Hedging Strategies using Futures
• Hedging is the process of reducing exposure to
risk.
• Futures act as a hedge, when position is taken
in them is opposite to that of existing or
anticipated cash positions.
• Short Hedge: it is used when hedger already owns
the asset or when asset is not owned right now,
but will be own in some future time.
• Suppose if the price would fall:
Cash market (Loss) and Futures market (Profit).
• Suppose if the price would rise:
Cash market (Profit) and Futures market (Loss).
• Long hedge: it is used when hedger knows it will
have to purchase certain assets in futures.
• Suppose if the price would increases:
Cash market (Loss) and Futures market (Profit).
• Suppose if the price would falls:
Cash market (Profit) and Futures market (Loss).
• In practice hedging through futures contract
does not work perfect. Some of the reasons
are;
• The assets whose price is to be hedged may
not be exactly the same as the asset
underlying futures contract. Therefore the
hedge actually cross hedge.
• Hedger may be uncertain as to exact date
when the asset will be bought or sold.
• These problems give rise to “Basis Risk”.
• Basis Risk: As the time passes the spot price and
future price do not necessarily change by the same
amount. Therefore a difference arises between any
two basis at different time period. This leads to basis
risk.
• Generally risk faced by unhedged investor on one unit
of cash asset is; (S1 – S0)
• Suppose after hedge using futures on one unit of
underlying asset investor believes that futures will
move in line with cash.
• Then the risk involves; (F1 – F0) - (S1 – S0),
where negative sign indicates position in
futures is opposite to cash asset.
• Rearranging, (F1 – S1) - (F0 – S0)
i.e. Basis 1 – Basis 0
• Basis 0 is known today but Basis 1 is unknown
at time 1. thus hedged investor faces a basis
risk
• Had the basis remain unchanged overtime,
investor would have a perfect hedge. Since
basis does change randomly, perfect hedging
may not be expected.
• Also, higher the degree of correlation between
the two, smaller is the basis risk
Cross Hedge
• Examples considered up to now, the asset
underlying the futures contract has been the same
as the asset whose price is being hedged. Cross
hedging occurs when the two assets are different.
• For example an airline that is concerned about the
future price of jet fuel. Because there is no futures
contract on jet fuel, it might choose to use heating
oil futures contract to hedge its exposure.
• Normally one believes that; size of
position in futures = size of exposure in cash market
• Particularly when the asset underlying the futures
contract is the same as the asset being hedged and
therefore it is natural to use hedge ratio 1.0.
• But when cross hedge is used, setting the hedge
ratio equal to 1.0 is not always optimal. The hedger
should choose a value for the hedge ratio that
minimizes the variance of the value of the hedged
position.
Hedge Ratio (h)
• To measure the appropriate number of futures
contract to buy or sell while hedging, we need
to find “Hedge Ratio”.
• Hedge Ratio is defined as number of futures
contracts to buy or sell to hedge per unit of
spot position.
Optimal Hedge Ratio (h*)
• Optimal hedge ratio (h*) can be found by
regressing ΔS (change in spot price on ΔF
(change in futures price).
ΔS = α + β*ΔF
Where, β is the hedge ratio (h*)
Proportion of the exposure that should
optimally be hedged is
S
F
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.
If r = 1 and ΔS = ΔF, then h* =?
If r = 1 and 2ΔS = ΔF, then h* =?
If r = 1 and ΔS = 2ΔF, then h* =?
Optimal Number of Contracts
Where,
QA = Size of position being hedged
QF = Size of one futures contract
N* = Optimal number of futures contracts for
hedging
Hedging Using Index Futures
• Index derivatives are derivative contracts which have the index as
the underlying. The most popular index derivative contracts the
world over are index futures and index options.
• Stock index futures can be used to hedge a well diversified equity
portfolio.
• If the portfolio mirrors the index, the optimal hedge ratio h* equals
1.0.
• But when the portfolio does not exactly mirror the index, we can
use the parameter beta (β) from CAPM to determine the
appropriate hedge ratio.
Changing the β of the portfolio
• After hedging the beta of the hedgers
portfolio is reduced to zero. But sometimes
futures contracts are used to change the beta
of the portfolio to some value other than zero.
• Continuing with the same example,
• 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?
• In general to change the beta of the portfolio
from β to β*,
• where β > β*, a short position in (β - β*) P/F
contracts is required.
• where β < β*, a long position in (β* - β) P/F
contracts is required.
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 to increase
the life of hedge but each time we switch from one
futures contract to another we incur a type of basis risk
• Suppose that in April 2007 a company realizes
that it will have 100,000 barrels of oil to sell in
June 2008 and decides to hedge its risk with a
hedge ratio of 1.0. the current spot price is $69.
• Although futures contracts are traded with
maturities stretching several years into the
futures, we suppose that only the first six
delivery months have sufficient liquidity to
meet the company’s needs.
• The company therefore shorts 100 October
2007 contracts. In September 2007 it rolls the
hedge forward into march 2008 contract. In
February 2008 it rolls the hedge forward again
into the July 2008 contract.
