307

13
Futures Hedging
13.1 Introduction

13.5 Futures versus Forward Hedging

13.2 To Hedge or Not to Hedge

13.6 Spreadsheet Applications:

Computing h

Should the Firm or the Individual

Hedge?
The Costs and Benefits of Corporate
Hedging
EXTENSION 13.1 Airlines and Fuel
Price Risk
EXTENSION 13.2 A Hedged Firm
Capturing a Tax Loss

13.3 Hedging with Futures

Perfect and Imperfect Hedges
Basis Risk
Guidelines for Futures Hedging

13.4 Risk-Minimization Hedging

The Mean-Variance Approach
Limitations of Risk-Minimization Hedging

13.7 Summary
13.8 Appendix
Deriving the Minimum-Variance Hedge
Ratio (h)
Computing the Minimum-Variance
Hedge Ratio (h)
Statistical Approach
Econometric Approach: A Linear
Regression Model

13.9 Cases
13.10 Questions and Problems

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13.1

Introduction

The novelist Dostoyevsky perceptively observed in The Gambler: as for profits and
winnings, people, not only at roulette, but everywhere, do nothing but try to gain
or squeeze something out of one another. This aptly defines a zero-sum game of
which, excluding transaction costs, futures trading is an excellent example. There
is a pool of talented futures traders who earn a living from this business thereby
depressing the chances of winning for ordinary traders who lose money on average.
Then, why trade futures?
Cynics give a facile explanation: people are into commodities because its as
thrilling as going to the casinos. True to circus-owner P. T. Barnums immortal
quote that theres a sucker born every minute, these gamblers gladly lose for the
joy of the ride. Perhaps others believe that they really can win the futures game. We
know no surefire strategy. Even if you stumble on such a strategy, repeated use will
destroy its efficacy. So, why trade futures?
In reality, most futures contracts are traded to hedge risks that preexist in some
line of business, and hedgers are willing to give up expected returns as payment for
this insurance. We discussed this issue in the context of normal backwardation
in chapter 12. For example, Figure 13.1 shows a man selling goods on some tourist
spot, perhaps a beach. If he chooses his wares wisely, say, by carrying an assortment
of umbrellas and sunglasses, then he has hedged well. Come rain or come shine,
he has something to sell. If this is not possible, he could use futures to manage
these risks. For example, he could sell only umbrellas and buy futures on a sunglass
companys stock, instead of selling sunglasses.
Who hedges? A majority of the Fortune 500 companies and a growing number
of smaller firms hedge risk. Farmers often hedge the selling price of their produce.
Many producers hedge input as well as output price riskchapter 1 gave us an
inkling of derivatives usage by the consumer product giant Procter & Gamble.
This chapter explores the reasons for hedging, discusses its cost and benefits,
and introduces futures hedging strategies. We discuss perfect and cross hedges,
long and short hedges, and risk-minimization hedging using standard statistical
techniques.

13.2

To Hedge or Not to Hedge

Unfortunately, there is no general answer to what may be phrased as (with apologies

to the immortal William Shakespeare) to hedge or not to hedgethat is the question.
We can only discuss hedgings benefits and costs.

Should the Firm or the Individual Hedge?

The classic Modigliani and Miller (M&M) papers argued that debt policies do
not affect firm value. This irrelevance follows because a shareholder can replicate
such policies herself by trading stocks in otherwise identical firms. Therefore the
no-arbitrage principle ensures that these companies, differing only in their debt

TO HEDGE OR NOT TO HEDGE

FIGURE 13.1: Wisely Hedged: Come Rain, Come Shine, He

Has Something to Sell*

Umbrellas $10

Umbrellas $10
Sunglasses $15
Inspired by a 1980s newspaper advertisement.

policies, must have equal value. The same argument can be applied to a firm hedging its balance sheet risks giving intellectual support to the irrelevance of hedging.
However, the M&M results rely on several key assumptions, including no market
frictions (including bankruptcy costs), no taxes, and no information asymmetry.
In the real world, these assumptions fail to hold. Consequently, if reducing the
firms risk is in the shareholders best interest, then a firm can usually do a better
job of hedging than individual investors. Indeed, a company (1) is likely to have
lower transaction costs; (2) can trade larger contracts than a shareholder; (3) can
dedicate competent personnel to hedging; (4) can hedge by issuing a whole range
of securities, which individuals cannot; (5) may have private information about the
companys risks; and (6) can hedge for strategic reasons that lie beyond an ordinary
investors knowledge. In all these cases, a company creates more value than an individual investor hedging on her own. But hedging is costly to implement, both in
developing and retaining the relevant expertise within the firm, and in executing
the transactions.

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The Costs and Benefits of Corporate Hedging

A hedged business has fewer risks to worry about, but exactly why is this an advantage? Arent businesses supposed to take risks? We answer these questions next,
and although we focus on the use of futures, many of these same benefits can be
obtained with other derivatives such as forwards, options, and swaps:
1. Hedging locks in a future price. Recall chapter 8, in which we discussed the establishment of the Chicago Board of Trade. The CBOT built orderly markets for grain
trading to avoid price crashes at harvest times and booms afterward. Hedging
with futures helps smooth such demandsupply imbalances. It allows traders to
lock in stable prices and plan production and marketing activities with greater
certainty.
2. Hedging permits forward pricing of products. For example, many airlines routinely
hedge aviation fuel prices, which is a major input cost. If fuel costs can be fixed
(and other costs, such as staff salary, airplane depreciation, airport gate rental
charges, and travel agents commissions, can be estimated in advance), then the
airline can better set a profit margin and determine future seat prices. Customers
like knowing travel costs far in advance.
3. Hedging reduces the risk of default and financial distress. Default means a failure
to pay a contractual payment, such as debt, when promised. Default triggers unfavorable outcomes such as lawyer fees, potential bankruptcy costs and liquidation fees, losing control over the companys assets, and increased costs of doing
business because suppliers fear that they may not be paid and customers may
worry about quality and service. These are called financial distress costs. A company can reduce the likelihood of incurring these costs by hedging some of the
risks it faces.
4. Hedging facilitates raising capital. Because of the decreased risk of default, bankers allow hedgers to borrow a larger percentage of a commoditys value at a lower
interest rate than nonhedgers. This same logic applies to firms.
5. Hedging enables value-enhancing investments. Froot et al. (1994) argue that if external sources of funds (like stock and bond issuances) are costlier to corporations than internally generated funds, then hedging can help stabilize internal
cash flows and make them available for attractive investment opportunities.
6. Hedging reduces taxes. A hedge may be used to capture the benefits of a tax loss
or take advantage of a tax credit. The basic intuition is simple. Because one can
use a tax loss or a credit only when the company has positive profits, it may be
worthwhile to smooth out profits by hedging rather than letting them fluctuate.
See Extension 13.2 for an example that illustrates this notion.
However, hedging also incurs costs. When trading with a speculator, a hedger
often pays an implicit fee by trading at a price inferior to the expected future
payoff. Of course, brokers must also be paid. The presence of these trading costs
constitutes a basic argument against futures hedging. Moreover, businesses must
allocate valuable personnel to devise hedging strategies, set up adequate checks and
balances to prevent rogue employees from ruinously speculating with the firms

TO HEDGE OR NOT TO HEDGE

311

money, ensure compliance with the laws of the land, and meet the governments
accounting requirements in this regard.1
Hedging is analogous to purchasing an insurance policy on some commoditys
spot price. It pays off when spot prices move in an adverse direction. However, as
with all insurance policies, there is a costthe premium. If the spot price does not
move adversely, one pays for insurance not used. Risk-averse individuals buy insurance despite this cost, and analogously, firms often hedge.
To hedge or not to hedge remains an unsettled question that must be resolved
on a case-by-case basis. One often hears any number of catchy maxims: no risk,
no gain alongside risk not thy whole wad. Which to choose requires expertise,
finesse, and knowledge, which are acquired through study and experience.

EXTENSION 13.1: Airlines and Fuel Price Risk

In August 2006, US president George W. Bush gathered his economic team in the picturesque retreat of
Camp David. Although the economic outlook was strong, the newly appointed secretary of the treasury,
Henry M. Paulson Jr., previous chairman and CEO of the Wall Street firm Goldman Sachs, was worried
about the likelihood of a financial crisis. If you look at recent history, there is a disturbance in the capital
markets every four to eight years, observed Paulson, as he painted a picture of how an enormous amount
of leverage and risk had accumulated in the financial system. In reply to a presidential query as to how this
risk can be reduced, the secretary gave a quick primer on hedging. He cited as an example that airlines
might want to hedge against rising fuel costs by buying futures to lock in todays prices for future needs
(Paulson, 2010).
Indeed, fuel costs can hit the airlines hard. Fuel is a major cost of the airline business; it can be between 10
percent (in good times) and more than 35 percent (in bad times) of their average expenses.2
When the going gets tough, the tough get going goes a familiar saying. As the oil price went up, the airlines
adopted a wide range of measures, some prudent and others drastic, to reduce fuel consumption. Most of these
approaches aimed at lowering the aircrafts weight because a lighter plane is cheaper to fly. Other steps included
flying more fuel-efficient planes and reducing the time that plane engines stay on. Some started trading commodities. Many commercial airlines as well as companies like FedEx (which uses its extensive fleet to quickly deliver
packages to numerous locations around the globe) use derivatives on crude oil to hedge. The hedged amount varies. Sometimes they hedge little or none of their exposure; at other times they hedge much more (see Table 13.1 for
a description of the fuel hedging situation in early 2005 for major US airlines, ranked in terms of passenger traffic).
Annual reports of companies mention their derivatives exposure. Southwest Airlines maintained its long
track record of profitability into the new millennium by extensive hedging even at a time when many other
airlines were reeling from losses and operating under bankruptcy protection. Consider the 2007 annual report
of Southwest Airlines, which gleefully gloats,
2

www.iata.org/index.htm.

Barings Bank, one of Englands oldest and most prestigious merchant banks, founded in 1762 by Sir
Francis Baring, collapsed in 1995 after a rogue employee, Nick Leeson, lost $1.4 billion of company
money speculating in futures contracts. Nowadays, most companies have stronger oversight of the
firms overall risk situation through the office of a chief risk management officer, who often reports
directly to the chief executive officer.

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TABLE 13.1: Fuel Hedge and Potential Impact of Fuel Price Increases for Leading

US Airlines (Ranked by Size in Terms of Passenger Traffic) in 2005a

Airlines

Hedging Situation (2005)

Impact of Fuel Price Increase (2005 or Earlier)

American
Airlines

15% hedged in first quarter, not

at all in remaining quarters

United Airlines

11% hedged for 2005, at about

$1.27 per gallon, excluding taxes

Delta Airlines

Not hedged

Every 1 cent rise in the average jet fuel price per gallon
increases its liquidity needs by about $25 million per year

Northwest
Airlines

Hedged about 25% for the first

quarter and 6% for the full year

A 1 cent change in the cost of each gallon of fuel impacts

operating expenses by about $1.6 million per month

Continental
Airlines

Not hedged

Annual fuel costs will increase by $40 million for each $1

increase in crude oil prices (rose by about $14 a barrel in
2005); also liable to pay regional carrier ExpressJets fuel
costs above 71.2 cents a gallon

Southwest
Airlines

85% hedged with derivatives

that cap prices at $26 a barrel
(current market price: over $57
a barrel)

Expects first-quarter fuel costs with hedge to exceed fourth

quarters 89.1 cents average price per gallon

US Airways

No fuel hedged as of December

31, 2004

About a $2 million increase per month, representing about

4% of its 2005 jet fuel requirements

America West
Airlines

45% hedged for the rest of this

year and 2% hedged for 2006

A 1 cent per gallon increase in jet fuel prices increases its

annual operating expense by $5.7 million

Alaska Airlines

50% hedged for 2005

A 1 cent per gallon increase in jet fuel prices increases its

annual operating expenses by about $4.0 million

JetBlue Airways

22% hedged for 2005

Negative impact on fuel costs from 33.7 cent per gallon

increase in jet fuel in 2004: $1 billion

Based on US Airlines Face Billions in Extra Fuel Costs, Airwise News, March 17, 2005.

We were well prepared and recorded our 35th consecutive year of profitability, a record unmatched in commercial
airline history. . . . Jet fuel prices have been rising every year for the last five years. Our fuel hedging program has
consistently mitigated such price increases dating back to year 2000. Since then, in each year, we have striven to
hedge at least 70 percent of our consumption. In 2007, we were approximately 90 percent protected at approximately $51 a barrel. That protection saved us $727 million last year and limited us to an 11.3 percent increase in
the economic cost per gallon, year-over-year. . . . A year ago, crude oil was hovering around $50 a barrel. By fourth
quarter 2007, crude oil prices had skyrocketed to $100 a barrel. Fortunately, we are again well hedged for 2008 with
approximately 70 percent of our fuel needs protected at approximately $51 a barrel.

Buoyed by a successful derivatives hedging program, Southwest did a brand-strengthening exercise in 2008
that hit the competition hard. It ran newspaper ads boasting its low airfare with no hidden fees, and its website
took snipes at the rivals by proudly proclaiming, Low fares. No hidden fees. No first checked bag fee. No

TO HEDGE OR NOT TO HEDGE

313

second checked bag bee. No change fee. No window or aisle seat fee. No curbside check-in fee. No phone
reservation fee. No snack fee. No fuel surcharge.3
Its hard to question successful hedging programs! But Southwest is also a very well-run company. The
annual report notes that its on-time performance, few flight cancellations (less than 1 percent of flights scheduled), and small number of complaints filed with the US Department of Transportation placed it in the front
rank in the airline industry.
Unfortunately, the tables turned. For the first quarter of 2009, Southwest reported a net loss of $91 million,
including special charges totaling $71 million (net), relating to non-cash, mark-to-market and other items
associated with a portion of the Companys fuel hedge portfolio.4 The companys CEO, Gary C. Kelly, stated
in a press release dated April 16, 2009,
We benefited from significantly lower year-over-year economic jet fuel costs in first quarter 2009. Even with $65
million in unfavorable cash settlements from derivative contracts, our first quarter 2009 economic jet fuel costs
decreased 16.2 percent to $1.76 per gallon. With oil prices rising, we have begun to rebuild our 2009 and 2010 hedge
positions, using purchased call options, to provide protection against significant fuel price spikes.

The press release also noted about Southwest:

The Company has derivative contracts in place for approximately 50 percent of its second quarter 2009 estimated
fuel consumption, capped at a weighted average crude-equivalent price of approximately $66 per barrel; approximately 40 percent for the remainder of 2009 capped at a weighted average crude-equivalent price of approximately $71 per barrel; and approximately 30 percent in 2010 capped at a weighted average crude-equivalent price
of approximately $77 per barrel. The Company has modest fuel hedge positions in 2011 through 2013.

Southwests hedging experience demonstrates the difficulties in distinguishing hedging from speculation
and illustrates that even well-considered actions do not always deliver favorable outcomes.
3

www.southwest.com.

Southwest Airlines Reports First Quarter Results, www.southwest.com.

EXTENSION 13.2: A Hedged Firm Capturing a Tax Loss

Hedging with derivatives expands a companys choices and may allow it to take advantage of tax situations.
The next example shows how futures contracts can be used to stabilize earnings so that a company can utilize
past losses to reduce current taxes.

EXAMPLE 1: Hedging to Capture a Tax Loss

O

Goldmines Inc. (fictitious name) mines, refines, and sells gold in the world market. The companys profits
move in tandem with gold price movements. Assume that the pretax profit is $100 million when gold prices
go up (which happens with a 50 percent chance) and 0 if gold prices go down (which also happens with a 50
percent chance). Alternatively, Goldmines can hedge with gold futures and have a known profit of $48 million.

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CHAPTER 13: FUTURES HEDGING

Figure 13.2 shows these payoffs. We label them as event 1 (profit $100) and event 2 (profit $0). These events
are shown in a binomial tree, where the payoff $100 is placed on the upper branch of the tree, while $0 is
placed on the lower branch.

Computing an Expected Value

O

To compute the companys expected profit multiply each events payoff by its respective probability and
then add across events:
The expected payoff

[(Probability of high gold price)  (Payoff $100)]  [(Probability of low gold price)

(Payoff $0)]

0.50 
$100 
0.50 
0

$50
for the unhedged company.

O

We can show the superiority of the hedging strategy by computing the expected after-tax profits for the
unhedged and hedged firm under different scenarios.

After-Tax Expected Profits (Simple Case)

O

Assume that the tax rate is 30 percent. When the gold price is high, $100 million pretax profit gives an aftertax profit of 100 
(1 
tax rate) 
$70 million. When the gold price is low, the pretax profit is 0, and so is
the after-tax profit. After-tax profits are shown in Figure 13.2.
Expected after-tax profit for unhedged firm

[(Probability of high gold price) 
(After-tax profit when the gold price is high)]

[(Probability of low gold price) 
(After-tax profit when the gold price is low)]

0.50 
70  0.50 
0

$35 million

O

The hedged firm makes a profit of $48 million irrespective of the gold price:
After-tax profit for hedged firm

48 
0.7

$33.6 million

O

The company can choose either. The actual choice depends on the risk preferences of the companys
management and shareholders.

After-Tax Expected Profits (When $25 Million Tax-Deductible Loss Is Carried Forward)
O

Now suppose that the company has accumulated losses totaling $25 million. It can deduct this loss from
this years profit and thus lower the tax burden. Such strategies of tax reduction are known as tax shields.

O

Assume that if unutilized, this one-shot opportunity disappears. We will show that the hedged firm can
always utilize the losses to lower its taxes, but the unhedged firm can only do this half the time.

O

For the unhedged firm, total tax when the gold price is high is
(Pretax profit 
Loss deducted)

(Tax rate)

(100 
25)

0.3

$22.5 million

TO HEDGE OR NOT TO HEDGE

315

FIGURE 13.2: Profits of a Hedged and an Unhedged Firm

Pre-Tax Profit
0.5

$100.00
Hedged Firm

Unhedged Firm

$48

0.5

0
Expected profit of the unhedged firm = 0.5 100 + 0.5 0 = $50 million
Expected After-Tax Profit (with No Loss Carried Forward)
0.5

$70.00
Hedged Firm

Unhedged Firm

$33.60

0.5

0
Expected profit = $35 million

Expected After-Tax Profit (with $25 Million Tax Deductible Loss)

0.5

$77.50

Unhedged Firm

Hedged Firm

$41.10

0.5

0
Expected profit = $38.75 million

The total tax when the gold price is low is 0. Consequently, the after-tax profit is (100 
22.5) 
$77.5 million
when the gold price is high and zero when it is low (see Figure 13.2):
Expected after-tax profit for the unhedged firm

[(Probability of high gold price)

(After-tax profit when gold price is high)]
 [(Probability of low gold price)

(After-tax profit when gold price is low)]

0.50

77.5  0.50  0

$38.75 million

O

By contrast, the total tax for the hedged firm is (48  25)  0.3  $6.90:
After-tax profit for the hedged firm
 (48  6.90)
 $41.10 million

O

Clearly hedging is a superior strategy: not only does the hedged firm generate greater after-tax profit but it
also removes swings and stabilizes this amount.

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CHAPTER 13: FUTURES HEDGING

13.3

Hedging with Futures

Chapter 4 gave us an inkling of how a company can use forward contracts for
hedging input and output price risks. Now that you are more familiar with the
workings of a futures contract (which are easier to use than forward contracts),
let us explore hedging with futures.

Perfect and Imperfect Hedges

Ours is an imperfect world, in which it is hard to find perfect hedges. A perfect
hedge completely eliminates spot price risk for some commodity. This happens
when (1) the futures is written on the commodity being hedged, (2) the contract
matures when you are planning to lift the hedge, and (3) the contract size and the
other characteristics of a futures unerringly fit the hedgers need. Imperfect or
cross hedges occur when these three conditions are not satisfied. For example, a
bank may reduce the price risk of its loan portfolio, which is vulnerable to interest rate changes, by trading Treasury bond futures contracts. This is a cross hedge
because the futures is written on US Treasury bonds, whereas the loans being
hedged consist of, say, house mortgages, car loans, and certificates of deposit. Even
when futures on the same commodity are available, the issue of a timing mismatch
may occur. Consequently, basis risk emerges as a paramount concept in analyzing,
setting, and managing a futures hedge.

Basis Risk
Basis risk is a focal point in understanding futures hedges. The basis is defined
as the difference between the spot and the futures price. It is written as
Basis  Cash price  Futures price. The next example shows how crucial basis
risk is when hedging a commoditys spot price risk. We illustrate this in the
context of two companies using buying and selling hedges to offset input and
output risks, respectively.

EXAMPLE 13.1: A Gold Futures Basis Risk

O

O

Today is January 1, which is time 0. Consider the gold futures contract trading on the COMEX
Division of the CME Group described in chapter 8. The prices are reported on a per ounce basis.
Figure 13.3 gives the timeline and the various prices. For simplicity, we assume that no interest is
earned on margin account balances.
On todays date, the spot price of gold S  $990, and the June contracts futures price F(0)  $1,000.
The basis is
b(0)  Spot price S(0) 
Futures price F(0)
 990 
1,000
 
$10

HEDGING WITH FUTURES

FIGURE 13.3: Timeline and Prices for Gold Futures Hedging Example

O

Start date
(January 1)
Time 0

Closing date
(May 15)
Time T

Delivery period
(June)

Spot price, S(0) = $990

Futures price, F(0) = $1,000
Basis, b(0) = S(0) F(0) = $10

S(T) = $950
F(T) = $952
b(T) = S(T) F(T) = $2

The delivery period for the contract is in June. For the subsequent discussion, suppose that on May
15, time T, the spot price S(T) is $950 and the June futures price F(T) is $952. The new basis is
b(T)  S(T) 
F(T)
 950 
952
 
$2

Goldmines Inc. Sets Up a Short Hedge

O

Suppose that the mining company Goldmines Inc. goes short June gold futures contracts on January
1 to hedge its output price risk. The company sells gold and lifts the hedge by closing out the futures
position on May 15.

O

Goldmines sells gold for $950, but it makes 
[F(T) 
F(0)]  
(952 
1,000)  $48 on the futures
position. So the effective selling price on May 15 is (see expression [9.1b] of Chapter 9)
Spot cash flow  Futures cash flow
 950  48
 $998

O

One can rewrite this as

Spot 
(Change in futures prices)
 S(T) 
[F(T) 
F(0)]
 [S(T) 
F(T)] 
F(0)
 New basis  Old futures price

(13.1)

No matter when the company closes its position, the old futures price is fixed, and only the new basis
affects profits.

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Jewelrygold Inc. Sets Up a Long Hedge

O

Now look at the same problem from the perspective of a jewelry maker, Jewelrygold Inc. As discussed
in chapter 4, the company can reduce input price risk by setting up a long hedge (a buying hedge) and
going long gold futures. When it is time to buy gold in the spot market, the company sells these futures
and removes the hedge.

O

On January 1, Jewelrygold goes long a June gold futures contract to hedge input price risk. On May
15, the company buys gold for $950 and simultaneously sells futures for $952 to end the hedge.
Although Jewelrygold pays less for gold, it has to surrender nearly all of its gains through the hedge.
The cash flow from the futures position is [F(T) 
F(0)]  952 
1,000  
$48.

O

Jewelrygolds effective price on May 15 is $998. By looking at the cash flows, the buying price is
  Spot  (Change in futures prices)
  S(T)  [F(T)  F(0)]
  [S(T)  F(T)]  F(0)
  (New basis  Old futures price)

(13.2)

This is the same value as in the previous example, except for the minus sign.

This example shows that a futures hedged spot commoditys portfolio value can
always be viewed as the sum of the old futures price and the new basis. Consequently,
hedgers are interested in how the basis evolves randomly through time. This randomness gives rise to basis risk in hedging, which is often measured by computing the basiss variance (or standard deviation). Basis risk is, thus, fundamental
to futures hedging, and hedgers often talk about the widening or narrowing of
the basis in passionate terms. Many of them have extensive charts depicting the
historic behavior of the basis, looking for a crystal ball to foretell the future.

Guidelines for Futures Hedging

Real life is far more complex than textbook examples. Exchanges offer only a
handful of futures, whereas there are thousands of commodities. The specter of an
imperfect hedge visits us again. When setting up a hedge, its natural to ask, which
contract and for what maturity? The next example discusses the issues involved in
answering this question.

EXAMPLE 13.2: Hedging by Selecting a Futures from Several Competing Contracts

Suppose that a new alloy Alloyum (a fictitious name) is developed that can replace precious metals in
industrial and ornamental use. Let Alloyum trade in the spot market. Alloyum futures may or may not
trade, and we discuss both possibilities. If you produce thirty thousand ounces of Alloyum, how would
you hedge output price risk?

HEDGING WITH FUTURES

Alloyum Futures Trade, and You Know When to Lift the Hedge
This case happens when the Alloyum futures contracts maturity date exactly matches the delivery
date of the spot commodity commitment. Then, sell [(Spot position)/(Alloyum futures contract
size)]  30,000/50  600 Alloyum futures, assuming a contract size of fifty ounces. Basis risk eventually disappears because the spot converges to the futures price at maturity. This can be shown by
setting S(T)  F(T) in Expression (13.1). With zero basis risk, you fix the selling price at maturity,
which is none other than todays futures price. Congratulations, you have set up a perfect hedge. (This
perfect hedge ignores the interest rate risk from marking-to-market. Such reinvestment risks will be
considered later in the chapter.)

Alloyum Futures Trade, and You Do Not Know When to Lift the Hedge
In this case, one way to proceed is to compute the variance of the basis for different maturity futures
contracts on Alloyum and select the one that scores the lowest. Lower basis risk means that the futures
price deviates less from the spot price. You are likely to find that the futures contract maturing in the
same month as the spot sale is the best candidate. In this case, hedge with the smallest basis risk futures
contract. The number of contracts to be shorted may be found by the risk-minimization hedging strategy discussed later in this chapter.

Alloyum Futures Do Not Trade, and You Know When to Lift the Hedge
In this case, you may first like to select a similar commodity on which a futures contract is written and
decide on the maturity month. Collect price data for Alloyum and for contender commodity futures
contracts maturing in the same month as the spot sale, and compute correlations of price changes as
in Tables 13.2a and 13.2b. On the basis of these tables, we select the platinum futures because it has the
highest correlation to Alloyum each year as well as in the overall period.

Alloyum Futures Do Not Trade, and You Do Not Know When to Lift the Hedge
This is the worst case for hedging. First, select a commodity futures contract as in the previous
case. Then, select a maturity month, and find the futures contract with the largest correlation with
Alloyum spot price changes and that minimizes the variance of the basis. Consider the data given in
Table 13.2a (Example 13.4 shows how to compute correlations) and Table 13.2b. The futures contract
that matures in the spot sale month is the best performer both in terms of the largest correlation and
the lowest variance of the basis. It is closely followed by the futures contract maturing a month after
the spot sale date.
The preceding analysis recommends the spot sale month futures contract. There is, however, a
famous saying in economics that there are no solutions, only trade-offs (Sowell 1995, p 113). The
other futures contracts may have lower transaction costs. Liquidity is another concern because it often
increases as the contract approaches maturity, but dries up in the delivery month. Furthermore, if
you happen to be holding a long futures position during the delivery month, then you run the risk
of accepting a truckload of the underlying commodity if the short decides to deliver. Thus the next
months futures contract, despite (slight) inferiority in terms of correlation and variance of the basis,
may be the better choice.

319

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CHAPTER 13: FUTURES HEDGING

TABLE 13.2a: Correlations between Alloyum Spot and Precious

Metal Spot Month Futures Price Changes5

Futures

Years 13

Year 1

Year 2

Year 3

Platinum futures

0.78

0.73

0.89

0.83

Gold futures

0.70

0.72

0.73

0.70

Silver futures

0.59

0.58

0.65

0.58

TABLE 13.2b: Correlations between Alloyum Spot and Platinum

Price Changes and the Variance of the Basis for

Platinum Futures Contracts6
Futures Contracts

Correlation of Price Changes

Variance of Basis

Previous-month futures

0.79

3.20

Spot-month futures

0.89

0.88

Next-month futures

0.87

0.99

Sixth-month futures

0.71

9.80

You can create Table 13.2a by (1) recording on a specific day of each month the Alloyum spot price and the precious metal
futures price for contracts that mature on that month (this will give four series of observations), (2) noting month-to-month
price differences for each of these four series, and finally, (3) computing (by a computer program such as Excel or by hand
calculation) the correlations among the Alloyum price and futures price differences for each of these series (this will give three
correlations). Alternatively, you can use daily or weekly data for computations.

You can create Table 13.2b by recording on a specific day of each month the Alloyum spot price and the four futures prices
(for contracts that matured in the previous month, will mature in the spot month, will mature the following month, and will
mature six months from the current month, respectively) and then proceeding as in Table 13.2a. There will be four different
series for each basis, each of which is created by subtracting from the Alloyum spot price the relevant futures price.

13.4

Risk-Minimization Hedging

Suppose that you want to hedge a long spot commodity position by shorting futures
contracts. Using a statistical or econometric model, assuming that past price patterns repeat themselves enables you to find the optimal number of contracts to
minimize the variance of the hedging error. This section discusses this statistical
approach to hedging.

The Mean-Variance Approach

The mean-variance approach to risk-minimization hedging (or optimal hedging)
determines the optimal number of contracts needed to minimize the variance of

RISK-MINIMIZATION HEDGING

the portfolios price changes. The intuition of this approach can be understood by
first considering a perfect hedge:
O

A perfect hedge. Suppose you are holding a long position in the spot commodity.
You need to short futures contracts to hedge the spot commoditys price risk.
In the pristine world of a perfect hedge, any change in the spot position will
be exactly offset by an equal and opposite change in the futures position.
Consequently,
Change in portfolio value

Change in spot position 
Change in futures position 
0

(13.3)

The minus sign before the change in the futures position is because we are short
the futures contract and the spot and futures prices move in the same direction.
With minor modifications, we can recast the problem to focus on how changes
in the spot and futures prices per unit are related. Using data from Example 13.2,
we can hedge a long position of thirty thousand ounces of Alloyum production
by selling [(Cash position)/(Alloyum futures contract size)]  30,000/50  600
Alloyum futures. We can write this as follows:
Change in portfolio value 
(30,000  Change in spot price per ounce)

(600  50  Change in futures price per ounce)

0
(13.4)
There is no change in the portfolio value because the spot and the futures price
changes exactly match.
O

An imperfect hedge. In reality, the hedge will be imperfect because the spot and
the futures price changes do not exactly match. Here you can find the riskminimizing number of futures contracts. Consider hedging our spot exposure
of n ounces by selling q futures contracts of size f ounces per contract. Then we
can rewrite the left side of expression (13.4) as
Change in portfolio value 
(n  Change in spot price per ounce)

(q  f  Change in futures price per ounce)

n[S(t) 
S] 
qf [F(t) 
F]

n$S  q f$F
(13.5)
where S(t) and S are the spot prices per ounce on some future date (time t) and
today (time 0), F(t) and F are futures prices per unit on those same respective
dates, and $ compactly denotes the price change. Note that this change does
not equal zero because it is an imperfect hedge. To find the number of contracts
to sell to risk-minimize hedge the spot portfolio, compute the variance of the
portfolio and select n to minimize this variance. You can do this by taking the
partial derivative of the portfolio variance with respect to q, setting it equal
to zero, and solving for q (see the appendix to this chapter). This leads to the
following result.

321

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CHAPTER 13: FUTURES HEDGING

RESULT 13.1

The Risk-Minimizing Number of Futures Contracts

for Hedging a Spot Commodity Position
To minimize the risk of a long portfolio of a spot commodity, sell short q
contracts where
q

(n/f )h

(13.6)

and n is the size of the spot position, f is the number of units of the underlying commodity in one futures contract, and h is the optimal hedge ratio
(or minimum-variance hedge ratio or risk-minimized hedge ratio).
The optimal hedge ratio is given by
covS,F
sdS

corrS,F
(13.7)
varF
sdF
where covS,F is the covariance between changes in the spot price ($S) and
the futures price ($F), varF is the variance of the change in the futures
price, sdS is the standard deviation (or volatility) of the change in the spot
price (standard deviation is the positive square root of the variance), sdF is
the standard deviation of change in the futures price, and corrS,F is the correlation coefficient between $S and $F.7
h 

7
The second part of the formula follows from the result: covariance equals the product of
the standard deviations and the correlation coefficient or covS,F  sdS  sdF  corrS,F.

Considering various cases reveals the intuition behind this result. Suppose
that the price changes for the spot commodity and the futures contract are
perfectly correlated (i.e., corrS,F equals 1) and their standard deviations match
(i.e., sdS 
sdF). Then the optimal hedge ratio h equals 1. This is the holy grail of
a perfect hedge, which is nearly impossible to attain in practice but is useful as
an illustration.
Next assume that there is a high correlation between the price changes (corrS,F
is close to one) and the spot price change has a lower volatility than the futures
price change (i.e., sdS  sdF). Then a unit of spot is hedged with less than a unit
of futures. Conversely, if the spot price change fluctuates more than the futures
price change (i.e., sdS 
sdF), then one unit of spot needs more than one unit of the
futures to hedge.
The optimal hedge ratio gives us an easy formula for setting up a futures hedge.
Example 13.3 shows how to implement this by utilizing spot and futures price
data, which can be easily collected from business newspapers or Internet data
sources.

RISK-MINIMIZATION HEDGING

EXAMPLE 13.3: Setting Up a Risk-Minimization Hedge with Price Data

O

Suppose that you are planning to sell thirty thousand ounces of Alloyum at some future date. To
start, you collect Alloyum spot price and platinum futures price data for sixteen consecutive trading
days (see Table 13.3).

O

Begin by computing the price differences for each of these two series of price observations. Next
use a spreadsheet to compute the parameter estimates needed for the optimal hedge ratio. (The
appendix to this chapter discusses related issues and demonstrates how to find h with the help of a
simple calculator; section 13.6 shows how to do these calculations using the spreadsheet program
Microsoft Excel.) We get
the standard deviation of changes in the futures price per unit, sdF  14.3368
the standard deviation of changes in the spot price sdS

15.5002
the correlation coefficient between the spot and futures price changes, corrS,F

0.7413

O

Use these estimates in the second part of expression (13.7) of Result 13.1 to compute the minimumvariance hedge ratio:
h 

O

sdS
15.5002
corrS,F 
0.7413  0.80158
sdF
14.3368

To hedge n

30,000 ounces of Alloyum with a platinum futures contract (contract size f 
50), you
need to sell
q

(n/f )h


(30,000/50)0.8015


480.9 or 481 contracts (with integer rounding)

Or, you can use the first part of Result 13.1 to determine the optimal hedge ratio, h  covS,F /varF  18.3048/22.8381  0.8015.

Alternatively, you can compute the hedge ratio by suitably framing the problem
and estimating a linear regression (see the appendix to this chapter).

Limitations of Risk-Minimization Hedging

Comedian Rodney Dangerfield often chuckled, I dont get no respect. Doesnt
this comment apply to risk-minimization hedging? It is purely computational, and
except for some ad hoc adjustments, it is a single-shot exercise with no prescription
for modifying the hedge over time. It works well if a closely related commodity can
be found and you know when to lift the hedge. It works less well otherwise and if
the hedge needs to be rolled over or rebalanced.

323

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CHAPTER 13: FUTURES HEDGING

TABLE 13.3: Alloyum Spot and Platinum Futures Price Data

Day t

Alloyum Spot S(t)

Platinum Futures F(t)

1,215

1,233

1,209

1,236

1,239

1,245

1,245

1,254

1,254

1,272

1,227

1,254

1,230

1,248

1,224

1,242

1,239

1,260

1,251

1,263

10

1,227

1,254

11

1,215

1,227

12

1,209

1,221

13

1,203

1,230

14

1,185

1,203

15

1,194

1,209

The idea of rebalancing is related to the concept of (exact) dynamic hedging,

which involves regular adjustments to a perfect hedge over time. Dynamic hedging requires sophisticated analytical tools, and it applies in a complete market. It
is impossible to implement in an incomplete market (see Duffie [1989] and Jarrow
and Turnbull [2000] for examples and issues related to dynamic hedging). In complete markets (remember chapter 8), all kinds of securities trade that generate
future payoffs contingent on all possible future events. In reality, the markets are
incomplete, and it may be difficult to develop good futures pricing models to which
dynamic hedging applies. Consequently, risk-minimization hedging, despite all its
limitations, starts looking respectable again. In incomplete markets, it continues to
attract serious research interest.

13.5

Futures versus Forward Hedging

Its common practice in many circles to treat forwards and futures as equivalent and
interchangeable contracts. However, this is incorrect for many reasons. Although a
forward is easy to price, ordinary investors rarely trade in the organized forward
market. Big banks, large corporations, and other institutions with excellent credit
ratings dominate this market, and to guarantee execution of the contracts, these
financial institutions usually need to post collateral. These trading restrictions are
imposed to reduce counterparty credit riskthe nonexecution of the contract
terms. Counterparty credit risk is a big concern in the trading of over-the-counter
derivatives, as recently evidenced by the related regulatory reforms following the

SPREADSHEET APPLICATIONS: COMPUTING H

325

2007 credit crisis in the DoddFrank Wall Street Reform and Consumer Protection
Act (see chapter 26 for more discussion of these issues). Second, given that forward
contracts are bilateral negotiated agreements, forward markets are illiquid and
subject to significant liquidity risk. For example, if a counterparty closes a forward
contract early, significant closing costs are incurred.
By contrast, a futures (1) is an exchange-traded, standardized contract; (2)
has margins and daily settlement, which makes it safer than a forward due to the
absence of credit risk; (3) allows small traders, weaker credits, and complete strangers to participate; and (4) usually trades in a liquid market, where traders can enter
or unwind their positions with ease.
But there is another important difference between futures and forward contracts due to the marking-to-market of a futures contract. Marking-to-market a
futures contract introduces risks involved with reinvesting the cash flows before
the contract matures. These same reinvestment risks are not faced by a forward
contract. Tracking the cash flows to these contracts, the futures trader, unlike the
forward trader, earns random and uncertain interest on margin balances.
As discussed in chapter 9, the interest earned on a futures margin account is
dependent on the futures price changes. In addition, interest rate changes also
affect the interest earnings. Indeed, if interest rate changes are positively correlated
with futures price changes, then the futures position benefits from interest rate
movements because as cash flows are received, more interest is earned. In this case,
the risk of a futures position is reduced slightly. Conversely, if interest rate changes
are negatively correlated with futures price changes, then the futures position suffers from interest rate movements. In this latter case, the risk is increased. This
interest rate risk affects hedging performance because of the random cash flows
received. This same risk is not present in a forward contract.

13.6

Spreadsheet Applications:
Computing h

You can easily compute the optimal hedge ratio (h) by using a standard spreadsheet
program such as Microsoft Excel. Next we demonstrate this for Example 13.3.

EXAMPLE 13.3: Computing the Optimal Hedge Ratio (Solved Using Microsoft Excel)

Generating the Inputs

Consider the same data as in Example 13.3. Type in the numbers and the terms exactly as follows in an
Excel spreadsheet (see Table 13.4):
O

Type Day t in cell A1, 0 in A2, 1 in A3, 2 in A4, and so on up to 15 in cell A17. You may speed up data
entry by using the Auto Fill feature: type 0 in A2 and 1 in A3, highlight the cells A2 and A3, and
then drag down the bottom right hand corner of the cursor so that the desired values get filled in
cells A4 to A17.

326

CHAPTER 13: FUTURES HEDGING

O

O

Type S(t) in B1 and then fill out the Alloyum spot prices as given in Table 13.3: 1,215 in B2, 1,209 in
B3, and so on, up to 1,194 in B17.
Type F(t) in C1 and then fill out the platinum futures prices F(t) as given in Table 11.2 for sixteen
consecutive trading days.

O

Type $S(t) in D1 and then type 
B3 
B2 in D3, 
B4 
B3 in D4, and so on. You may speed this
up by using the Auto Fill feature: type 
B3 
B2 in D3 and then drag down the bottom right hand
corner of the cursor so that the desired values fill in cells D4 to D17.

O

Type $F(t) in E1 and then type 
C3 
C2 in E3. Use Auto Fill as we have just mentioned and fill
out the desired values in cells E4 to E17.

TABLE 13.4: Computing h Using Microsoft Excel

A

Day t

S(t)

F(t)

$S(t)

$F(t)

$S(t) 
$S(t)

$F(t) 
$F(t)

$S(t) 
$F(t)

1,215

1,233

1,209

1,236

6

36

18

1,239

1,245

30

900

81

270

1,245

1,254

36

81

54

1,254

1,272

18

81

324

162

1,227

1,254

27

18

729

324

486

1,230

1,248

6

36

18

1,224

1,242

6

6

36

36

36

1,239

1,260

15

18

225

324

270

1,251

1,263

12

144

36

10

1,227

1,254

24

9

576

81

216

11

1,215

1,227

12

27

144

729

324

12

1,209

1,221

6

6

36

36

36

13

1,203

1,230

6

36

81

54

14

1,185

1,203

18

27

324

729

486

15

1,194

1,209

81

36

54

Sums

21

24

3,393

2,916

2,340

VARA

240.2571

205.5429

STDEV
COVAR

15.50023

14.33677

164.7429

CORREL

0.74134

0.801501

0.801501

SUMMARY

327

Computing Estimates from the Sample and the Minimum-Variance Hedge Ratio
The entries in columns D and E are the two data series with which we work. You can do the computations
as follows (and verify that these are the same as the sample variances that you computed in Example 13.3):
O

Type in a name for the sample variance such as VARA in cell A20, type 
VARA(D3:D17) in D20
and hit return to get 240.2571, and type 
VARA(E3:E17) in E20 and hit return to get 205.5429.

O

Type STDEV in A21, type 
STDEV(D3:D17) in D21 and hit return to get 15.50023, and type

STDEV(E3:E17) in E21 and hit return to get 14.33677.

O

As Excels covariance formula is given for the population, you need to multiply the estimator by n/(n  1) to get the sample estimate. Accordingly, type COVAR in A22, and type

COVAR(D3:D17,E3:E17)*(15/14) in D22 and hit return to get 164.7429.

O

Type CORREL in A23 and 
CORREL(D3:D17,E3:E17) in D23 and hit return to get 0.74134.

O

Type h in A24 and 
D22/E20 in D24 and hit return to get 0.801501. This is the expression (13.6)
given in Result 13.1. You may also get h via the second result in (13.6) by typing 
D23*D21/E21 in
E24 and hitting returnits the same answer.

13.7

Summary

1. Most futures contracts are traded to hedge spot commodity price risk. Producers may set up a long hedge (or a buying hedge) to fix the buying price for
an input and a short hedge (or a selling hedge) to fix the selling price of an
output.
2. As with any other derivatives, the costs and the benefits must be carefully weighed
before hedging a spot commodity with futures. They involve direct and indirect
costs: the brokers must be paid, and a trade may fetch a bad price. But hedging
also has many potential benefits: it can stretch the marketing period, protect inventory value, permit forward pricing of products, reduce the risk of default and
financial distress costs, and perhaps facilitate taking advantage of a tax loss or tax
credit.
3. A perfect hedge completely eliminates price risk. It happens when (1) the
futures is written on the commodity being hedged and (2) the contract matures when you are planning to lift the hedge. Generally, there is basis risk.
The basis is defined as the difference between the spot price and the futures
price.
4. For a seller of a futures contract who hedges output price risk, the effective
selling price is (new basis  old futures price). For a buyer of a futures contract
who hedges input price risk, the effective buying price is the negative of (new
basis 
old futures price).
5. We can use a statistical model, assuming past price patterns repeat themselves,
to set up a risk-minimization hedge. To minimize the risk of a long portfolio

328

CHAPTER 13: FUTURES HEDGING

of the spot commodity, sell short q  (n/f)h contracts, where n is the size
of the spot position, f is the contract size, and h is the optimal hedge ratio
(or minimum-variance hedge ratio) defined as covS,F /varF, where covS,F is the
sample covariance between the change in the spot price ($S) and the change
in the futures price per ($F) and varF is the variance of the change in the
futures price.

13.8

Appendix

Deriving the Minimum-Variance Hedge Ratio (h)

Suppose you are planning to sell n units of a spot commodity at some future date
and decide to hedge this exposure by selling short q futures contracts today.
O

Rewrite the change in the portfolio value between today (time 0) and some
future date (time t) as
$Portfolio

(n 
Change in spot price)  (q  f  Change in futures price)

n[S(t)  S(0)] 
q f [F(t)  c(0)]

n$S  qf$F

(13.8)

where f is the number of units of the futures contract, S(t) is the spot price at
date t, F(t) is the futures price at date t, and $ denotes a price change.
O

Select q so as to minimize the change in the portfolio value. First, use statistics
to compute the variance of the portfolios price change:
variance(aX 
bY) , a2variance(X) 
b2 variance(Y) 
2ab[covariance(X, Y)]

(13.9)

where a and b are constants and X and Y are random variables. As n, q, and f are
constant parameters, set a

n, b

q f, X

$S, and Y

$F in expression (13.9)
to get
var($Portfolio)

n2varS

(q f )2varF 
2nq f  covS,F

(13.10)

where varS is the variance of change in the spot price ($S), varF is the variance
of change in the futures price ($F ), and covS,F is the sample covariance between
the change in the spot and futures prices.
O

Using calculus, we minimize expression (13.10) by taking the partial derivative

with respect to q and setting it equal to zero:

[var($Portfolio)]

2q f 2 varF 
2nf covS,F

0
q

APPENDIX

The second partial derivative is a positive number, which indicates that this
minimizes the expression. Rearrange terms to get the number of futures contracts to sell short (or go long in case you are setting up a buying hedge):
q 
(n/f )h

(13.11)

where the optimal hedge ratio h equals (covS,F /varF).

Computing the Minimum-Variance Hedge Ratio (h)

Example 13.3 shows how to input the values into a business calculator or a computer
to determine the minimum variance hedge ratio (h). Here we show how to directly
calculate h.

Statistical Approach
Start by deciding how frequently and over what time interval you collect your data.
Standard practice is to fix a time interval (daily, weekly, or monthly) and use the
end of the intervals settlement prices.

DATA SERIES
O

To cross-hedge Alloyum spot with platinum futures, we need their prices as

basic inputs. These are reported in Table 13.5 (Appendix), whose first three columns are as follows:
- The first column is labeled Day t, and it keeps track of the days. There are
(T  1)

16 observations corresponding to sixteen consecutive trading days,
where t runs from day 0 to day t 
15.
- Columns 2 and 3 record the Alloyum spot price S(t) and the platinum futures
price F(t), respectively, for these sixteen consecutive trading days. All prices
are reported for one unit of the respective commodity.

PRICE DIFFERENCES
O

Compute price differences for each price series.

- Column 4 reports changes in the value for Alloyum spot. Denote the spot
price change from date (t  1) to date t as $S(t) , S(t) 
S(t 
1). Label column 4 as x(t) for convenience. For example, when t  6,
x(6) , $S(6) , S(6) 
S(5) 
1,230 
1,227 
3
- Column 5 does the same for platinum futures. Label this as y(t). For example,
y(6) , $F(6) 
$F(t) , F(t) 
F(t 
1)

F(6) 
F(5) 
1,248 
1,254 
6

O

Notice that when computing the difference, you lose the first observation. We
now have T 
15 observations. We denote them by t, where t 
1, 2, . . . , 15.

O

We can now forget our second and third columns. We use the fourth and fifth
columns to compute the minimum-variance hedge ratio h.

329

330

CHAPTER 13: FUTURES HEDGING

TABLE 13.5: Price Data and Calculations for the Minimum-Variance

Hedge Ratio (h)

$F(t) , F(t) 
F(t  1) , y(t)

[$S(t)]2
, x(t)2

6

36

18

1,245

30

900

81

270

1,245

1,254

36

81

54

1,254

1,272

18

81

324

162

1,227

1,254

27

18

729

324

486

1,230

1,248

6

36

18

1,224

1,242

6

6

36

36

36

1,239

1,260

15

18

225

324

270

1,251

1,263

12

144

36

10

1,227

1,254

24

9

576

81

216

11

1,215

1,227

12

27

144

729

324

12

1,209

1,221

6

6

36

36

36

13

1,203

1,230

6

36

81

54

14

1,185

1,203

18

27

324

729

486

15

1,194

1,209

81

36

54

jx 
 21

jy 
 24

jx2 
3,393

jy2 
2,916

Day t

Alloyum
Spot S(t)

Platinum
Futures F(t)

1,215

1,233

1,209

1,236

1,239

Sums

$S(t) , S(t) 

S(t  1) , x(t)

Some values useful for the computations follow:

T

= x(t)   21

t1
15

= y(t)   24
1

2
= x(t)  3,393
2
= y  2,916
15

= x(t)y(t)  2,340

t1

[$F(t)]2
, y(t)2

$S(t)  $F(t)
, x(t)y(t)

jxy 
2,340

APPENDIX

COMPUTATION-SIMPLIFYING TECHNIQUES
O

Three more columns are introduced to help simplify our calculations.

- Columns 6 and 7 record the square of the price changes reported in columns
4 and 5, respectively. Finally, column 7 reports the product of the values in
columns 5 and 6. For example, when t 
6, we get
[x(6)]2

32

9
[y(6)]2

(6)2

36
x(6)y(6)

18

STATISTICAL ESTIMATES
O

To compute h from historical data, modify our formulas for covariance and variance by replacing the T with (T  1) in the denominator to get an unbiased estimate.9

O

We get the following parameter estimates to help us compute h (see Table 13.6
[Appendix]):
sample covariance, covS,F 
164.7429
sample variance of $S, varS 
240.2571
sample variance of $F, varF 
205.5429
sample standard deviations, sdS 
15.5002 and sdF 
14.3367
correlation coefficient between $S and $F, corrS,F 
0.7413

O

These estimates are used to compute the minimum-variance hedge ratio h. The
first part of equation (13.7) of Result 13.1 gives
covS,F
164.7429
h 
 0.8015

(13.12)
varF
205.5429
while the second part veries the same result:
h 

O

sdS
15.5002
0.7413  0.8015
corrS,F 
sdF
14.3367

(13.13)

If you are estimating these values over a longer period, then you run the risk that
a futures contract may mature and no longer trade. Suppose you are hedging with
the nearest maturity futures contract, whose price changes are likely to have the
best correlation with the spot price changes. Suppose this contract stops trading
on day 12. Select the futures contract that is going to mature next, get its futures
prices for days 12 and 13, and write the price difference $F (13) , F (13)  F (12)
in the first table in the cell corresponding to day 13s price difference.

Econometric Approach: A Linear Regression Model

Econometrics is the branch of economics that studies relationships between
economic variables using mathematics and statistics. A staple of econometrics is
the linear regression model,10 in which a dependent variable may be determined
9
Such adjustments make the estimator BLUE, and statisticians love BLUEs (Best Linear Unbiased
Estimators). See DeGroot and Schervish (2011), or Mood et al. (1974).
10

See standard econometrics textbooks like Amemiya (1994) or Johnston and DiNardo (1997) for a
discussion of the linear regression model.

331

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CHAPTER 13: FUTURES HEDGING

TABLE 13.6: Statistical Estimates and Computation of the Optimal

Hedge Ratio h
Statistical Estimate

Formula

Computations

Estimated
Value

a. Sample mean, x

1 T
x(t)
T t=
1

21/15

1.4000

b. Sample mean, y

1 15
y(t)
15 t=
1

24/15

1.6000

T
1
 x(t)  x    y(t)  y 
T  1 t=
1
15
1

8 6 = x(t)y(t) 7  15xy 9
14 t  1

1
 21
 24
6 2,340  154
54
57
14
15
15

164.7429

d. Sample variance of
$S, varS

T
1
 x(t)  x  2
=
T  1 t1
1 15

6
x(t)2  15x2 7
14 t=
1

1
 21 2
6 3,393  154
5 7
14
15

240.2571

e. Sample variance of
$F, varF

T
1
 y(t)  y  2
=
T  1 t1

1
 24 2
6 2,916  154
5 7
14
15

205.5429

f. Sample standard
deviation of $S, sdS

 varS

 240.2571

15.5002

g. Sample standard
deviation of $F, sdF

 varF

 205.5429

14.3367

h. Correlation
coefficient between
$S and $F, corrS,F

covS,F

164.7429
15.5002  14.3367

0.7413

164.7429
205.5429

0.8015

c. Sample covariance of

$S and $F, covS,F

i. Minimum-variance
hedge ratio, h
j. h (alternate
computation)

sdS  sdF
covS,F
varF
sdS
corrS,F
sdF

0.74134

15.5002
5
14.3367

0.8015

from the values of one or more independent variables, under the assumption that
these variables are linearly related. In this case, the model takes the form
$S(t)

A  B$F(t)  u(t)

(13.14)

where A and B are unknown parameters and u(t) are independent and identically
distributed error terms with an expected value of 0 and a constant variance.
Next you have to estimate these parameters. The most popular approach is the
least squares method, in which A and B are chosen so that the sum of squared
errors j[$S(t)  A  B$F(t)]2 is minimized. Interestingly, the value of B obtained
is identical to the hedge ratio h in Result 13.1. This makes life easy. Estimate the

QUESTIONS AND PROBLEMS

regression equation (13.12) by hand or by using a standard statistical package like

MATHEMATICA, MINITAB, SAS, or TSP, and the estimated value of B will give you
the hedge ratio. Spreadsheet programs like Microsoft Excel can also run regressions.

13.9

Cases

Lufthansa: To Hedge or Not to Hedge . . . (Richard Ivey School of Business

Foundation Case 900N22-PDF-ENG-PDF-ENG, Harvard Business Publishing).

A short case that explores the costs and benefits of hedging and the derivatives
that may be used for hedging purposes.
Enron Gas Services (Harvard Business School Case 294076-PDF-ENG). The case

considers the risks and opportunities of selling a variety of natural gas derivatives
by a financial services subsidiary of the largest US integrated natural gas firm.
Aspen Technology Inc.: Currency Hedging Review (Harvard Business School

Case 296027-PDF-ENG). The case examines how a small, young firms business
strategy creates currency exposure and how one can manage such risks.

13.10 Questions and Problems

13.1. Define a long hedge and a short hedge and give examples of each kind of hedge.
13.2. What are the benefits of a corporations hedging? In your answer, explain

why the corporation and not the corporations equity holders must do the
hedging. Are there any costs to a corporations hedging?
13.3. What is the difference between a perfect hedge and a cross hedge? Give

examples to clarify your answer.

13.4. If one cannot create a perfect hedge, what are the alternatives? Give an

example to explain your answer.

13.5. What is the basis for a futures contract? What happens to the basis on the

delivery date?
13.6. There is no futures contract on aviation fuel. Combo Air Inc. has to buy

3 million gallons of aviation fuel in three months. Suppose you are in charge
of Combo Airs hedging activities. You gather the following data:

TABLE 13A: Jet Fuel Cash Prices vs. Near Month Energy

Futures Prices: Correlations of Price Changes

198688

1986

1987

1988

Heating oil futures

0.54

0.76

0.89

0.32

Gasoline futures

0.41

0.74

0.73

0.19

Crude oil futures

0.45

0.70

0.72

0.25

a. Which energy futures contract will you choose for hedging jet fuel purchase?
b. Is this a long hedge or a short hedge?

333

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CHAPTER 13: FUTURES HEDGING

13.7. The variance of monthly changes in the spot price of live cattle is (in cents per

pound) 1.5. The variance of monthly changes in the futures price of live cattle
for the April contract is 2. The correlation between these two price changes is
0.8. Today is March 11. The beef producer is committed to purchasing four
hundred thousand pounds of live cattle on April 15. The producer wants to
use the April cattle futures contract to hedge its risk. What strategy should
the beef producer follow? (The contract size is forty thousand pounds.)
13.8. Are hedging with forwards and futures contracts the same, or are there differ-

ent risks to be considered when using these two contracts? Explain your answer.
13.9. When you hedge a commoditys price risk using a futures contract, give an

example where the counterparty is also hedging. Give an example where the
counterparty is speculating.
13.10. Kellogg will buy 2 million bushels of oats in two months. Kellogg finds that

the ratio of the standard deviation of change in spot and futures prices over a
two-month period for oats is 0.83 and the coefficient of correlation between
the two-month change in price of oats and the two-month change in its
futures price is 0.7.
a. Find the optimal hedge ratio for Kellogg.
b. How many contracts do they need to hedge their position? (The size

of each oats contract is five thousand bushels; oats trades in the CME
Group.)
13.11. Explain why hedging is like buying an insurance policy. To buy an insurance

policy, you need to pay a premium; what is the corresponding premium in

hedging? Give an example to clarify your answer.
13.12. Suppose that after you graduate, you plan to be a stock analyst for a major

financial institution. You know that if the stock market increases in value,
you will get a job with a good salary. If the stock market declines, you will
get a job, but the salary will be lower. How can you hedge your salary risk
using futures contracts? Is this a perfect or imperfect hedge?
13.13. Your company will buy tungsten for making electric light filaments in the

next three to six months. Suppose there are no futures on tungsten. How
would you hedge this risk? (Discuss the type of hedge, general hedging approach, and guidelines that you would like to follow.)
13.14. You are the owner of a car rental business. If gasoline prices increase, your

car rental revenues will decline. How can you hedge your car rental revenue
risk using futures contracts? Is this a perfect or imperfect hedge?
13.15. What commodity price risk does Southwest Airlines hedge, and why? Has it

always been successful in its hedging program?

13.16. What is risk-minimizing hedging? Briefly outline how you would set up a

risk-minimizing hedge. Is a risk-minimizing hedge a perfect or imperfect

hedge? Explain your answer.
13.17. Canadian American Gold Inc. (CAG) has half its gold production from

mines located in Canada, while the other half is from those in the United
States. CAG uses a quarter of its production for making gold jewelry sold at

QUESTIONS AND PROBLEMS

a fixed price through stores in the two nations, and the rest is sold on the
world market, where the gold price is determined in US dollars. Canadian
profits are repatriated to the United States, where CAGs headquarters are
located. CAGs chief executive officer wants to use futures contracts to
hedge the entire production of ten thousand ounces of gold and as many
other transactions as possible. He communicates his desire to you but seeks
your opinion one last time before the orders go out. Devise a sensible hedging strategy that would still be in line with the CEOs wishes (assume x is
the quantity used for making gold jewelry in the United States).
13.18. The spot price of gold today is $1,505 per ounce, and the futures price for a

contract maturing in seven months is $1,548 per ounce. Suppose CAG puts
on a futures hedge today and lifts the hedge after five months. What is the
futures price five months from now? Assume a zero basis in your answer.
13.19. Suppose that Jewelry Company is planning to sell twenty thousand ounces

of platinum at some future date. The standard deviation of changes in the

futures price per ounce sdF is 12.86, that for changes in the spot price per
ounce sdS is 14.38, and the correlation coefficient between the spot and futures price changes corrS,F is 0.80.
a. Compute the optimal hedge ratio for Jewelry Co.
b. How many contracts do they need to hedge their position? (The con-

tract size is fifty ounces.)

c. Will this be a buying or a selling hedge?
13.20. (Microsoft Excel) Given the following data, compute the hedge ratio for a

risk minimizing hedge.

Day
t

Alloyum Spot
S(t)

Platinum Futures
&(t)

1,233

1,245

1,219

1,256

1,118

1,130

1,246

1,264

1,250

1,280

1,219

1,223

1,230

1,248

1,227

1,280

1,249

1,260

1,225

1,289

10

1,227

1,254

11

1,223

1,255

12

1,211

1,223

13

1,203

1,267

14

1,189

1,213

15

1,199

1,219

335