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Lecture 3
Basis Risk
Minimum Hedge Ratio
Some Excercises
Short Hedges
A short hedge is a hedge that involves a
short position in futures contracts.
A short hedge is appropriate when the
hedger already owns an asset and
expects to sell it at some time in the
future.
A short hedge can also be used when an
asset is not owned right now but will be
owned at some time in the future
Solution
The firm could sell futures contracts in
heating oil in order to lock in the sales
price. Again the firm will use short
hedge
What is future contract on heating oil is
not available?
BASIS RISK
In practice, hedging is often not quite
straightforward due to the following reasons:
1. 1.The asset whose price is to be hedged may not
be exactly the same as the asset underlying the
futures contract.
2. The hedger may be uncertain as to the exact date
when the asset will be bought or sold.
3. The hedge may require the futures contract to be
closed out well before its expiration date.
. These problems give rise to what is termed basis
risk.
The Basis
An Example
a company knows that it will need to purchase 20,000 barrels of
crude oil at some time in October or November. Oil futures
contracts are currently traded for delivery every month and the
contract size is 1,000 barrels. The company therefore decides to
use the December contract for hedging and takes a long position
in 20 December contracts. The futures price on June 8 is $68.00
per barrel. The company finds that it is ready to purchase the
crude oil on November 10. It therefore closes out its futures
contract on that date. The spot price and futures price on
November 10 are $70.00 per barrel and $69.10 per barrel.
1. Can you find the gain on future contract?
2. What is the BASIS when the contract is closed out?
3. What is the final effective price paid by the company for the
oil purchased on November 10?
solution
1. Can you find the gain on future
contract?
Gain = 69.1 68 = 1.1
2. What is the BASIS when the contract is
closed out? Basis = 70 69.1 = 0.9
3. What is the final effective price paid
by the company for the oil purchased on
November 10?
Effective Price = Initial future price + Basis
=> 68.00+0.9=68.9
CROSS HEDGING
If there is no futures contract on the asset
being hedged, use a cross hedge,
Cross hedge occurs when the asset
underlying the future contract is different
from the asset whose price is being hedged
The changes in the prices of the two asset
should be as highly correlated as possible
The delivery month should be the same as,
or just after, the date the hedge will be
lifted.
V
VHH =
= the
the value
value of
of the
the hedged
hedged portfolio
portfolio
Q
QSS =
= the
the quantity
quantity of
of the
the spot/cash
spot/cash position
position being
being hedged
hedged
Q
QFF =
= the
the number
number of
of units
units of
of the
the underlying
underlying asset
asset in
in one
one futures
futures contract
contract
used
used to
to hedge
hedge
NFF =
= the
the number
number of
of futures
futures contracts
contracts
N
-- S
S =
= change
change in
in the
the spot
spot price
price of
of the
the good
good
-
-- F
F =
= change
change in
in the
the futures
futures price
price
If VHH =
= 0,
0, then
then (S)(QSS) = (F)NFFQFF, and the risk-minimizing number of
futures contracts to trade, N FF**, is
NF*
Q S S
QF F
Suppose you are long 1000 oz. of gold (in the cash
market).
Example: Solution
Q S
*
N S
F Q F
F
N* (1000/100) (0.9/1.0)
F
N* 9
F
Mathematics of Hedge
Ratio
Hedge Ratio = S/ F
This is similar to Slope coefficient /beta
Beta/Slope = OR
As we know =(CovA,B)/A. B
Note
It is really important to note here
that we are assuming that the
relationship between the changes
in the spot price and changes in
the futures price will remain the
same (i.e., at 0.90 to 1.00) over
the time period we are hedging.
Example 2, Cont.
S
*
S
N
F Q F
F
N* (410,000/4 2,000) (0.9837)
F
N* 9.60
F
Example 2, Cont.
Q S
*
N S
F Q F
F
N* (410,000/4 2,000) (0.9837)
F
N* 9.60
F
Example 2
Masood is another mortgage banker. His firm uses advance
commitments, where he promises to deliver loans to a
financial institution before he promises with borrowers. On
March 1, his firm agreed to sell mortgages to State
Insurance Co. The agreement specifies that he must turn
over 12-percent coupon mortgages with a face value of Rs.
1 million to State by May 1. As of March 1, Masood had not
signed up any borrowers. Over the next two months, he will
seek out individuals who want mortgages beginning May 1.
If interest rates fall before he signs up a borrower, the
borrower will demand a premium on a 12-percent coupon
loan. That is, the borrower will receive more than par on
May 1. Because Masood receives par from the insurance
company, he must make up the difference. How to hedge?
Excercises
Suppose that the standard deviation of
quarterly changes in the prices of a
commodity is $0.65, the standard
deviation of quarterly changes in a
futures price on the commodity is $0.81,
and the coefficient of correlation
between the two changes is 0.8. What is
the optimal hedge ratio for a 3-month
contract? What does it mean?
Example.2
The standard deviation of monthly changes in the spot
price of live cattle is (in cents per pound) 1.2. The
standard deviation of monthly changes in the futures
price of live cattl for the closest contract is 1.4. The
correlation between the futures price changes and the
spot price changes is 0.7. It is now October 15. A beef
producer is committed to purchasing 200,000 pounds
of live cattle on November 15. The producer wants to
use the December live cattle futures contracts to
hedge its risk. Each contract is for the delivery of
40,000 pounds of cattle. What strategy should the beef
producer follow?
Example 3
A corn farmer argues "I do not use futures
contracts for hedging. My real risk is not
the price of corn. It is that my whole crop
gets wiped out by the weather."
Discuss his view point?
Should the farmer estimate his or her
expected production of corn and hedge
and to try to lock in a price for expected
production?