Hedging Strategies Using

Futures
Chapter 3
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HEDGERS

PROBLEM: TO OPEN

A LONG HEDGE

OR

A SHORT HEDGE?



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3
Long & Short Hedges
A long futures hedge is appropriate when
you know you will purchase an asset in
the future and want to lock in the price
A short futures hedge is appropriate
when you know you will sell an asset in
the future and want to lock in the price
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Short Hedges
Assume that it is May 15 today and that an oil
producer has just negotiated a contract to sell
1 million barrels of crude oil. It has been
agreed that the price that will apply in the
contract is the market price on August 15.
Suppose that on May 15 the spot price is $80
per barrel and the crude oil futures price for
August delivery is $79 per barrel.

Each futures contract is for the delivery of
1,000 barrels
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Long Hedges
Suppose that it is now January 15. A copper
fabricator knows it will require 100,000
pounds of copper on May 15 to meet a
certain contract. The spot price of copper is
340 cents per pound, and the futures price
for May delivery is 320 cents per pound.

Each contract is for the delivery of 25,000
pounds of copper
Suppose that the spot price of copper on
May 15 proves to be 325 cents per pound
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Arguments in Favor of Hedging
Companies should focus on the main
business they are in and take steps to
minimize risks arising from interest rates,
exchange rates, and other market
variables


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Arguments against Hedging
Shareholders are usually well diversified
and can make their own hedging decisions
It may increase risk to hedge when
competitors do not
Explaining a situation where there is a loss
on the hedge and a gain on the underlying
can be difficult
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Convergence of Futures to Spot
(Hedge initiated at time t
1
and closed out at time t
2
)

Time
Spot
Price
Futures
Price
t
1
t
2

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Basis Risk
Basis is the difference between the
spot and futures price
Basis risk arises because of the
uncertainty about the basis when
the hedge is closed out
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Basis Risk
1. The asset whose price is to be hedged
may not be exactly the same as the
asset underlying the futures contract.
2. The hedger may be uncertain as to the
exact date when the asset will be bought
or sold.
3. The hedge may require the futures
contract to be closed out before its
delivery month.
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Long Hedge
We define
F
1
: Initial Futures Price
F
2
: Final Futures Price
S
2
: Final Asset Price
If you hedge the future purchase of an
asset by entering into a long futures
contract then
Cost of Asset=S
2
(F
2
F
1
) = F
1
+ Basis
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Short Hedge
Again we define
F
1
: Initial Futures Price
F
2
: Final Futures Price
S
2
: Final Asset Price
If you hedge the future sale of an asset by
entering into a short futures contract then
Price Realized=S
2
+ (F
1
F
2
) = F
1
+ Basis
Example
It is March 1. A US company expects to receive
50 million Japanese yen at the end of July. Yen
futures contracts on the CME Group have
delivery months of March, June, September, and
December. One contract is for the delivery of
12.5 million yen. The company therefore _____
four September yen futures contracts on March
1. When the yen are received at the end of July,
the company closes out its position. We suppose
that the futures price on March 1 in cents per yen
is 0.7800 and that the spot and futures prices
when the contract is closed out are 0.7200 and
0.7250, respectively.
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Example
It is June 8 and a company knows that it will
need to purchase 20,000 barrels of crude oil
at some time in October or November. Oil
futures contracts are currently traded for
delivery every month on the NYMEX. The
futures price on June 8 is $68.00 per barrel.
The company finds that it is ready to
purchase the crude oil on November 10. The
spot price and futures price on November 10
are $70.00 per barrel and $69.10 per barrel.
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Choice of Contract
Choose a delivery month that is as close as
possible to, but later than, the end of the life
of the hedge
When there is no futures contract on the
asset being hedged, choose the contract
whose futures price is most highly
correlated with the asset price. This is
known as cross hedging.
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Optimal Hedge Ratio
Proportion of the exposure that should
optimally be hedged is


where
s
S
is the standard deviation of DS, the change
in the spot price during the hedging period,
s
F
is the standard deviation of DF, the change
in the futures price during the hedging period
r is the coefficient of correlation between DS
and DF.

F
S
s
s
r
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Optimal Number of Contracts

N* = h* Qa / Qf

Where,
Q a = Size of position to be hedged (units)
Q f = Size of one future contract (units)
N* = Optimal number of future contracts for hedging


Example- Calculating the optimal
# of contracts.
An airline expects to purchase 2 million
gallons of jet fuel in 1 month and decides
to use heating oil futures for hedging. the
usual formulas for calculating standard
deviations and correlations give standard
deviation of future price =0.0313, standard
deviation of spot price =0.0263, and
correlation of 0.928.
Each heating oil contract is on 42,000
gallons of heating oil.
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Tailing the Hedge
Two way of determining the number of
contracts to use for hedging are
Compare the exposure to be hedged with the
value of the assets underlying one futures
contract
Compare the exposure to be hedged with the
value of one futures contract (=futures price time
size of futures contract
The second approach incorporates an
adjustment for the daily settlement of
futures
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Hedging Using Index Futures
To hedge the risk in a portfolio the
number of contracts that should be
shorted is

where P is the value of the portfolio, b is
its beta, and F is the value of one futures
contract
F
P
b
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Example
S&P 500 index is 1,000
S&P 500 future price (250 times) is 1,010
Value of Portfolio is 5,050,000 million
Beta of portfolio is 1.5

What position in futures contracts on the
S&P 500 is necessary to hedge the
portfolio?
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Changing Beta
What position is necessary to reduce
the beta of the portfolio to 0.75?
What position is necessary to increase
the beta of the portfolio to 2.0?
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Hedging Price of an Individual
Stock
Similar to hedging a portfolio
Does not work as well because only the
systematic risk is hedged
The unsystematic risk that is unique to the
stock is not hedged
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Why Hedge Equity Returns
May want to be out of the market for a
while. Hedging avoids the costs of selling
and repurchasing the portfolio
Suppose stocks in your portfolio have an
average beta of 1.0, but you feel they have
been chosen well and will outperform the
market in both good and bad times.
Hedging ensures that the return you earn is
the risk-free return plus the excess return of
your portfolio over the market.
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Rolling The Hedge Forward
We can use a series of futures contracts to
increase the life of a hedge
Each time we switch from one futures
contract to another we incur a type of
basis risk
Questions
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 futures price is
currently standing at 1080, and each
contract is for delivery of $250 times the
index. What is the hedge that minimizes
risk? What should the company do if it
wants to reduce the beta of the portfolio
to 0.6?
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