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! " LONG
!" Spot
Hedge
Market: asset will be bought (lose when price increases); !" Futures Market: LONG position (gain when price increases).
! " SHORT
!" Spot
Hedge
Market: asset will be sold (lose when price decreases); !" Futures Market: SHORT position (gain when price decreases).
Risk Factor
2."
"
3."
" "
15:
1 mil. Barrels crude oil at August 15
!" SELL
! !
Spot market:
"
August 15 (possibility 1)
SA15 = $17.50 which means + $17.5 mil. FA15 = $17.50 ~ close to the spot price because August is the delivery month
Futures market:
"
Profit: $18.75 - $17.50 = $1,25 / barrel i.e. + $1.25 mil. from the Futures position Result: $18.75 mil.
August 15 (possibility 2)
! !
Spot market:
"
Futures market:
"
FA15 = $19.50 ~ close to the spot price because August is the delivery month
Loss: $18.75 - $19.50 = $0.75 / barrel i.e. - $0.75 mil. from the Futures position Result: $18.75 mil.
undertake a one-year hedge transaction, an investor must sell oneyear futures. This is often difficult because a futures contract with this maturity tends to be illiquid. alternative is to hedge forward using more liquid, shorter maturity contracts.
! " One
Prediction is expensive;
!"
Usually companies make no prediction of market variables they need their cash flow to be certain.
!"
They hedge to avoid unpleasant price movements; Thus they focus on their main activities.
!"
Shareholders are usually well diversified and can make their own hedging decisions;
!"
!"
(Ex. build portfolio of copper producer and copper user companies.) However hedging might be more expensive for shareholders.
! !"
It may increase risk to hedge when competitors do not ! hedging becomes risky Explaining a situation where there is a loss on the hedge and a gain on the underlying can be difficult hedging strategies should be set by a companys board of directors and clearly communicated to companys management and shareholders.
b2
t1
t2
! !
that F1 : Initial Futures Price F2 : Final Futures Price S2 : Final Asset Price " You hedge the future purchase of an asset by entering into a long futures contract " Cost of Asset = S2 (F2 F1) = F1 + b2
If basis weakens hedgers position improves The lower the basis the better
! !
that: F1 : Initial Futures Price; F2 : Final Futures Price; S2 : Final Asset Price; " You hedge the future sale of an asset by entering into a short futures contract " Price Realized = S2+ (F1 F2) = F1 + b2
If basis strengthens hedgers position improves
assets vs. consumption assets; " The case of different asset in the hedging contract S2 + F1 F2 F1 + (S*2 F2) + (S2 S*2)
Basis if the asset being hedged were the underlying asset Basis from the difference between the 2 assets
Choice of Contract
!"
Choose a delivery month that is as close as possible to, but later than, the end of the life of the hedge; When there is no futures contract on the asset being hedged, choose the contract whose futures price is most highly correlated with the asset price. When the correlation is different from 1 we have the 2 components of basis.
!"
+
The payoff of S i.e. the hedged asset
!F
S0-!S
S0
S0+!S !S Price of underlying
We need to make the hedgers payoff as certain as possible i.e. we need to minimize its variance.
where "#S is the standard deviation of $S, the change in the spot price during the hedging period; #F is the standard deviation of $F, the change in the futures price during the hedging period; % is the coefficient of correlation between $S and $F.
h* = regression coefficient of !S on !F; Hedge effectiveness; Parameters are estimated from historical data; Ideally the length of each time interval is the same as the length of the time interval for which the hedge is in effect (we should have previous realizations of the change we try to estimate).
NA size of position being hedged (units); QF size of one futures contract (units); N* optimal number of futures contracts for * hedging hN *
N =
QF
If we have a portfolio that mirrors the index (we are long on the stocks that are in the index with the same weights) then the number of contracts that should be shorted is
P N = A
*
!"
P N =! A
*
where P is the value of the portfolio, & is its beta, and A is the value of the assets underlying one futures contract
22
Example
Value of S&P 500 is 1,000 Value of Portfolio is $5 million Beta of portfolio is 1.5 What position in futures contracts on the S&P 500 is necessary to hedge the portfolio?
Desire to be out of the market for a short period of 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.) Can do the same with a single stock when the investor feels the stock will outperform the market or an investment bank wants to protect its new issue against market moves.
2."
3."
Until now we used the futures contract to reduce the Beta to 0. What position is necessary to reduce the beta of the portfolio? (" > "*)
Short this to reduce beta to 0
P * P N = ! "! A A
*
What position is necessary to increase the beta of the portfolio? ("* > ")
Long this to increase beta to !*
P P N =! "! A A
* *
can use a series of futures contracts to increase the life of a hedge; time we switch from 1 futures contract to another we incur a type of basis risk (rollover basis).
!"
! " Each
Can postpone the rollover in the hope the basis will improve.