Derivatives and Risk

Management
Hedging Strategies Using Futures

Summer Term 2024: ACV Subrahmanyam

Hedging Strategies Using Futures
› Agenda
– Basic Principles
› Short and Long Hedging
– Basis Risk
› Basis and Choice of Contract
– Cross Hedging
› Minimum Variance Hedge Ratio
› Optimal Number of Contracts
– Stock Index Futures
› Stock Indices
› Hedging Equity Portfolio
› Changing “beta” of the Portfolio
– Stack and Roll
– Arguments for and against Hedging
2
 Basic Principles
⇉ Hedging is for neutralizing Risk
⇉ Short Hedges
⇉ Long Hedges
⇉ Hedging – Profitable outcomes ???
⇉ No one know “future” price – best Knowledge is current futures price

3
 Basis Risk

• Asset to be hedged may not be

same as the underlying asset in
futures contract
• Hedges are Closed out earlier
• All this will lead to Basis Risk
Basis = Spot price of the asset to be
hedged – futures price of the
contract used CLOSE PRICE SBIN Futures NSE ( 25th July 2024 Expiry)
920
• At maturity “Spot Prices 890
Converge to Futures Prices” 860

• But before expiry or maturity 830

the spot and futures prices may 800

differ (non-zero deviation) 770

6-May-24
7-May-24
8-May-24
9-May-24
10-May-24
11-May-24
12-May-24
13-May-24
14-May-24
15-May-24
16-May-24
17-May-24
18-May-24
19-May-24
20-May-24
21-May-24
22-May-24
23-May-24
24-May-24
25-May-24
26-May-24
27-May-24
28-May-24
29-May-24
30-May-24
31-May-24
1-Jun-24
2-Jun-24
3-Jun-24
• Strengthening: increase in basis
• Weakening: decrease in basis Spot Price Futures Price

4
 Basis Risk (Contd.)
• S1 : Spot Price at time t1
• S2 : Spot Price at time t2
• F1 : Futures prices at time t1
• F2 : Futures prices at time t2
• b1 : Basis at time t1
• b2 : Basis at time t2
• S2* : Spot price of underlying asset in futures contract at t2
“ A futures entered at time t1 and closed out at time t2”
• b1 = S1 – F1 and b2 = S2 –F2
• Short futures position : S2 + F1-F2 (closing out) = F1+b2
• Long futures position : S2+F1-F2 (closing out) = F1+b2
• F1 is known at time t1 and b2 is “basis risk”

Asset being hedged is different from the asset used for futures contract
• S2 + F1-F2
• S2+F1-F2+S2*-S2*
• F1+(S2*-F2) +(S2-S2*)
• S2*-F2 : basis that would exist if hedged asset and underlying are same
• S2-S2*: this is due to difference in two assets

5
 Basis Risk - Numerical
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. When the yen are received at the end of July, the company closes out
its position. 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. What is the gain/ loss?

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 contract size is 1,000 barrels. 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. What is the gain/ loss?

6
7
 Cross Hedging Choice of Contract and Delivery Months
• Asset underlying futures
contract same as the asset
whose price is being hedged –
Ex: SBI share and SBI futures

• Cross Hedging occurs when

the two assets are different
• Jet fuel Price hedged using
heating oil
• Non-Nifty stock using NIFTY
futures
• Necessity of cross hedge viz.
the asset to be hedged might
not have active futures market
with adequate depth and
liquidity

8
 Cross Hedging Minimum Variance 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= (𝑺𝒊𝒛𝒆 𝒐𝒇
𝑷𝒐𝒔𝒊𝒕𝒊𝒐𝒏 𝒊𝒏 𝑭𝒖𝒕𝒖𝒓𝒆𝒔
𝑪𝒐𝒏𝒕𝒓𝒂𝒄𝒕)/(𝑺𝒊𝒛𝒆 𝒐𝒇
𝑬𝒙𝒑𝒐𝒔𝒖𝒓𝒆)
• ∆𝑆=𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑠𝑝𝑜𝑡 𝑝𝑟𝑖𝑐𝑒, 𝑆
𝑑𝑢𝑟𝑖𝑛𝑔 𝑡ℎ𝑒 𝑝𝑒𝑟𝑖𝑜𝑑 𝑜𝑓 𝑡𝑖𝑚𝑒
𝑒𝑞𝑢𝑎𝑙 𝑡𝑜 𝑡ℎ𝑒 𝑙𝑖𝑓𝑒 𝑜𝑓 𝑡ℎ𝑒
ℎ𝑒𝑑𝑔𝑒
• ∆𝐹=𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑓𝑢𝑡𝑢𝑟𝑒𝑠
𝑝𝑟𝑖𝑐𝑒, 𝐹 𝑑𝑢𝑟𝑖𝑛𝑔 𝑡ℎ𝑒 𝑝𝑒𝑟𝑖𝑜𝑑
𝑜𝑓 𝑡𝑖𝑚𝑒 𝑒𝑞𝑢𝑎𝑙 𝑡𝑜 𝑡ℎ𝑒 𝑙𝑖𝑓𝑒
𝑜𝑓 𝑡ℎ𝑒 ℎ𝑒𝑑𝑔𝑒
• Let ∆𝑆=𝑎+𝑏∆𝐹+∈ 9
10
11
 Cross Hedging – Minimum Variance Hedge Ratio
• Let ( a and b are constants with being the error term)
• h hedge ratio defined as percentage ‘h’ of exposure S is hedged with futures
• - h [ finding minimal value – first order conditions]
• This equation is at minimum of b= h ; let this is be h*

is the standard deviation of and

is the standard deviation of
is the correlation coefficient between and

• Variance value of hedge position depends on ‘hedge ratio’

• Hedge effectiveness can be defined as the proportion of the variance eliminated by

hedging and is equal to

• Observing historical data to compute

12
 Cross Hedging – Minimum Variance Hedge Ratio – Optimal Contracts
Optimal Number of Contracts DAILY SETTLEMENT
› ;
Percentage Change

› = optimal number of futures contract for hedging

› Futures contracts should be on h* units of the asset (to be hedged)
› Number of futures contracts required is therefore given by
Regression of daily
Percentage change in Spot
and Futures Prices
Impact of Daily Settlements


 = Correlation between percentage one-day change in spot and futures prices

 S = spot price
 F = futures price
 ;

13
14
 Numerical
• An airline expects to purchase 2 million gallons of jet fuel in 1 month and decides to use heating oil futures for
hedging. We suppose that Table 3.2 gives, for 15 successive months, data on the change, S, in the jet fuel price per
gallon and the corresponding change, F, in the futures price for the contract on heating oil that would be used for
hedging price changes during the month. In this case, the usual formulas for calculating standard deviations and
correlations give = 0:0313, = 0:0263, and 0:928:

• Suppose that in the above case, the spot price and the futures price are 1.94 and 1.99 dollars per gallon, respectively.
the optimal number of contracts is

15
 Stock Index Futures
Portfolio value : Rs. 5.00 Crore
• Stock index futures used to hedge a well- diversified equity portfolio
Index Futures Price is Rs. 1000
• = Current Value of “one” futures contract (the futures price times Contract lot size 250
the contract size) Compute N*
Va = 5.00 Crore
• Portfolio does not mirror the index – a hedge ratio other than “1” for Vf = 250* 1000 = 2.50 Lakh
optimal hedging (minimum variance hedge)
N* = 5 CR/ 2.5 Lakh = 200
Contracts
• Use of “Capital Asset Pricing Model CAPM” Computation of
{ =1 , 1.5, 0.5, and 2 cases) Portfolio value : Rs. 5.00 Crore
• is the slope of the best-fit line when the return from the portfolio is
Index Futures Price is Rs. 1000
regressed against the return for the index
Contract lot size 250, = 1.5
• h is the slope of the best-fit line when percentage one day changes in Compute N*
the portfolio are regressed against percentage one day changes in the Va = 5.00 Crore
futures price index Vf = 250* 1000 = 2.50 Lakh
N* = 1.5 *(5 CR/ 2.5 Lakh)
= 300 Contracts
16
 Hedging and Equity Portfolio using Stock Index Futures
Portfolio Value 50,50,000 50,50,000 50,50,000 50,50,000 50,50,000
Current Index value 1000 1000 1000 1000 1000
Value at end of 3 Months 900 950 1000 1050 1100
Strike Price 1010 1010 1010 1010 1010
Futures Prices 902 952 1003 1053 1103
Return -10.000% -5.000% 0.000% 5.000% 10.000%
Dividend 0.250% 0.250% 0.250% 0.250% 0.250%
Risk Free Rate @4% 1.000% 1.000% 1.000% 1.000% 1.000%
Beta of portfolio 1.5 1.5 1.5 1.5 1.5
index return -10.750% -5.750% -0.750% 4.250% 9.250%
-16.125% -8.625% -1.125% 6.375% 13.875%
1.000% 1.000% 1.000% 1.000% 1.000%
Expected Returm CAPM -15.125% -7.625% -0.125% 7.375% 14.875%
Total Value 42,86,188 46,64,938 50,43,688 54,22,438 58,01,188
Futures Gain 108 58 7 -43 -93
Futures Gain Per contract 27000 14500 1750 -10750 -23250
Futures Gain Total 810000 435000 52500 -322500 -697500
Net Position 50,96,188 50,99,938 50,96,188 50,99,938 51,03,688
Return 0.91% 0.99% 0.91% 0.99% 1.06%
Portfolio @ Rf 51,00,500 51,00,500 51,00,500 51,00,500 51,00,500
Relative Gain over Rf -4,313 -563 -4,313 -563 3,188
17
 Changing Beta of a Portfolio
Altering using short or long
futures
• In general
• Reduce 𝛽 to * ( >
› Short
• Increase 𝛽 to * (
• Value of Portfolio 50,50,000
• futures contract size is 250 times index Vf = 1010
• B is 1.5
• Number of contracts is 30
30 contracts
• = 1.5 to reduce it to 0.75
• Take 15 short contracts
• = 1.5 to increase to 2.0
• Take 10 long contracts
18
 Hedging an Equity Portfolio
• Hedging an Equity Portfolio  objective is to protect the value of portfolio
• CAPM Model : Expected return = Risk Free Return + (Excess Market Return)  Rf + (Rm-Rf)
• Reasons for Hedging an Equity Portfolio
• Hedging allows investor to grow the portfolio at risk free rate (Why take the trouble)
• CAPM model Expected return = Rf + (Rm-Rf) [Market volatility affects expected return]
• Hedging using index futures (Rm) risk from market movements is eliminated
• Only exposed to risks to the portfolio return relative to market
• Locking in the Benefits of Stock Picking
• Investor is confident about his stock but not about the market ( Domain or market analysis etc.)
• Portfolio will outperform the index ( then short the index futures) ( Short this position)
• Investor wants to hold for longer tenure and protect from short term market movements
• Alternative is to sell and buy later (but risks of transaction cost)

19
 Stack and Roll
Stack and Roll
• Hedge is required for a longer date than the
delivery futures
• Roll forward the position at the end of expiry
• Stack and roll
• 2. Sept. 2021 Short 100 Contracts for Mar 2022
T1, T2, T3 and T4
• Short at t1 and
• Short at t2 close out Contract entered at T1
• Short at t3 close out Contract entered at T2
• T Close out contract entered at T3
In April 2021, a Company knows it will have 100000 barrels of
oil in June 2022  Time gap 15 months
1 lot = 1000 barrels 100 contracts
Only 6 months delivery is available
1. April 2021 Short 100 Contracts for Oct 2021
3. Feb. 2022 Short 100 Contracts for July 2022
April spot price $ 49 and June 2022 spot is $ 46
OCT 2021 Futures $ 48.20 closed at $47.40 = +$0.80
Mar 2022 Futures $ 47.00 closed at $ 46.50 = +$0.50
July 2022 Futures $ 46.30 closed at $ 45.90 = +$0.40
Total gain $1.70 ; loss if not hedged $ 3 (49 – 46)
Total loss cannot be averted but can be minimized when futures
price is below spot price
20