Hedging Strategies Using Futures Chapter 4

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Hedging
Definition
risk reduction or avoidance, risk management establishing a position in the futures market that is "EQUAL & OPPOSITE" to a position in the actual commodity

Function
want to lock in the price or profit pass on price level risk to speculator taking relatively less basis risk
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Long Hedge (1)

Situation :
Anticipatory or procurement hedge You will purchase an asset in the future and want to lock in the price Procurement cost = S1 (F1 F0) = F0 + B1
Date t=0 t=1 Total Spot (Short at S0) Long at S1 S1 Futures Long at F0 Short at F1 F1 F0 Basis B0 = S0 F0 B1 = S1 F1
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Long Hedge (2)

Situation :
Margin fixing hedge You short sell an asset and will buy it back in the future and want to lock in the margin Margin = (S0 S1) + (F1 F0) = B0 B1
Date t=0 t=1 Total Spot Short sell at S0 Long at S1 S0 S1 Futures Long at F0 Short at F1 F1 F0 Basis B0 = S0 F0 B1 = S1 F1 B0 B1
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Short Hedge (1)

Situation
Anticipatory or sales hedge You will sell it in the future and want to lock in the price Sales price = S1 + (F0 F1) = F0 + B1
Date t=0 t=1 Total Spot (Long at S0) Short at S1 S1 Futures Short at F0 Long at F1 F0 F1 Basis B0 = S0 F0 B1 = S1 F1
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Short Hedge (2)

Situation
Inventory hedge You hold an asset now and will sell it in the future and want to lock in the margin Sales margin = (S1 S0) + (F0 F1) = B1 B0
Date t=0 t=1 Total Spot Long at S0 Short at S1 S1 S0 Futures Short at F0 Long at F1 F0 F1 Basis B0 = S0 F0 B1 = S1 F1 B1 B0
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Basis Risk
Arises since there may be difference between SP & FP when hedge is closed out
transportation cost, quality, etc.

Var(SP) >> Var(Basis)

volatility(level) >> volatility(difference) Always workable for hedging

Is it possible to hedge basis risk?

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Hedging Rules using Basis (1)

A SHORT HEDGER IS LONG THE BASIS. (1) prefers when basis is wider than normal (SP < FP) and expected to increase (2) makes profit if basis narrows or increases, or SP rises relative to FP (3) makes loss if basis widens or decreases, or SP drops relative to FP
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Hedging Rules using Basis (2)

A LONG HEDGER IS SHORT THE BASIS. (1) prefers when basis is narrower than normal (SP < FP) and expected to decrease (2) makes loss if basis narrows or increases, or SP rises relative to FP (3) makes profit if basis widens or decreases, or SP drops relative to FP
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Illustration : Short Hedge

Assuming contango (SP < FP)
SP,FP FP SP,FP FP SP t t

SP

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Example : Short Hedge

(1) What if X = 18.10? (2) What if X = 18.05? (B narrows or soars) (3) What if X = 18.15? (B widens or drops) (4) What if in backwardation?
Date t=0 t=1 Total Spot Long at $20.00 Short at $18.00 18.00 20.00 = 2.00 Futures Short at $20.10 Long at $X 20.10 X = ? Basis $0.10 under ? ?
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Attractiveness of Hedging
(1) Without basis risk (constant basis), you always get S0 as an effective price (2) You dont need to predict future price, and just need to judge current price level (3) Hedging is never risky nor costs too high, What if comparing with speculation?
No hedging implies speculation on spot

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Choice of Contract
Choose most highly correlated with the asset price
Cross hedging : futures contract not directly corresponding to the asset being hedged

Choose a delivery month that is as close as possible to the end of the life of the hedge
Also futures expiry date > end of hedge life

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Strip vs Stack Hedges

Choice of contract also depend on liquidity () risk exposure period Strip hedge : exposure > contract expiry
Crude oil trade of 36 months with futures as far as 17 months

Stack hedge : exposure < contract expiry

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Illustration
Strip hedge
Contract expiry Risk exposure

Stack hedge

Contract expiry Risk exposure

4-15

Rolling Hedge Forward

A series of futures to increase hedge life
switches from one contract to another incurs a type of basis risk

Rolling over short futures :

(F0,1 F1,1) + (F1,2 F2,2) + (F2,3 F3,3) = 1.70
[0.80] 18.20 17.40 17.00 [0.50] 16.50 16.30 [0.40]

15.90
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Optimal Hedge Ratio

Proportion of the exposure that should optimally be hedged
h=

S = SF S = SF 2 F SF F F

Equivalent to simple OLS coefficient of

S t = + Ft + t = 2
SF F
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Hedging Effectiveness
Proportion of the variance that is eliminated by hedging
2 Var ( S ) Var ( R * ) Var ( R * ) 2 F E = = 1 = h 2 = 2 Var ( S ) Var ( S ) S *

Var ( S ) = Var of unhedged position Var ( R * ) = Var of minimum risk portfolio

Equivalent to coefficient of determination, R2 from the simple OLS

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Hedging Using Index Futures

To hedge the risk in a portfolio the number of contracts (N) that should be shorted is N = *(P/A)
: beta of (Rp rf) regressed on (Rm rf) P : value of the portfolio A : value of the stocks underlying futures contract

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Example
Situation : to hedge the value of S&P 500 over the next 3 months
current value of portfolio = $5 million current value of S&P 500 = 1,000 (pt) futures on S&P500 = $250 x index beta of portfolio = 1.5 risk-free interest rate = 10%/yr dividend yield on index = 4%/yr

If the value of S&P 500 in 3 months turns out to be 900, the expected value of hedge?
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Step (1) : Futures Position

How many futures contracts on S&P?
1.5 x [5,000,000/(250 x 1,000)] = 30

Current futures prices?

F(0,4) = S0e(r-q)T = 1,000e(0.10-0.04)x(4/12) = 1,020.20

Futures prices in 3 months?

F(3,4) = 900e(0.10-0.04)x(1/12) = 904.51

Gains from short positions in futures?

30 x (1020.20 904.51) x 250 = $867,676
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Step (2) : Spot Position

Expected return (%) on the portfolio?
loss on index = -[10 4 x (3/12)] = -9% rf for 3 months = 10 x (3/12) = 2.5% using CAPM pricing (Rp rf) = (Rm rf) Rp = 2.5 + [1.5 x (-9.0 2.5)] = -14.75

Expected value of portfolio in 3 months?

$5,000,000 x (1 0.1475) = $4,262,500

Expected value of spot and futures?

$4,262,500 + $867,676 = $5,130,176
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Step (3) : More Important?

If the value of S&P 500 in 3 months turns out to be 900 => 1,000 => 1,100, the expected value of hedge? Guess
gains of cash increase, losses of futures increase

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Reasons for Hedging an Equity Portfolio

To hedge systematic risk
Appropriate when you feel that you have picked stocks that will outperform the market, but uncertain the market as a whole

To be out of the market for short period

Hedging may be cheaper than selling the portfolio and buying it back
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Arguments in Favor of Hedging

Companies should focus on the main business they are in and take steps to minimize risks arising from market
interest rates, exchange rates, and other market variables

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Arguments against Hedging

Shareholders are usually well diversified and can make their own hedging decisions It may increase 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
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Assignment
Ch.4 (p.96) : 4-21. to 4-24.
: 1018 1-2(1) : 4-5 40 ( )

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