

▪…
 Can use index futures to hedge market
exposure for an equity portfolio
 If portfolio perfectly tracks the index:
▪ Optimal hedge ratio ℎ∗ = 1.0

▪ Number of contracts to short: 𝑁 ∗ = 𝑉𝐴 /𝑉𝐹 (value

of portfolio/value of a futures contract)
 Can use index futures to hedge market
exposure for an equity portfolio
 If portfolio does not perfectly track the index:
▪ Hedge ratio is ℎ∗ = 𝛽, the CAPM 𝛽 (why do you
think that is?)

▪ 𝑁 ∗ = 𝛽𝑉𝐴 /𝑉𝐹
 You want to hedge your portfolio against
S&P500 movements, over next 3 months
▪ S&P500 today: 1,000
▪ S&P futures 𝐹0 : 1,010
▪ Portfolio value: $5,050,000
▪ Risk-free 𝑟: 4% per annum
▪ Dividend yield on index 𝑞: 1% per annum
▪ Portfolio 𝛽: 1.5
 One futures contract: delivery of $250 ×
index; so 𝑉𝐹 = $250 × 1,010 = $252,500

 Number of contracts to short:

∗
$5,050,000
𝑁 = 1.5 × = 30
$252,500
 Suppose in 3 months S&P500 is at 900, and
futures price is 902.
 Gain on futures hedge:
30 × 1,010 − 902 × $250 = $810,000
 Loss on index: 10%, minus 0.25% dividends
over 3 months = 9.75%
 Based on CAPM, expected loss on portfolio:
1% + 1.5 × −9.75% − 1% = −15.125%
 In dollar terms:
15.125% × $5.05m = $763,812.50
 Summing up:
▪ Gain on futures hedge: $810,000.00

▪ Loss due to portfolio exposure: $763,812.50

 Net result for our portfolio: $5,096,187.50

 Approximately 1% return
 Compare to risk-free
 Why bother?
If we hedge, we make the risk-free return
(approximately). How about not hedging, and just
investing in risk-free asset?

 Typical reason: you believe you can pick your

stocks well (generate “alpha”), but cannot
predict broad market movements
 Similarly: Changing the beta of your portfolio
 Number of contracts to be shorted to bring
portfolio beta from 𝛽 to 𝛽 ∗ :
∗
𝑉𝐴
𝛽−𝛽 ×
𝑉𝐹
A fund manager has maintained an actively
managed portfolio with 𝛽 = 0.2. During the
last year 𝑟 = 5% and equities performed very
badly, with a −30% return on the S&P500. The
portfolio manager produced a −10% return,
and claims that, under the circumstances, it
was good. Does this claim make sense?
 Apply the CAPM:
𝐸 𝑟𝑃 = 𝑟 + 𝛽 × 𝐸 𝑟𝑀 − 𝑟
 For our fund manager:
5% + 0.2 × −30% − 5% = −2%
 Thus: Fund manager underperformed by 8%
 Could have improved by investing:
20% in S&P500
80% in the risk-free asset
You manage a $100m portfolio, with 𝛽 = 1.2.
In July, you would like to enter the December
S&P500 futures to change its beta. The index is
currently at 1,000, and each futures is on $250
times the index.
a) What position do you take to have 𝛽 ∗ = 0.5?
b) And to have 𝛽 ∗ = 1.5?
a) What position do you take to have 𝛽 ∗ = 0.5?

Reduce 𝛽 ⇒ Short futures

$100𝑚
𝑁∗ = 1.2 − 0.5 × =
$250 × 1,000
b) And to have 𝛽 ∗ = 1.5?

Increase 𝛽 ⇒ Long futures

$100𝑚
𝑁∗ = 1.5 − 1.2 × =
$250 × 1,000