1 Hedging: Long and Short èLong futures hedge appropriate when you will purchase an asset in the future and fear a rise in prices –If you have liabilities now, what do you fear? èShort futures hedge appropriate when you will sell an asset in the future and fear a fall in price –If you expect to issue liabilities, what do you fear? èLong futures hedge appropriate when you will purchase an asset in the future and fear a rise in prices –If you have liabilities now, what do you fear? èShort futures hedge appropriate when you will sell an asset in the future and fear a fall in price –If you expect to issue liabilities, what do you fear?

2 Arguments For Hedging èCompanies should focus on their main business and minimize risks arising from interest rates, exchange rates, and other market variables –Non-intrusive risk management tool èHedging may help smooth income and minimize tax liabilities èHedging may help smooth income and reduce managerial salaries èCompanies should focus on their main business and minimize risks arising from interest rates, exchange rates, and other market variables –Non-intrusive risk management tool èHedging may help smooth income and minimize tax liabilities èHedging may help smooth income and reduce managerial salaries

3 Arguments Against Hedging èWell-diversified shareholders can make their own risk management decisions èIt may increase business risk to hedge when competitors do not èExplaining a loss on the hedge and a gain on the underlying can be difficult èWell-diversified shareholders can make their own risk management decisions èIt may increase business risk to hedge when competitors do not èExplaining a loss on the hedge and a gain on the underlying can be difficult

4 Basis Risk èBasis is the difference between spot and futures prices èBasis risk arises because of uncertainty about the price difference when the hedge is closed out èBasis risk usually less than the risk of price or rate level changes èBasis risk depends on futures pricing forces èBasis is the difference between spot and futures prices èBasis risk arises because of uncertainty about the price difference when the hedge is closed out èBasis risk usually less than the risk of price or rate level changes èBasis risk depends on futures pricing forces

5 Choice of Hedging Contract èDelivery month should be as close as possible to, but later than, the end of the life of the hedge èIf no futures contract hedged position, choose the contract whose futures price is most highly correlated with the asset price –Called cross-hedging –Additional basis risk èDelivery month should be as close as possible to, but later than, the end of the life of the hedge èIf no futures contract hedged position, choose the contract whose futures price is most highly correlated with the asset price –Called cross-hedging –Additional basis risk

6 Naive Hedge Ratio èDivide the face value of the cash position by the face value of one futures contract èProblems: –Market values should be focus –Ignores differences between the cash and futures instruments èVariation: divide the market value of the cash position by the market value of one futures contract èDivide the face value of the cash position by the face value of one futures contract èProblems: –Market values should be focus –Ignores differences between the cash and futures instruments èVariation: divide the market value of the cash position by the market value of one futures contract

7 Minimum Variance Hedge Ratio èProportion of the exposure that should optimally be hedged is hedge per dollar of cash market value èHedge ratio estimated from: èProportion of the exposure that should optimally be hedged is hedge per dollar of cash market value èHedge ratio estimated from:

8 Hedging Stock Portfolios èIf hedging a well-diversified stock portfolio with a well-diversified stock index futures contract, what are implications? –No diversifiable risk in the cash stock portfolio and futures hedge removes systematic risk –Since no risk, systematic or unsystematic, what can an investor expect to earn by hedging a well-diversified stock portfolio? èIf hedging a well-diversified stock portfolio with a well-diversified stock index futures contract, what are implications? –No diversifiable risk in the cash stock portfolio and futures hedge removes systematic risk –Since no risk, systematic or unsystematic, what can an investor expect to earn by hedging a well-diversified stock portfolio?

9 èBut has all risk been eliminated? èProblems: –Stock portfolio being hedged may have a different price volatility than the stock-index futures –Hedging goal is not to reduce all systematic risk èPrice sensitivity to market movements determined by beta èBut has all risk been eliminated? èProblems: –Stock portfolio being hedged may have a different price volatility than the stock-index futures –Hedging goal is not to reduce all systematic risk èPrice sensitivity to market movements determined by beta Hedging Stock Portfolios

10 Hedging Stock Portfolios èOptimal number of contracts to hedge a portfolio is èFuture contracts can be used to change the beta of a portfolio –If  * >(<)  S, hedging implies a long (short) stock index futures position èOptimal number of contracts to hedge a portfolio is èFuture contracts can be used to change the beta of a portfolio –If  * >(<)  S, hedging implies a long (short) stock index futures position

11 Rolling The Hedge Forward èWhat if hedging further in the future than available delivery dates? èSeries of futures contracts used to increase the life of a hedge èEach time a futures contract matures, switch position into another, later contract –Basis risk, cash flow problems possible èWhat if hedging further in the future than available delivery dates? èSeries of futures contracts used to increase the life of a hedge èEach time a futures contract matures, switch position into another, later contract –Basis risk, cash flow problems possible