Derivatives
Hedging Strategies using Futures
Hedging Fundamentals
• Trading futures contracts with the objective of reducing price risk is called hedging.
• Hedging with futures typically involves taking a position in a futures market that is
opposite the position already held in a cash market.
• A Short (or selling) Hedge: Occurs when a firm holds a long cash position and then
sells futures contracts for protection against downward price exposure in the cash
market.
• A Long (or buying) Hedge: Occurs when a firm holds a short cash position and then
buys futures contracts for protection against upward price exposure in the cash
market. Also known as an anticipatory hedge.
• A Cross Hedge: Occurs when the asset underlying the futures contract differs from
the product in the cash position
• Firms can simultaneously hold long and short hedges (but for different price risks).
Profit Profile for a Long Hedge
Change in profit
Q: What’s the “Complaint”
about flattening the payoff
profile to a horizontal line?
Change in price
A rise in the price of a good
A long hedge is
will lower profits (or firm
appropriate: buy
value)
futures to hedge
Profit Profile for a Short Hedge
Change in profit
Change in price
A short hedge is
A decline in the price of a
appropriate: sell futures to
good will lower profits
hedge
(or firm value)
Arguments on Hedging
• Favor
• 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
• Against
• Shareholders are usually well-diversified and can make their own hedging
decisions
• It may increase the 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
Example: Short hedge
• It is February 21, and an oil producer has negotiated a contract to sell 1 million
barrels of crude oil for the price that will prevail on May 21.
• The producer wins/loses $10,000 per 1 cent increase/decrease in oil price over the
next three months.
• Suppose the May crude oil futures price is $18.75 per barrel. Because the contract
delivers 1,000 barrels, the producer can hedge its position by going short 1,000
contracts.
• If the producer closes its position on May 21, the effect of the strategy would be to
lock in a price of $18.75 per barrel.
• What are the cash flows if the oil spot price on May 21 is (a) $17.50 and (b) $19.50
Example: Short hedge
Date Spot market Futures market Basis
t St = $800/unit Ft,T = $825/unit -25
Contract to sell short one gold
Gold on k. futures for delivery at T
k Sell the gold Long one gold
Sk = $784/unit futures for delivery at T.
Fk,T = $812/unit -28
3
T Amount received: 784 + 825 – 812 = $797/unit
or 825 + (784 – 812) = $797/unit
Example: Long hedge
• It is 15 January, and a copper fabricator knows it will require 100,000 pounds of
copper on May 15 to meet a certain contract.
• The fabricator wins/loses $1,000 per 1 cent decrease/increase in copper price over
the next five months.
• Suppose the May copper futures price is $1.20 per pound. Because the contract
delivers 25,000 pounds, the fabricator can hedge its position by going long 4
contracts.
• If the producer closes its position on May 15, the effect of the strategy would be to
lock in a price of $1.20 per pound.
• What are the cash flows if the copper spot price on May 15 is (a) $1.25 and (b) $1.05
Example: Long hedge
Date Spot market Futures market Basis
t St = $800/unit Ft,T = $825/unit -25
Contract to buy long one gold
Gold on k. futures for delivery at T
k Buy the gold Short one gold
Sk = $816/unit futures for delivery at T.
Fk,T = $842/unit -26
1
T Amount paid: 816 + 825 – 842 = $799/unit
or 825 + (816 – 842) = $799/unit
NOTATIONS:
t < T t = current time; T = delivery time
F t,T = THE FUTURES PRICE AT TIME t FOR
DELIVERY AT TIME T.
St = THE SPOT PRICE AT TIME t.
k= THE DATE UPON WHICH THE FIRM
TRADES THE ASSET IN THE SPOT MARKET.
k≤T
Sometimes t = 0 denotes the date the hedge is opened.
THE HEDGE TIMING
k = is the date on which the hedger conducts the firm
spot business and simultaneously closes the futures
position. This date is almost always before the delivery
month; k ≤ T.
Today Trade spot and Delivery
Open the hedge: Close the futures
open a futures position
position
t k T Time
THE HEDGE TIMING
Date k is (almost) always before the delivery month.
WHY?
1. Often k is not in any of the delivery months available.
2. From the first trading day of the delivery month, the
SHORT can decide to send a delivery note. Any LONG
with an open position may be served with this delivery
note.
Spot and Futures prices over time
Commodities and assets are traded in the
spot and futures markets simultaneously.
Thus, the relationship between the sport
and futures prices:
At any point in time
And
Over time
Is of great importance for traders.
The Basis
The basis at any time point, j, is the difference between the
asset’s spot price and the futures price on j.
BASISj = SPOT PRICEj - FUTURES PRICEj
Notationally: Bj = Sj - Fj,T j < T.
When discussing a basis, one must specify the futures in
question, i.e., a specific delivery month. Usually, however, it
is understood that the futures is for the nearest month to
delivery.
A LONG HEDGE
TIME SPOT FUTURES B
t Contract to buy LONG Ft,T Bt
Do nothing
k BUY Sk SHORT Fk,T Bk
T delivery
Actual purchase price = Sk + Ft,T - Fk,T
= Ft,T + [Sk - Fk,T]
= Ft,T + BASISk
A SHORT HEDGE
TIME SPOT FUTURES B
t Contract to sell SHORT Ft,T Bt
Do nothing
k SELL Sk LONG Fk,T Bk
T delivery
Actual selling price = Sk + Ft,T - Fk,T
= Ft,T + [Sk - Fk,T]
= Ft,T + BASISk
In both cases,
Long hedge and short hedge
the hedger’s purchase/sale price, when the hedge is
closed on date k, is:
Ft,T + BASISk
This price consists of two portions:
a known portion: Ft,T
and a random portion: the BASISk
We return to this point later.
ALSO NOTICE:
t k T
The purchase/sale price when the hedge is closed on date
k is: Ft,T + BASISk
Which may be rewritten:
= Ft,T + BASISk + St – St
= St – [St – Ft,T - Bk]
= St + [Bk – Bt]
Open close Long hedge Short hedge
the hedge
Fk,T a success a failure
Sk Loss on
Ft,T the hedge
St a failure a success
Fk,T Loss on
the hedge
Sk
Example: A LONG HEDGE
TIME SPOT FUTURES BASIS
t St= $3.40 LONG
Do nothing Ft,T=$3.50 -$.10
k BUY Sk=$3.80 SHORT
F k,T=3.85 -$.05
T delivery
Actual purchase price:
NO hedge: $3.80
With hedge: $3.45 (Successful hedge)
Example: A LONG HEDGE
TIME SPOT FUTURES BASIS
t St= $3.40 LONG
Do nothing Ft,T=$3.50 -$.10
k BUY Sk=$3.00 SHORT
F k,T=3.05 -$.05
T delivery
Actual purchase price:
NO hedge: $3.00
With hedge: $3.45 (Unsuccessful hedge)
The basis upon delivery: BT = 0
On date k, the basis is
Bk = Sk - Fk,T k < T.
If k coincides with the delivery date, however, k = T. The
basis is:
BT = ST - FT, T at T.
BUT, FT,T is the futures price on date T for delivery on date T,
which implies that:
FT,T = ST BT = 0.
Basis Risk
The Basis is the difference between the spot and the futures prices.
I.e., the Basis is a RANDOM VARIABLE. Thus,
Basis risk
arises because of the uncertainty about the Basis when the hedge is
closed out on k.
The basis, however, is the difference of two random variables and
thus, the Basis is LESS RISKY than each price by itself.
Moreover, we do know that BT = 0
upon delivery.
Generally, the basis fluctuates less than both the cash and the futures prices.
Hence, hedging with futures reduces risk. Basis risk exists in any hedge,
nonetheless.
Sk
Pr
Ft,T Bk
St
BT = 0
Bt
k T time
t
We showed that for both types of hedge
A SHORT HEDGE or A LONG HEDGE,
The price received/paid by the hedger:
Ft,T + BASISk
This price consists of two parts:
Part one: Ft,T is KNOWN when the hedge is opened.
Part two: BASISk is risky.
Conclusion:
At time t, WITHOUT HEDGING
cash-price risk.
WITH HEDGING,
basis risk.
Hedging with futures is nothing more than changing the firm’s spot
price risk
Into a smaller risk, namely,
The basis risk.
Cross Hedging
• Req. 2 million gal
• Lot Size 42,000 gal
• σs = .0263
• σf = .0313
• Ρ = .928
