Hedging Strategies Using Futures Chapter 3 (all editions)

Hedging Strategies Many investors in futures markets are hedgers (farmer and Kellogg’s) Perfect hedge eliminates all risk but is rare When is a short/long futures position appropriate? Which futures contract to use? What is the optimal contract size? Hedge and forget strategy: no attempt is made to adjust the hedge with the change in the price of the underlying asset

Long & Short Hedges A long futures hedge is appropriate when you know you will purchase an asset in the future and want to lock in the price A short futures hedge is appropriate when you know you will sell an asset in the future & want to lock in the price

Arguments in Favor of Hedging 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

Arguments against Hedging Shareholders are usually well diversified and can make their own hedging decisions Explaining a situation where there is a loss on the hedge and a gain on the underlying can be difficult, pg 52 (old text), pg 50 (new text)

Basis Risk Hedging is not quite straightforward: –Asset to be hedged may not be the same as the asset underlying the futures contract –Hedger uncertain of exact date to buy/sell asset –Futures contract may have to be closed before the delivery month Basis risk arises because of the uncertainty about the basis when the hedge is closed out If asset to be hedged and asset underlying futures contract are the same, basis is zero at expiration Basis is the difference between spot & futures Basis = Spot price – Futures price

Convergence of Futures to Spot If the asset to be hedged and the asset underlying the futures contract are the same, the basis should be zero at the expiration of the futures. Time (a)(b) Futures Price Futures Price Spot Price

Long Hedge Suppose that F 1 : Initial Futures Price F 2 : Final Futures Price S 2 : Final Asset Price You hedge the future purchase of an asset by entering into a long futures contract Cost of Asset = S 2 –( F 2 – F 1 ) = F 1 + Basis If the basis strengthens, the hedger’s position _________.

Short Hedge Suppose that F 1 : Initial Futures Price F 2 : Final Futures Price S 2 : Final Asset Price You hedge the future sale of an asset by entering into a short futures contract Price Realized= S 2 + ( F 1 –F 2 ) = F 1 + Basis If the basis strengthens, the hedger’s position _________.

Choice of Contract Key factor affecting basis risk is the choice of the futures contract and choice of delivery month Choose a delivery month that is as close as possible to, but later than, the end of the life of the hedge (futures price are erratic during the delivery month Cross hedging: occurs when asset underlying the futures contract is different from the asset to be hedged

Cross Hedging Hedge ratio: ratio of the size of the position taken in futures contracts to the size of the exposure where  S is the standard deviation of the change in the spot price during the hedging period  F is the standard deviation of the change in the futures price during the hedging period  is the coefficient of correlation between  S and  F. When cross hedging, choose a value for the hedge ratio that minimizes the variance of the value of the hedged position

Optimal Number of Contracts Optimal number of contracts: –N A size of position being hedged –Q F size of one futures contract –N* optimal number of futures contracts hedged –Example on pg. 60 (old text), pg 59 (new text)

Hedging Using Index Futures Stock index futures can be used to hedge an equity portfolio To hedge the risk in a portfolio the number of contracts that should be shorted is where P is the value of the portfolio being hedged,  is its beta, and A is the value of the assets underlying one futures contract, pg 64 (old); pg 62 (new)

Reasons for Hedging an Equity Portfolio Desire to hold portfolio for a long time (Hedging may be cheaper than selling the portfolio and buying it back.) Desire to hedge systematic risk (Appropriate when you feel that you have picked stocks that will outperform the market.)

Questions (all editions): 3.1, 3.2, 3.6, 3.7, 3.10, 3.16, 3.18