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Hedging Strategies Using Futures

ISSUES

ASSUME

3.1 Basic Principle

3.2 Arguments For and Against Hedging

3.3 Basis Risk

3.4 Cross Hedging

3.5 Stock Index Futures

3.6 Rolling the Hedging Forward


ISSUES

1. When is a short futures position appropriates

2. When is a long futures position appropriate

3. Which futures contract should be used

4. What is the optimal size of the futures position for reducing risk
ASSUME

1 Hedge-and forget

2 Futures contracts as forward contracts


3.1 Basic Principles-Short Hedge ()

A hedge involves a short position in futures.

A short hedge is appropriate when the


hedger already owns an assets and expects
to sell it at some time in the future.

A short hedge can also be used when an


assets is not owned right but will be
owned at some time in the future.
3.1 Basic Principles-Long Hedge ()

Hedges that involve taking a long position in a futures contract


are known as long hedges.

A long hedge is appropriate when a company knows it will have


to purchase a certain assets in the future and wants to lock a
price now.

Long hedge can be used to manage an existing short position.


3.2 Arguments For and Against Hedging

Hedging and Shareholders

1 Shareholders can do the hedging themselves.

It assumes that shareholders have as much


2 information about the risks faced by a company
as does the companys management.

Shareholders can do far more easily than


3
a corporation is diversify risk.
3.2 Arguments For and Against Hedging

Hedging and Competitors

If hedging is not the norm in a certain industry, it


may not make sense for one particular company to
choose to be different from all other.
3.2 Arguments For and Against Hedging

Change in Effect on price Effect on profits of Effect on profits of


gold price of gold jewelry TakeaChance Co. SafeandSure Co.

Increase Increase
Increase None

Decrease Decrease None Decrease

All implications of price changes on a


companys profitability should be taken into
account in the design of a hedging strategy
to protect against the price changes.
3.3 Basis Risk

1 The asset whose price is to be hedged may not be exactly


the same as the asset underlying the futures contract.

2 The hedger may be uncertain as to the exact when the


asset will be bought or sold.

The hedge may require the futures contract to be closed


3
out before its delivery month.

These problem gives rise to what is termed basic risk.


3.3 Basis Risk

The basis in a hedging situation is as follows:


Basis = Spot price of asset to be hedged Futures price of contract used
=SF

An increase in the basis is referred to a strengthening of the basis


.

A decrease in the basis is referred to as a weakening of the basis


3.3 Basis Risk
Suppose that
F1 : Initial Futures Price
Spot price F2 : Final Futures Price
S1 S2 : Final Asset Price

b1
b1 = S1 F1
b2 =S2 F2
F1
Long Hedge :
Futures price S2
b2 You hedge the future purchase of an asset by entering into a
long futures contract
F2
The effective price( ) that is paid with hedge is
S2 + F1 F2 = F1 + b2
basis risk()
Short Hedge :
You hedge the future sold of an asset by entering into a short
t1 t2 futures contract

Figure 3.1 Variation of basic over time The effective price( ) that is obtained for the asset
with hedge is S2 + F1 F2 = F1 + b2
3.3 Basis Risk

Choice of Contract

One key factor affecting basis risk is the choice of the futures contract
to be used for hedging. This choice has two components:
1. The choice of the assets underlying the futures contracts
2. The choice of the delivery month

A contract with a later delivery month is


usually chosen in these circumstances.
3.4 Cross Hedging
Calculating the Minimum Variance Hedge Ratio
()

S
h*
F
h* : Hedge ratio that minimizes the variance of the hedgers position.
: Coefficient of correlation between S and F
S : Change in spot price, S, during a period of time equal to the life of the hedge.
F : Change in future price, F, during a period of time equal to the life of the hedge.
S : Standard deviation of S

F : Standard deviation of F
3.4 Cross Hedging
Optimal Number of Contracts
()

h* NA
N* The futures contracts used should
QF have a face value of h* NA

NA : Size of position being hedged (unit)


QF : Size of one futures contract (unit)
N* : Optimal number of futures contracts for hedging
3.5 Stock Index Future

Hedging Using Stock Index Futures

P
N*
A
N*: Optimal number of futures contracts for hedging
P : Current value of the portfolio
A : Current value of one futures contract
: From the capital asset pricing model to determined
the appropriate hedge ratio
3.5 Stock Index Future

Example

Value of S&P 500 index =1000


S&P 500 futures price =1010
Value of portfolio = $5,000,000
Risk-free interest rate = 4% per annum
Dividend yield on index = 1% per annum One future contract is for
Beta of portfolio = 1.5 delivery of $250 times the index

Current value of one futures contract = 250*1000 = 250,000

Optimal number of futures contracts for hedging


P 5,000,000
N* 1.5 30
A 250,000
3.5 Stock Index Future

Value of index in
900 950 1 ,000 1,050 1,100
three months
Time to maturity
Futures price of
1,010 1,010 1,010 1,010 1,010
index today
1
( 0.04 0.01)
Futures price of index 900 e 12
902 952 1,003 1,053 1,103
in three months
The gain from the short futures position
Gain on futures
= 30* ( 1,010 902 ) *250 = $ 810,000
810,000 435,000 52,500 697,500
position 322,500
The loss on the index = 10 %
Return on market 9.750% The
4.750%
index pays 0.250%
a dividend of5.250%
0.25%per 310.250%
months
The risk-free interest rate = 1 % per 3 months
Expected return An investor in the index would earn = 9.75 %
Expected
7.625% return on portfolio
0.125% 7.375% 14.875%
on portfolio 15.125%
==$15,000,000*(1
+ 1.5*( 9.75 0.15125)
1 ) = 15.125 %
= $4,243,750
Expected portfolio
5,368,75
value in three months 4,243,750 4,618,750 4,993,750 5,743,750
0
(including dividends) =$ 4,243,750 + $810,000
Total expected value
5,046,25
of position in three 5,053,750 5,053,750 5,046,250 5,046,250
0
months
3.5 Stock Index Future

Reasons for Hedging an Equity Portfolio

A hedge using index futures removes the risk arising from market
and leaves the hedger exposed only to the performance of the
portfolio relative to the market.

The hedger is planning to hold a portfolio for a long period of time


and requires short-term protection.
3.5 Stock Index Future

Changing the Beta of a Portfolio

To reduce the beta of the portfolio to 0.75

P 5,000,000
( *) (1.5 0.75) 15( short )
A 250,000
To increase the beta of the portfolio to 2.0

P 5,000,000
( * ) (2 1.5) 10(long )
A 250,000
3.5 Stock Index Future

Exposure to the Price of an Individual Stock

Similar to hedging a well-diversified stock portfolio

The performance of the hedge is considerably worse,


only against the risk arising from market movements
3.6 Rolling The Hedge Forward

This involves entering into a sequence of futures


contracts to increase the life of a hedge

Rollover basis risk