Hedging Strategies Using

Futures
Chapter 3

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Outline
 Basic principles
 Arguments for and against hedging
 Basis risk
 Cross hedging

 Optimal number of contracts

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Hedger
 Many of the participants in futures markets are hedger
 The aim is to use futures markets to reduce a particular risk
they face
 Risk, for example, includes the changes in the price of oil, a
foreign exchange rate, the level of the stock market
 We consider hedge-and-forget strategies in this chapter
 Assume traders have two positions, one is on an asset in future
(buy/sell), the other is on the futures contract (buy/sell today, and then
sell/buy in future)
 No adjustments to the hedge once it has been put in place
 We treats futures contracts as forward contracts (i.e., ignore daily
settlement)
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Short & Long Futures Hedges
The hedger has a position on the asset in the future
(buy or sell). Then he/she considers the hedging
strategy trading futures contracts (before the delivery
date)
 A short futures hedge is appropriate when the hedger
already owns an asset and expects to sell it at some time in
the future and wants to lock in the price now
 As short hedge can also be used when an asset is not
owned right now but will be owned at some time in the
future
 A long futures hedge is appropriate when the hedger knows
it will have to purchase an asset in the future and wants to
lock in the price now 4
Example 1
Consider a company that knows it will gain $1000 for
each 1 cent increase in the price of a commodity over
the next three months and lose $1000 for each 1 cent
decrease in the price during the same period. What is
the strategy of the company on the futures contract?

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Example 1

 To hedge, the company should take a short futures

position to offset this risk
 If the price of the commodity goes down, the gain on the futures
position offsets the loss on the rest of the company’s business
 If the price goes up, the loss on the futures position is offset by the gain
on the rest of the company’s business

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Example 2
 “When the futures price of an asset is less than its
spot price, long hedges are likely to be particularly
attractive.” Explain this statement.

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 Answer: A company that knows it will purchase a
commodity in the future is able to lock in a price
close to the futures price. This is likely to be
particularly attractive when the futures price is less
than the spot price.

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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 (e.g., In example 3.1, the treasurer of the
company may have a difficult time justifying it…)

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Basis Risk
 Basis risk occurs when
 The asset whose price is to be hedged may not be exactly
the same as the asset underlying the futures contract
 The hedger may not be certain of the exact date the asset
will be bought or sold
 The hedge may require the futures contracts to be closed
out before its delivery month

 Basis = Spot price of asset to be hedged – Futures price of

contract used

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Basis Risk in a Long Hedge
 Define
F1 : Futures price at time hedge is set up (time 1)
F2 : Futures price at time asset is purchased (time 2)
S1: Asset price at time hedge is set up (time 1)
S2 : Asset price at time of purchase (time 2)
b1 : Basis at time hedge is set up (time 1)
b2 : Basis at time of purchase (time 2)
Cost of buying an asset S2
Gain on Futures F2 −F1
Net amount paid/the effective S2 − (F2 −F1) =F1 + b2
price paid with hedging

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Strengthening and Weakening of
the Risk Using a Long Hedge

The company plans to buy the asset, effective price = S2 − (F2

−F1) =F1 + b2
 If the basis strengthens unexpected (an increase in the
basis), the company’s position worsens because it will pay
a higher price for the asset after futures gain and losses are
considered
 If the basis weakens unexpected (a decrease in the basis),
the company’s position improves.

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Example 3
On March 1 a commodity’s spot price is $60 and its August
futures price is $59. On July 1 the spot price is $64 and the
August futures price is $63.50. A company entered into futures
contracts on March 1 to hedge its purchase of the commodity on
July 1. It closed out its position on July 1. What is the effective
price (after taking account of hedging) paid by the company?

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 The effective price = S2 – (F2-F1) = 64 – (63.5 - 59)
= 59.5

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Basis Risk in a Short Hedge
 Define
F1 : Futures price at time hedge is set up (time 1)
F2 : Futures price at time asset is sold (time 2)
S1: Asset price at time hedge is set up (time 1)
S2 : Asset price at time of sale (time 2)
b1 : Basis at time hedge is set up (time 1)
b2 : Basis at time of sale (time 2)
Sale of asset S2
Gain on Futures F1 −F2
Net amount received/the S2 +(F1 −F2)=F1 + b2
effective price received

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Strengthening and Weakening of
the Risk Using a Short Hedge

The company plans to sell the asset,

effective price=S2+(F1 −F2)=F1 + b2
 If the basis strengthens unexpected (i.e., increases), the
company’s position improves because it will get a higher price
for the asset after futures gain and losses are considered
 If the basis weakens unexpected (i.e., decreases), the
company’s position worsens.

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Example 4
On March 1 the price of a commodity is $1,000 and the
December futures price is $1,015. On November 1 the price is
$980 and the December futures price is $981. A producer of the
commodity entered into a December futures contracts on March
1 to hedge the sale of the commodity on November 1. It closed
out its position on November 1. What is the effective price (after
taking account of hedging) received by the company for the
commodity?

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The effective price = S2 + (F1-F2) = 980 + (1015 - 981)
= 1014

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Choice of Contract

 One key factor affecting basis risk is the

choice of the futures contract to be used for
hedging
 Two components:
 The choice of the assets: choose the contract whose futures
price is most highly correlated with the asset price
 The choice of the delivery month: choose a delivery month
that is as close as possible to, but later than, the end of the
life of the hedge

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Example 5
In the CME Group’s corn futures contract, the following delivery
months are available: March, May, July, September, and
December. State the contract that should be used for hedging
when the expiration of the hedge is in:
A. June
B. July
C. January

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Answer: We should choose a futures contract that has a
delivery month as close as possible, but later than, the month
containing the expiration of the hedge. The contracts that
should be used are therefore July, September, and March.

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Cross Hedging
 Cross hedging occurs when the asset underlying the
futures contract and the asset whose price is being
hedged are different.

 For example, an airline that is concerned about the

future price of jet fuel. Since jet fuel futures are not
actively traded, it might choose to use heating oil
futures contracts to hedge its exposure.

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Hedge Ratio
 Hedge ratio is the ratio of the size of the
position taken in futures contracts to the size
of the exposure
 Hedge ratio =1 when the asset underlying the
futures contract is same as the asset being hedged
 When cross hedging is used, the hedger should find
a optimal hedge ratio that minimizes the variance
of the value of the hedge position

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Optimal (Minimum Variance)
Hedge Ratio
The optimal hedge ratio is the slope of the best-fit line
obtained when changes in the spot price are regressed
against changes in the futures price

S
h 


where F
sS is the standard deviation of DS, the change in the spot
price during the hedging period,
sF 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.

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Optimal Number of Contracts

 Optimal number of contracts

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Example 6
Airline will purchase 2 million gallons of jet fuel in one
month and hedges using heating oil futures. Each
heating oil contract traded is on 42,000 gallons of
heating oil. From historical data sF =0.0313, sS
=0.0263, and r= 0.928. What is the optimal number of
contract?

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 0.0263
h  0.928 
*
 0.78
0.0313
Optimal number of contracts = 0.78×2,000,000/42,000
=37

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Example 7
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 cattle 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.
(1)What is the hedge ratio?
(2) Should the beef producer take a long or short futures position?
(3) What is the optimal number of futures contracts?
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 1. The optimal hedge ratio is:
0.7*(1.2/1.4) = 0.6
2. The beef producer requires a long position in
200000x0.6 =120,000 lbs of cattle. The beef producer
should therefore take a long position
3. The beef producer should take the long position in
three (=120,000/40000) December contracts closing
out the position on November 15.

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Summary
 Hedging is a way of reducing risk
 A short hedge is appropriate if you are expected to sell the
asset in the future
 A long hedge is appropriate if you plan to buy the asset in the
future
 Basis risk arises from a hedger’s uncertainty as to what the
basis will be at maturity of the hedge
 The optimal hedge ratio is the slope of the best-fit line
obtained when changes in the spot price are regressed against
changes in the futures price

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