Lecture 3 – Derivative Market

Futures
Forwards
Options
 What is in today’s lecture?

Principles of Hedging with Future

Some Examples
Lecture 3
Basis Risk

Minimum Hedge Ratio

Some Exercises
 BASIC PRINCIPLES OF HEDGING
• Using futures markets to hedge a risk, the
objective is to take a position that neutralizes the
risk
• The key to hedging with future contracts is to take
an opposite position to what a firm/individual
already has or is expected to have
• Long Hedge
• Short Hedge
 Short Hedges
• A short hedge is a hedge that involves a short
position in futures contracts.
• A short hedge is appropriate when the hedger
already owns an asset and expects to sell it at
some time in the future.
• A short hedge can also be used when an asset is
not owned right now but will be owned at some
time in the future
• Producers or those who anticipates to receive inventory should use short-hedge to reduce
the risk of their output
• An Example of Hedging
• Let's assume part of your investment portfolio includes 100 shares of Company XYZ, which
manufactures autos. Because the auto industry is cyclical (meaning Company XYZ usually
sells more cars and is more profitable during economic booms and sells fewer cars and is less
profitable during economic slumps), Company XYZ shares will probably be worth less if the 
economy starts to deteriorate. How do you protect your investment?
• One way is to buy defensive stocks. These stocks might be from the food, utility, or other
industries that sell products that consumers consider basic necessities. During economic
slumps, these stocks tend to gain or at least hold their value. Thus, these stocks may gain
when your XYZ shares lose.
• Another way to hedge is to purchase a put option contract on the shares (this would
essentially allow you to "lock in" a particular sale price on XYZ, so even if the stock crashed,
you wouldn't suffer much). You could also sell a futures contract, promising to sell your stock
at a set price at a certain point in the future
 Real Life Example of long-hedge
• A group of students opened a small meat market
called What’s Your Beef near the University of
Pennsylvania in the late 1970s. this was a time of
volatile consumer prices, especially food prices.
Knowing that their fellow students were
particularly budget-conscious, the owners vowed
to keep food prices constant, regardless of price
movements in either direction. They accomplished
this by purchasing futures contracts in various
agricultural commodities.
 BASIS RISK
In practice, hedging is often not quite straightforward due to
the following reasons:
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 well before its expiration date.
• These problems give rise to what is termed basis risk.
 The Basis
• The basis in a hedging situation is as follows:
• Basis = Spot price of asset to be hedged - Futures price of
contract used
• If the asset to be hedged and the asset underlying the
futures contract are the same, the basis should be zero at
the expiration of the futures contract. Prior to expiration,
the basis may be positive or negative
 Some terms related to basis
• When the spot price increases by more than the
futures price, the basis increases. This is referred
to as a strengthening of the basis.
• When the futures price increases by more than the
spot price, the basis declines. This is referred to as
a weakening of the basis
 An Example
• 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 and the contract size is 1,000 barrels. The
company therefore decides to use the December contract for hedging
and takes a long position in 20 December contracts. 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. It therefore closes out its futures contract
on that date. The spot price and futures price on November 10 are $70.00
per barrel and $69.10 per barrel.
• 1. Can you find the gain on future contract?
• 2. What is the BASIS when the contract is closed out?
• 3. What is the final effective price paid by the company for the oil
purchased on November 10?
 solution
• 1. Can you find the gain on future contract?
• Gain = 69.1 – 68 = 1.1
• 2. What is the BASIS when the contract is closed
out? Basis = 70 – 69.1 = 0.9
• 3. What is the final effective price paid by the
company for the oil purchased on November 10?
• Effective Price = Initial future price + Basis =>
68.00+0.9=68.9
 What to do to reduce basis risk?
• One key factor affecting basis risk is the choice of
the futures contract to be used for hedging. This
choice has two components:
1. The choice of the asset underlying the futures
contract
2. The choice of the delivery month
 1. The choice of the asset
• If the asset being hedged exactly matches an asset
underlying a futures contract, the first choice is
generally fairly easy.
• In other circumstances, it is necessary to carry out
a careful analysis to determine which of the
available futures contracts has futures prices that
are most closely correlated with the price of the
asset being hedged.
 2. The choice of the delivery month
• Generally, basis risk increases as the difference between
the hedge expiration and the delivery month increases
• A good rule of thumb is therefore to choose a delivery
month that is as close as possible to, but later than, the
expiration of the hedge.
• Sometime, a contract with a later delivery month is
chosen, can you imagine why?
• Might be the hedger has to take the delivery in cases,
which can be expensive
 CROSS HEDGING

• If there is no futures contract on the asset being

hedged, use a cross hedge,
• Cross hedge occurs when the asset underlying the
future contract is different from the asset whose
price is being hedged
• The changes in the prices of the two asset should
be as highly correlated as possible
• The delivery month should be the same as, or just
after, the date the hedge will be lifted.
 Minimum variance hedge ratio
• The number of options required to offset the chang
e in value due to a price change in
100 shares of common stock. For example, if two op
tions are needed to offset value
changes for 100 shares of stock, the hedge ratio is 2.
 Minimum variance hedge ratio
• The hedge ratio is the ratio of the size of the position
taken in futures contracts to the size of the exposure.
• When the asset underlying the futures contract is the
same as the asset being hedged; it is natural to use a
hedge ratio of 1.0.
• When cross hedging is used, setting the hedge ratio equal
to 1.0 is not always optimal.
• The optimal hedge ratio is determined by the factors
outlined in the next slide
 The Risk Minimizing Hedge Ratio
• Consider the following:
• DVHH = (DS)(QSS) – (DF)NFFQFF, where:
- DVHH = the value of the ‘hedged portfolio’
– QSS = the quantity of the spot/cash position being hedged
– QFF = the number of units of the underlying asset in one futures contract used to
hedge
– NFF = the number of futures contracts
- DS = change in the spot price of the good
- DF = change in the futures price

Q S ΔS
NFFF*, and
• If DVHH = 0, then (DS)(QSS) = (DF)NFFQ  the risk-minimizing number of futures
contracts to trade, NFF**, is Q F ΔF

• The fractional term, DS/ DF, is the “Hedge Ratio.”

 Example Using the Hedge Ratio
• Suppose you are long 1000 oz. of gold (in the cash market).

• There are 100 oz. of gold per futures contract.

• For every $1.00 change in the futures price, the cash market changes
by $0.90
• You want to engage in a risk minimizing hedge.

• What position should you take in the futures market?

• How many contracts should you use?

 Example: Solution

• Because you are long in the cash market, using a risk minimizing
hedge means that you should take a short position in the futures
market. Concerning the number of contracts:

* Q ΔS
N  S
F Q ΔF
F
N *  (1000/100) (0.9/1.0)
F
N*  9
F
 Note

• It is really important to note here that we

are assuming that the relationship between
the changes in the spot price and changes
in the futures price will remain the same
(i.e., at 0.90 to 1.00) over the time period
we are hedging.
 Hedge Ratio: Example 2
• Running the following regression equation results in an
estimate of the hedge ratio:
DS = a + b DF + e

• Then, b = DS/DF, is an estimate of the hedge ratio.

• Suppose you have a long position of 410,000 gallons of
heating oil.
• You are concerned heating oil prices are going to ___ (rise
or fall?), and you want to protect your inventory value.
Therefore, you ___ (buy or sell?) heating oil futures).
 Example 2, Cont.

• There are 42,000 gallons of heating oil in one futures contract.

• You estimate the following regression equation:

DS = 0.0177 + 0.9837 DF
R22 = 0.80

* Q ΔS
N  S
F Q ΔF
F
N*  (410,000/42,000) (0.9837)
F
N*  9.60
F
 Example 2, Cont.

* Q ΔS
N  S
F Q ΔF
F
N*  (410,000/42,000) (0.9837)
F
N*  9.60
F

• So, sell either 9 or 10 contracts for a risk-

minimizing hedge.
The optimal Hedge ratio
 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.
• Hedges can be rolled forward many times.
• But that would give rise to basis risk
 Risk hedging in financial contracts
• Salman Khan owns a mortgage-banking company. On Feb 1
he made a commitment to loan a total of Rs. 1 million to
various homeowners on April 1. The loans are 20-year
mortgages carrying a 12-percent coupon.
• Like many mortgage bankers, he has no intention of paying
the Rs.1 million out of his own pocket. Rather, he intends to
sell the mortgages to an insurance company. He will reach an
insurance company March 30 to sell the mortgage to.
Though Mr. Khan will earn profitable fees on the loan, he
bears interest-rate risk. He loses money if interest rates rise.
What would you suggest to him for hedging this risk?
 Solution: Use short-hedge
• To hedge this risk, he sells 2-months Treasury-
bond futures contracts.
• With rise in interest rates, the price of mortgage
as well as T-bonds will fall
• His loss on mortgage is offset by the profit on
short-hedge of t-bons
 Example 2
• Masood is another mortgage banker. His firm uses advance
commitments, where he promises to deliver loans to a financial
institution before he promises with borrowers. On March 1, his
firm agreed to sell mortgages to State Insurance Co. The
agreement specifies that he must turn over 12-percent coupon
mortgages with a face value of Rs. 1 million to State by May 1. As
of March 1, Masood had not signed up any borrowers. Over the
next two months, he will seek out individuals who want mortgages
beginning May 1. If interest rates fall before he signs up a
borrower, the borrower will demand a premium on a 12-percent
coupon loan. That is, the borrower will receive more than par on
May 1. Because Masood receives par from the insurance company,
he must make up the difference. How to hedge?
 Solution: use long hedge
• Because he loses in the cash market when interest rates
fall, he should buys futures contracts to reduce the risk.
• When interest rates fall, the value of his futures
contracts increases.
• The gain in the futures market offsets the loss in the
cash market.
• Conversely, he gains in the cash markets when interest
rates rise. The value of his futures contracts decreases
when interest rates rise, offsetting his gain.
• This is called a long hedge
 Excercises
• 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 3-month contract? What does it mean?
 Example.2
• The standard deviation of monthly changes in the spot
price of live cattle is (in cents per pound) 1.2. The
standard deviation of monthly changes in the futures
price of live cattlé for the closest contract is 1.4. The
correlation between the futures price changes and the
spot price changes is 0.7. It is now October 15. A beef
producer is committed to purchasing 200,000 pounds of
live cattle on November 15. The producer wants to use
the December live cattle futures contracts to hedge its
risk. Each contract is for the delivery of 40,000 pounds of
cattle. What strategy should the beef producer follow?
 Solution to cattle example
• The optimal hedge ratio is = .7*1.2/1.4 = .6
• The beef producer requires a long position in
200000x.6=120000 lbs of cattle. The beef
producers thus requires a long position in
December contracts, closing out the position on
November 15.
 Example 3
• A corn farmer argues "I do not use futures
contracts for hedging. My real risk is not the price
of corn. It is that my whole crop gets wiped out by
the weather."
• Discuss his view point?
• Should the farmer estimate his or her expected
production of corn and hedge and to try to lock in
a price for expected production?
 Discussion on the farmers view
• If weather creates significant uncertainity about
volume of the crops, then future contracts are not
appropriate
• Future contracts plus the weather can create
further problems for him as the prices are
expected to rise in weather is bad
• An airline executive has argued: "There is no point
in our using oil futures. There is just as much
chance that the price of oil in the future will be
less than the futures price as there is that it will
be greater than this price." Discuss the executive's
viewpoint.
• What he is saying might be true, but the firm is
not in the business of speculating on the oil prices
and making profit from rising/falling oil prices, it
would be a lot better if the company executives
focus on the main business.