Week 2 Chapter 3 Lecture Slides

Chapter 3
Hedging strategies
using futures
PowerPoint to accompany:
Basic principles
Hedgers:
Use futures market to reduce risk
Take short futures position or long futures position
Choose which futures contract should be used
Decide the optimal size of the futures position
Copyright 2014 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781442532793/Hull Et Al/Fundamentals of Futures and Options Markets Australian/1e
Long and 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 and want to lock in the price
Short hedge example

It is 15 October. An Australian wheat farmer wants to sell 1 million
metric tonnes of Western Australian wheat in January. The futures
price for January delivery on the ASX is AUD 275 per metric tonne.
How can the farmer hedge his exposure?
What is the gain/loss on the futures contract if the spot price of
wheat on 19 January is:
AUD 270 per metric tonne?
AUD 285 per metric tonne?
Short hedge example (cont.)

The farmer can hedge with the following transactions:
15 October: Short 50,000 January futures contracts on Western
Australian wheat
19 January: Close out futures position
Futures price on 19 January should be very close to the spot price
If the spot price is AUD 270
Gains = AUD 275 AUD 270 = AUD 5 per contract
Losses = AUD 285 AUD 275 = AUD 10 per contract
Long hedge example

It is 15 October. A clothing manufacturer requires 100,000 kilograms
of greasy wool on 16 December to meet a certain contract. The
December futures price is AUD 200 per kilogram.
How can the manufacturer hedge his exposure?
What is the gain/loss on the futures contract if the spot price of
wheat on 16 December is:
AUD 205 per kilogram?
AUD 195 per kilogram?
Long hedge example (cont.)

The manufacturer can hedge with the following transactions:
15 October: Long position in 40 December futures contracts on
greasy wool
16 December: Close out the position
Futures price on 19 January should be very close to the spot price
Gains = 100,000 (AUD 205 AUD 200) = AUD 500,000
Losses = 100,000 (AUD 200 AUD 195) = AUD 500,000
Argument in favour of hedging

Companies should focus on the main business they are in and take
steps to minimise 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
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 asset can be difficult
Basis risk
Basis is the difference between spot and futures
Basis risk arises because of the uncertainty about the basis when
the hedge is closed out
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Basis risk
Variation of basis over time
Figure 3.1, page 55
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Short hedge and long hedge

Suppose that:
S1: spot price at time t1
S2: spot price at time t2
F1: futures price at time t1
F2: futures price at time t2
b1: basis at time t1; b1 = S1 F1
b2: basis at time t2; b2 = S2 F2
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Long hedge and short hedge

You hedge the future sale of an asset by entering into a short
futures contract
Price realised = S2 + (F1 F2) = F1 + b2
You hedge the future purchase of an asset by entering into a long
futures contract
Cost of asset = S2 (F2 F1) = F1 + b2
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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
14
Basis risk in a short hedge

It is 1 September. An Australian wool farmer expects to sell 100,000
kilograms of greasy wool on 25 September. The October futures price
for greasy wool is currently AUD 220 per kilogram.
What hedging strategy should the farmer follow?
If the spot and futures prices are AUD 205 and AUD 210 per kilogram
respectively:
What is the basis?
What is the gain/loss on futures?
What is the net price of greasy wool after hedging?
15
Basis risk in a long hedge

It is 1 November. An Australian clothing manufacturer needs to
purchase 100,000 kilograms of greasy wool on 18 November. The
December futures price is currently AUD 215 per kilogram.
What hedging strategy should the manufacturer follow?
If the spot and futures prices are AUD 225 and AUD 220 per
kilogram respectively:
What is the basis?
What is the gain/loss on futures?
What is the net price of greasy wool after hedging?
16
Cross hedging
Assets are different (jet fuel vs. heating oil)
The hedge ratio is the ratio of the size of the position taken in
futures contracts to the size of the exposure
Cross hedging is setting the hedge ratio to minimise the variance of
the value of the hedged position
17
Optimal hedge ratio

Proportion of the exposure that should optimally be hedged is:
where:
h*: the optimal hedge ratio
S: the standard deviation of S , change in the spot price during the hedging period
F: the standard deviation of F, change in the futures price during the hedging
period
: the coefficient of correlation between S and F
18
Optimal number of contracts

Optimal number of contracts:
where:
N*: the optimal number of futures contracts for hedging
QA: the size of position being hedged (units)
QF: the size of one futures contract (units)
19
Tailing the hedge

Tailing the hedge incorporates an adjustment for the daily
settlement of futures
Optimal number of contracts:
where:
N*: the optimal number of futures contracts for hedging
VA: the dollar value of the position being hedged
VF: the dollar value of one futures contract (the futures price times the size of
futures contract)
20
Hedging using index futures

To hedge the risk in a portfolio the number of contracts that should be
shorted is:
where:
: the beta of the portfolio
VA: the current value of the portfolio
VF: the current value of one futures contract
21
Reasons for hedging an equity portfolio

Desire to hedge systematic risk
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
22
Changing the beta of a portfolio

To change the beta of the portfolio from to *:
When > *, a short position in
When < *, a long position in
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contracts is required
contracts is required
Portfolio beta example

Futures price of SPI 200 is 4,200
Size of portfolio is AUD 2.1 million
Beta of portfolio is 1.5
One futures contract is for delivery of AUD 25 times the index
What position in futures contracts on the SPI 200 is necessary to
hedge the portfolio?
What position is necessary to reduce the beta to 0.75?
What position is necessary to increase the beta to 2.0?
24
Stock picking
If you think you can pick stocks that will outperform the market,
futures contracts can be used to hedge the market risk
If you are right, you will make money whether the market goes up
or down
25
Rolling the hedge forward

We can use a series of futures contracts to increase the life of a
hedge
Each time we switch from one futures contract to another we incur
a type of basis risk
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Rolling the hedge forward example

It is 11 April. An American company knows it will have 100,000 barrels of oil to sell
in June 2012. The current spot price is USD 69 per barrel. Only the first six
delivery months have sufficient liquidity to meet the companys needs.
What strategy should the company take?
What is the gain/loss from the futures contract?
Table 3.5, page 69
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Week 2 Chapter 3 Lecture Slides

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Chapter 3

Long and short hedges

Short hedge example

Short hedge example (cont.)

Long hedge example

Long hedge example (cont.)

Argument in favour of hedging

Arguments against hedging

Figure 3.1, page 55

Short hedge and long hedge

Long hedge and short hedge

Basis risk in a short hedge

Basis risk in a long hedge

Optimal hedge ratio

Optimal number of contracts

Tailing the hedge

Hedging using index futures

Reasons for hedging an equity portfolio

Changing the beta of a portfolio

When < *, a long position in

Portfolio beta example

Rolling the hedge forward

Rolling the hedge forward example

Table 3.5, page 69

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