Using Futures
Chapter 3
1
HEDGERS
OPEN POSITIONS IN THE FUTURES
MARKET IN ORDER TO
ELIMINATE THE RISK
ASSOCIATED WITH THE
SPOT PRICE
OF THE UNDERLYING ASSET
2
Sj
St
t
time
HEDGERS
PROBLEM: TO OPEN
A LONG HEDGE
OR
A SHORT HEDGE?
There are two ways to
determine whether to open a short
or a long hedge:
4
1.
A LONG HEDGE
2.
A LONG HEDGE
Spot market
Amount paid:
or
= $799/unit
7
Spot market
8
= $797/unit
NOTATIONS:
t<T
F t,T =
St =
k=
kT
Sometimes t = 0 denotes the date the
hedge is opened.
9
Time
10
The Basis
The basis at any time point, j, is the
difference between the assets spot
price and the futures price on j.
BASISj = SPOT PRICEj - FUTURES
PRICEj
Notationally: Bj = Sj - Fj,T
j < T.
A LONG HEDGE
TIME
SPOT
FUTURES
B
t Contract to buy
LONG Ft,T
Bt
Do nothing
k
T delivery
Actual purchase price
= Sk + Ft,T - Fk,T
14
A SHORT HEDGE
TIME
SPOT
FUTURES
B
t Contract to sell
SHORT Ft,T Bt
Do nothing
k
Bk
T delivery
Actual selling price = Sk + Ft,T - Fk,T
= Ft,T + [Sk - Fk,T]
= Ft,T + BASISk
15
In both cases,
Long hedge and short hedge
the hedgers purchase/sale price,
when the hedge is closed on date k,
is:
Ft,T + BASISk
This price consists of two portions:
a known portion:
and a random portion: the
BASIS
Ft,T
16
ALSO NOTICE:
t
Ft,T + BASISk + St St
St + [Bk Bt]
17
Open
close
the hedge
Fk,T
Ft,T
Sk
a success
a failure
Loss on
St
the hedge
Fk,T
Sk
a failure
success
Loss on
19
Example:
TIME
SPOT
t
St= $3.40
Do nothing
k
A LONG HEDGE
FUTURES
LONG
BASIS
Ft,T=$3.50
-$.10
BUY Sk=$3.80
F
k,T
=3.85
SHORT
-$.05
T delivery
Actual purchase price:
NO hedge:
$3.80
20
Example:
TIME
SPOT
t
St= $3.40
Do nothing
k
A LONG HEDGE
FUTURES
LONG
BASIS
Ft,T=$3.50
-$.10
BUY Sk=$3.00
F
k,T
=3.05
SHORT
-$.05
T delivery
Actual purchase price:
NO hedge:
$3.00
k < T.
at T.
BT =
22
0.
Futures
Price
Spot Price
Spot Price
Futures
Price
Time
(a)
Time
(b)
23
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.
24
Pr
Bk
Ft,T
St
t
BT = 0
Bt
k
time
25
Conclusion:
At time t, WITHOUT HEDGING
cash-price risk.
WITH HEDGING,
basis risk.
Hedging with futures is nothing more
than changing the firms spot price
risk
Into a smaller risk, namely,
27
A CROSS HEDGE:
When there is no futures contract on the
asset being hedged,
choose the contract whose futures price
is most highly correlated with the spot
asset price.
NOTE, in this case, the hedger creates a
two components basis:
one component associated with the
asset underlying the futures
and one component associated with the
spread between the two spot prices.
28
A CROSS HEDGE:
Let S1t
be the spot asset price at time t.
Remember! - This is the asset that the
hedger is trying to hedge; e.g. jet fuel.
Let S2t
be the spot price at time t of the asset
underlying the futures. E.g., natural
gas. This, of course, is a different
asset and that is why this hedge is
called a
CROSS HEDGE
29
A CROSS HEDGE
TIME
CASH
FUTURES
Trade for
S1K
Fk,T(2)
T delivery
PAY/RECEIVE= S1K + Ft,T(2) - Fk,T(2)
= Ft,T(2) +[S2k - Fk,T(2)] +[S1k - S2k]
30
31
34
n
= The number of futures
contracts
to be used in the
hedge.
h
35
HEDGE RATIOS:
Open a hedge.
Question:
Given that the firm has a contract to
trade NS units of the underlying
commodity on date k in the spot
market and given that one futures
covers NF units of the underlying
commodity:
How many futures to use in the
36
hedge? i.e., what is n?
nN F
h
NS
NS
nh
.
NF
h = 1.
nN F
h
1
NS
NS
n
NF
38
NF = 1,000 barrels.
SHORT:
n
= 75,000/1,000
= 75 NYMEX futures.
39
NF = 100
SHORT:
n
= 3,600/100
= 36 CBT futures.
41
SPOT MARKET
Contract to buy
of WTI crude oil.
on: Oct 1,07;
Nov 1,07;
Dec 1,07;
Jan 2,08.
42
A STRIP.
A STRIP is a hedge in which there
are several long (or several short)
positions opened simultaneously
with equal time span between the
delivery months of the positions.
Each one of these futures exactly
hedges a specific future trade in the
spot market
43
FUTURES MARKET
FUTURES
Sep1,07
contract to
92.00
buy 75,000bbls on
Oct 1,07;
Nov 1,07;
Dec 1,07;
Jan 2, 08.
Long 75 NOV 07
93.00
long 75 NOV
Long 75 DEC 08
93.50
long 75 DEC
07
08
44
Date
SPOT MARKET
POSITIONS
Sep1,07
75 NOV 2007
75 DEC 2007
75 JAN 2008
75 FEB 2008
FUTURES MARKET
contract to
92.00
buy 75,000bbls
Long
Long
Long
Long
75
75
75
75
NOV 2007
DEC 2007
JAN 2008
FEB 2008
FUTURES
93.00
93.50
93.85
94.60
93.10
long
long
long
long
long 75
long 75 JAN
2008
long 75 FEB
2008
Nov1,07 buy 75,000bbls
long 75 JAN 2008
92.90
short 75 DEC 07
93.05
long 75 FEB
2008
Dec1,07
FEB 2008
buy 75,000bbls
94.15
94.95
long 75
NO
45
SPOT MARKET
FUTURES MARKET
FUTURES POSITIONS
SHORT 100
47
Date
SPOT MARKET
DEC, 07 contract to
89.00
FUTURES MARKETF
FUTURES POSITIONS
88.20
Short 100
87.40
87.00
Short 100 SEP
86.50
86.30
Short 100 FEB
2008
AUG 08
2009
JAN, 09 sell 100,000bbls
86.00
$86.00/barrel
$87.70/barrel
48
Spot
Futures
$1
$2
$1
$0.5
50
NOTATIONS
t
St
k
=
T
=
Fj,T=
for
T.
NOTATIONS
n = The number of futures
contracts
used in the hedge.
h = The hedge ratio.
NF = The number of units of the
asset in
one
contract.
NS = The number of units of the
asset
to be traded spot on k.
53
NS
n h
.
NF
*
= SkNS +nNFFk,T
t,T
PROBLEM: Find h* so as to
minimize
the Variance of (VP).
56
= NS2 [VAR(S)+h2VAR(F)+2hCOV(S;F)]
Set:
d[VAR(VP)]/dh = 0:
cov(S; F)
h* .
var(F)
S
n * NF
h* - S,F
.
F
NS
NS
n h
.
NF
58
cov(S; F)
h* .
var(F)
S n * N F
h* - S,F
.
F
NS
NS
n h
.
NF
59
63
h* , using Regression:
DATA:
n+1 weeks.
S F e
i1,2, ..., n.
h*
64
Date:
SEP 04 2005
MAR 2006
2.723
SEP 2006
2.728
MAR 2007
2.716
SEP 2007
2.695
66
FUTURES MARKET
SEP 05 contract
2.728
Do nothing
2.695
FUTURES
67
2.69
6
2.65
2.77
7
2.88
for delivery
2.691
2.702 2.648
2.707 2.643 2.767
68
Date
SPOT MARKET
SEP 05 NOTHING
long 28 MAR 2006
2.728
FUTURES MARKETF
FUTURES POSITIONS
2.716
long 28 MAR
2.695
long 28 SEP
short 28 SEP 06
Feb 07
short 28 MAR 07
2007
2007
Feb 06
short 28 SEP 07
2.648
2.767
2.882
70
STOCK
INDEXES (INDICES)
STOCK
INDEXES (INDICES)
I=
;
j
j = 1,,N.
j = 1,..., N.
1
(S1 S2 ,...,SN ) / D 2 I1
2
2.
(S1S2 (XYZ)...SN ) / D 2 I1
and
D =4.5.
An instant later:
(30 + 150 + 50 + 60 + 20)/D = 40
The new divisor is D = 7.7576
77
78
ADDITIONAL STOCKS
1.
2.
80
NS
I
N S
tj tj
j 1,2,......, n
Bj Bj
t=B
R Pt w tjR tj.
w tj
tj tj
N S
tj tj
tj
VtP
83
VPt
N tjStj
R Pt
S N tjStj
t +1j t +1j
N S
tj tj
R Pt
N (S S )
N S
tj
t +1j
tj tj
tj
84
R Pt
St 1j Stj
N tjStj S
tj
N S
tj tj
N S R
. Rewrite this as :
N S
tj tj
tj
tj tj
N tjStj
N S
tj tj
R tj , or
Vtj
R tj . Finally,
VtP
R Pt w tjR tj.
w tj
N tjStj
N S
tj tj
Vtj
VtP
85
86
Let:
P denote the portfolio
underlying
the Index, I.
Let:
the
COV(R P ; R M )
P
.
VAR(R M )
The Index is a proxy for the Market :
COV(R P ; R I )
P
.
VAR(R I )
COV([ w jR j ]; R I )
VAR(R I )
.
88
w COV(R ; R )
, or :
j
VAR(R I )
COV(R j ; R I )
P w j
w j j.
VAR(R I )
89
PRICE
FEDERAL MOUGUL
MARTIN ARIETTA
IBM
US WEST
BAUSCH & LOMB
FIRST UNION
WALT DISNEY
DELTA AIRLINES
P =
18.875
73.500
50.875
43.625
54.250
47.750
44.500
52.875
SHARES
9,000
8,000
3,500
5,400
10,500
14,400
12,500
16,600
VALUE
169,875
588,000
178,063
235,575
569,625
687,600
556,250
877,725
3,862,713
WEIGHT
BETA
.044
.152
.046
.061
.147
.178
.144
.227
1.00
.80
.50
.70
1.1
1.1
1.4
1.2
(1.2)
= 1.06
90
BENEFICIAL CORP.
CUMMINS ENGINES
GILLETTE
KMART
BOEING
W.R.GRACE
ELI LILLY
PARKER PEN
PRICE
40.500
64.500
62.000
33.000
49.000
42.625
87.375
20.625
SHARES
11,350
10,950
12,400
5,500
4,600
6,750
11,400
7,650
VALUE
459,675
706,275
768,800
181,500
225,400
287,719
996,075
157,781
3,783,225
WEIGHT BETA
.122
.187
.203
.048
.059
.076
.263
.042
.95
1.10
.85
1.15
1.15
1.00
.85
.75
91
(GE)
1.25
NYSECI
Index
Data
Weekly Price
5 yrs (Monthly)
Bloomberg
(Weekly)
1.21
S&P500I
Weekly Price
2 yrs
1.13
S&P500I
Daily Price
2 yrs
S&P500I
Monthly P
1.14
1.20
DailyStock.com
1.21
S&P500I
1.2287
1.23
1.23
Monthly Price
92
93
RECALL THAT
cov(S; F)
h* .
var(F)
S
h * - S,F
n * NF
.
NS
NS
n h
.
NF
97
S Sk - St
=
= rS
St
St
F Fk,T - Ft,T
=
= rF
Ft,T
Ft,T
S = St rS
F = Ft,T rF
COV(St rS , Ft,T rF )
COV(S; F)
h*= VAR( F)
VAR(Ft,T rF )
COV(rS , rF ) [St Ft,T ]
h*= 2
VAR(r F )
Ft,T
98
99
PRICE
FEDERAL MOUGUL
MARTIN ARIETTA
IBM
US WEST
BAUSCH & LOMB
FIRST UNION
WALT DISNEY
DELTA AIRLINES
18.875
73.500
50.875
43.625
54.250
47.750
44.500
52.875
SHARES
9,000
8,000
3,500
5,400
10,500
14,400
12,500
16,600
VALUE
WEIGHT BETA
169,875
88,000
178,063
235,575
569,625
687,600
556,250
877,725
3,862,713
.044
.152
.046
.061
.147
.178
.144
.227
100
1.00
.80
.50
.70
1.1
1.1
1.4
1.2
TIME
CASH
MAR.31 VS = $3,862,713
FUTURES
SEP SP500I FUTURES. F = 1,052.60.
VF = 1,052.60($250) = $263,300
3,862,713
n = - 1.06
= - 16.
263,300
*
JUL.27
VS = $3,751,307
TOTAL VALUE
$3,853,747.00
101
ANTICIPATORY HEDGE OF A
TAKEOVER
A firm intends to purchase 100,000 shares of
XYZ ON DEC.17.
DATE
SPOT
FUTURES
NOV.17
S = $54/SHARE
= 1.35
VF = 1,465.45($250)
VS = (54)100,000
= $5,400,000
5,400,000
$366,362.50
n= =
- 1.35
= - 20
366,362.50
*
S = $58/SHARE
PURCHASE 100,000 SHARES.
COST = $5,800,000
Gain: 20(1,567.45 - 1,465.45)$250
$5,800,000 - $510,000
= $52.9/SHARE
= $510,000
100,000
102
SPOT
FUTURES
2,606,250
n = - 1.1
= - 11
272,500
*
S = $17.125
V = $2,568,750
ACTUAL
103
VF
105
Proof:
VP VS nVF
(VP ) (VS ) n * (VF )
(VP ) (VS )
(VF ) (VS )
VF (VF )
n*
n*
.
VS
VS
VS
VS
VS VF
DEFINE
(VP )
rP
;
VS
(VS )
rS
;
VS
VF
ErP ErS n * ErF ErT
VS
and
(VF )
rF
.
VF
106
Again :
VF
E(rT ) E(rS ) n * E(rF ).
VS
VF
E(rT ) E(rS ) n
E(rF )
VS
*
VF
rf [E(rM ) rf ] n
[E(rM ) rf ]
VS
*
rf T [E(rM ) rf ]
*
108
VS
SHORT n* [ T ]
contracts .
VF
If T ; we wish to increase to T
LONG
VS
n* [ T ]
contracts .
VF
109
PRICE
BENEFICIAL CORP.
CUMMINS ENGINES
GILLETTE
KMART
BOEING
W.R.GRACE
ELI LILLY
PARKER PEN
40.500
64.500
62.000
33.000
49.000
42.625
87.375
20.625
SHARES
11,350
10,950
12,400
5,500
4,600
6,750
11,400
7,650
VALUE
WEIGHT
459,675
706,275
768,800
181,500
225,400
287,719
996,075
157,781
3,783,225
BETA
.122
.187
.203
.048
.059
.076
.263
.042
110
.95
1.10
.85
1.15
1.15
1.00
.85
.75
TIME
SPOT
FUTURES
AUG.29
V = $3,783,225.
DEC SP500I Fs
= 0.95.
= 1,079.8($250) = $269,950
3,783,225
n * = (1.25 - .95)
=4
269,950
LONG 4 DEC SP500I Futures
NOV.29
V = $4,161,500
F = 1,154.53
SHORT 4 DEC SP500I Futures
GAIN (1,154.53 - 1,079.8)(250)(4)
= $74,730
112
FOREIGN
CURRENCY:
THE SPOT MARKET
EXCHANGE RATES:
THE PRICE OF ONE CURRENCY IN
TERMS OF ANOTHER CURRENCY
IS THE EXCHANGE RATE 113
1
S(FC /FC ) =
1 2 S(FC /FC )
2 1
Example :
S(USD/EUR) = 1.4821
S(EUR/USD) .67476
1
1
= 1.4821 S(USD/EUR)
S(EUR/USD) .67476
115
ASK S(USD/FC)
1
S(FC/USD)
BID S(USD/FC)
S(GBP/USD)
S(USD/GBP)
S(USD/GBP)
S(GBP/USD)
ASK
BID
ASK
BID
BID
ASK
BUY
USD
GBP
S(GBP/USD)ASK S(USD/GBP)BID
= GBP 0.50
= USD 2.083
PAY
GBP
117
S(FC1/FC3)
S(FC1/FC2) =
S(FC2/FC3)
S(FC3/FC2)
=
118
S(FC3/FC1)
USD
GBP
CAD
EUR
MXN
USD
2.01400
0.989609
1.439200
0.092080
1
GBP
CAD
0.496524
0.491364
0.714597
0.045720
1.010500
2.03515
1
1.454310
0.093047
EUR
0.694830
1.39938
0
0.687611
0.063980
MX
N
10.86010
9
21.8723
0
10.74730
0
15.62990
0
119
USD
GBP
MXN
USA
1
2.01400
0.0920801
UK 0.496524 1
0.045720
MEX
10.860109 21.87230 1
120
S(GBP/MXN)
S(USD/MXN) =
S(GBP/USD)
S(USD/GBP)
=
.
S(MXN/GBP)
121
S(GBP/MXN) 0.045720.
S(GBP/USD) 0.496524.
S(USD/GBP) 2.014000.
S(MXN/GBP) 21.872300.
S(GBP/MXN) 0.045720
0.092080.
S(GBP/USD)
0.496524
S(USD/GBP)
2.014000
0.092080.
S(MXN/GBP) 21.872300
122
USD
GBP
CHF
U.S.A
1.0000
1.5640
0.5580
U.K
0.6394
1.0000
0.3546
SWITZERLAND
1.7920
2.8200
1.0000
THEORY :
S(GBP/USD)
= S(CHF/USD)
S(GBP/CHF)
BUT :
S(USD/GBP)
= S(CHF/GBP)
S(USD/CHF)
1.5640
= 2.8029 < 2.8200
0.5580
123
End.
USD1,000,000
USD1,006,134
0.6394
0.5580
GBP639,400
CHF1,803,108
2.8200
124
SPOT
USD1.997200/GBP
1 Month forward
USD1.995300/GBP
2 Months forward
USD1.993760/GBP
3 Months forward
USD1.992010/GBP
6 Months forward
125
SIZE
MINIMUM
FUTURES
CHANGE USD/FC
CHANGE F
JAPAN YEN
12.5M
.000001
USD12.50
CANADIAN DOLLAR
100,000
.0001
USD10.00
62,500
.0002
USD12.50
SWISS FRANC
125,000
.0001
USD12.50
AUSTRALIAN DOLLAR
100,000
.0001
USD10.00
MEXIAN PESO
500,000
.000025
USD12.50
BRAZILIAN REAL
100,000
.0001
USD10.00
EURO FX
125,000
.0001
USD12.50
BRITISH POUND
126
T- SEPTEMBER
SPECULATOR:
TIME
MAR 1
CASH
DO NOTHING
FUTURES
LONG n, CD SEP FUTURES
AT USD.6270/CD
AUG 20
DO NOTHING
127
HEDGING
IN THE FOLLOWING EXAMPLES WE USE
THE NAVE HEDGE RATIO:
h = 1.
Two ways:
1.n = NS/NF
2.n = VS/VF
128
A U.S. FIRM NEEDS TO BORROW USD200M FROM MAY 25, 2003 TO DECEMBER 20,
2003, FACES THE FOLLOWING DATA:
BID
ASK
SPOT:
USD1.25000/EUR
USD1.25100/EUR
DEC FUTURES:
USD1.25850/EUR
USD1.26000/EUR
ITALY:
6.7512%
6.9545%
USA:
8.6100%
8.75154%(360-day year)
Interest rates:
(365-day year)
129
TIME
SPOT
FUTURES
MAY 25
F = 1.26000
166,500,000
n
= 1,332
125,000
1
209,790,000
ln[
] = .0823, or 8.23%.
209/360 200,000,000
130
SPOT
FUTURES
JUL. 1
S(USD/GBP) = 1.3060
FOR F = USD1.2780/GBP
DO NOTHING
NOV. 1
h 1;
3,656,800
n=
= 46
62,500(1.2780)
S(USD/GBP) = 1.4420
COST = 28,000(1.4420)(100)
FOR F = USD1.4375/GBP
= USD4,037,600
131
TIME
SPOT
FUTURES
MAR. 1
S(USD/CHF) = .6369
AUG. 25
= USD2,388,375
CONTRACT = (.6514)125,000
DO NOTHING
= USD81,425.
S=USD.6600/CHF
F(SEP) = USD.6750/CHF
(375)(.6600)(10,000)
PROFIT(.6750 - .6514)125,000(30)
TOTAL $2,475,000.
= USD88,500.
2,388,375
n=
= 30
81,425
132
TIME
SPOT
FUTURES
MAY. 1
S(EUR/USD) = .87000
CURRENT VALUE:
F(DEC) = USD1.17EUR
= EUR43,500,000
43,500,000
n=
= 348
125,000
S=EUR.81300/USD
F(DEC) = USD1.29000/EUR
PAYMENT: EUR40,650,000.
PROFIT(1.29 1.17)(125,000)(348)
OCT. 26
=USD5,220,000
133
BID
SPOT:
USD.007020/JY
USD.007027/JY
(142.4501245)
142.3082396)
USD.007190/JY
USD.007185/JY
DEC FUTURES:
N = USD142,191,345/(JY12,500,000)(USD.007190/JY) = 1,582.
134
TIME
CASH
FUTURES
MAY 23
DO NOTHING
V = USD142,191,345
F(ask) = USD.007190/JY
S = USD.0080/JY
BUY MOTORCYCLES
FOR USD.0080/JY
FOR USD161,880,000
PROFIT: (.0080-.00719)12,500,000(1,582)
CASE I:
DEC 20
= USD16,017,750
NET COST: USD161,880,000 - USD16,017,750 = USD145,862,250.
CASE II:
DEC 20
S = USD.0065/JY
BUY MOTORCYCLES
FOR USD.0065/JY
USD131,527,500
LOSS: (.00719-.0065)12,500,000(1,582)
= USD13,644,750
135
CASH
FUTURES
F(JUN) = USD1.17675/EUR
F = 125,000(1.17675) = USD147,093.75
= USD2,981,019.28
n = 2,981,019.28/147,093.75 = 20.
DO NOTHING
136