Lecture 9
Hedging Strategies Using Futures
Reading: Chapter 3
Hull J. 2013, Fundamentals of futures and options markets, 8th edn., Pearson
Education
1
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 & want to lock in the 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
3
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
4
Convergence of Futures to Spot
(Hedge initiated at time t1 and closed out at time t2)
Futures
Price
Spot
Price
Time
t1 t2
5
Basis Risk
• Basis is the difference between spot & futures
• Basis risk arises because of the uncertainty about the basis when the
hedge is closed out
6
Long Hedge
• Suppose that
F1 : Initial Futures Price
F2 : Final Futures Price
S2 : Final Asset Price
• You hedge the future purchase of an asset by entering into a long
futures contract
• Cost of Asset=S2 – (F2 – F1) = F1 + Basis
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Short Hedge
• Suppose that
F1 : Initial Futures Price
F2 : Final Futures Price
S2 : Final Asset Price
• You hedge the future sale of an asset by entering into a short futures
contract
• Price Realized=S2+ (F1 – F2) = F1 + Basis
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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. There are then 2 components to basis
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Optimal Hedge Ratio
Proportion of the exposure that should optimally be hedged is
sS
h=r
sF
where
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.
10
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
VA
b
VF
where VA is the current value of the portfolio, b is its beta, and VF is the
current value of one futures (=futures price times contract size)
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Reasons for Hedging an Equity Portfolio
• Desire to be out of the market for a short period of time. (Hedging
may be cheaper than selling the portfolio and buying it back.)
• Desire to hedge systematic risk
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Example
Futures price of S&P 500 is 1,000
Size of portfolio is $5 million
Beta of portfolio is 1.5
One contract is on $250 times the index
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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Stock Picking
• If you think you can pick stocks that will outperform the market,
futures contract can be used to hedge the market risk
• If you are right, you will make money whether the market goes up or
down
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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 1 futures contract to another we incur a
type of basis risk
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