Lecture 2 Derivative

Market
Futures
Forwards
Options
What is in todays lecture?

Principles of Hedging with Future

Some Examples
Lecture 3
Basis Risk

Minimum Hedge Ratio

Some Exercises
 BASIC PRINCIPLES OF HEDGING
Using futures markets to hedge a risk,
the objective is to take a position that
neutralizes the risk
The key to hedging with future contracts
is to take an opposite position to what a
firm/individual already has or is
expected to have
Long Hedge
Short Hedge
 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
 Producers or those who anticipates to
receive inventory should use short-hedge
to reduce the risk of their output
An Example of Hedging
An oil company may hold large
inventories of petroleum to be processed
into heating oil. The firm can sustain
heavy inventory losses if oil price decline,
how the firm can hedge its position.
 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?
 Examples of Hedging with
future/forward contracts
On April 1, Glaxosmith Chemical agreed to
sell petrochemicals to the Pakistan
government in the future. The delivery
dates and prices have been determined.
Because oil is a basic ingredient of the
production process, Glaxosmith Chemical
will need to have large quantities of oil on
hand. Moreover, if prices of oil increase,
the firm cannot pass on the additional
cost to the government, how to hedge?
An example of long hedge
The firm can buy futures contracts with
expiration months corresponding to the
dates the firm needs inventory.
The futures contract locks in the purchase
price
This strategy is called a long hedge where
the firm purchases a futures contract to
reduce risk.
In general, a firm institutes a long hedge
when it is committed to a fixed sales price
Real Life Example of long-
hedge
A group of students opened a small meat
market called Whats Your Beef near the
University of Pennsylvania in the late 1970s.
this was a time of volatile consumer prices,
especially food prices. Knowing that their
fellow students were particularly budget-
conscious, the owners vowed to keep food
prices constant, regardless of price
movements in either direction. They
accomplished this by purchasing futures
contracts in various agricultural commodities.
 BASIS RISK
In practice, hedging is often not quite
straightforward due to the following reasons:
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
The basis in a hedging situation is as follows:
Basis = Spot price of asset to be hedged -
Futures price of contract used
If the asset to be hedged and the asset
underlying the futures contract are the same,
the basis should be zero at the expiration of
the futures contract. Prior to expiration, the
basis may be positive or negative
 Some terms related to
basis
When the spot price increases by more
than the futures price, the basis
increases. This is referred to as a
strengthening of the basis.
When the futures price increases by
more than the spot price, the basis
declines. This is referred to as a
weakening of 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 OR
Final spot price gain on futures=> 70-1.1=68.9
Total price paid=> 68.90x20,000=$1,378,000
What to do to reduce basis
risk?
One key factor affecting basis risk is the
choice of the futures contract to be used
for hedging. This choice has two
components:
1. The choice of the asset underlying the
futures contract
2. The choice of the delivery month
 1. The choice of the asset
If the asset being hedged exactly matches
an asset underlying a futures contract, the
first choice is generally fairly easy.
In other circumstances, it is necessary to
carry out a careful analysis to determine
which of the available futures contracts
has futures prices that are most closely
correlated with the price of the asset
being hedged.
2. The choice of the delivery month
Generally, basis risk increases as the
difference between the hedge expiration and
the delivery month increases
A good rule of thumb is therefore to choose a
delivery month that is as close as possible to,
but later than, the expiration of the hedge.
Sometime, a contract with a later delivery
month is chosen, can you imagine why?
Might be the hedger has to take the delivery
in cases, which can be expensive
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.
Minimum variance hedge
ratio
The hedge ratio is the ratio of the size of the
position taken in futures contracts to the size
of the exposure.
When the asset underlying the futures contract
is the same as the asset being hedged; it is
natural to use a hedge ratio of 1.0.
When cross hedging is used, setting the hedge
ratio equal to 1.0 is not always optimal.
The optimal hedge ratio is determined by the
factors outlined in the next slide
 The Risk Minimizing
Hedge Ratio
Consider the following: VHH = (S)(QSS) (F)NFFQFF, where:
-- 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 ofof units
units of
of the
the underlying
underlying asset
asset in
in one
one futures
futures contract
contract
used
used to
to hedge
hedge

NNFF =
= the
the number
number ofof futures
futures contracts
contracts
-- 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, then (S)(QSS) = (F)NFFQFF, and the risk-minimizing number of
0, then
futures contracts to trade, N FF**, is

Q S S
NF*
QF F
The fractional term, S/ F, is the Hedge Ratio.
Example Using the
Hedge Ratio
Suppose you are long 1000 oz. of gold (in the cash
market).

There are 100 oz. of gold per futures contract.

For every $1.00 change in the futures price, the cash

market changes by $0.90
You want to engage in a risk minimizing hedge.

What position should you take in the futures

market?

How many contracts should you use?

Example: Solution

Because you are long in the cash market, using a risk

minimizing hedge means that you should take a short
position in the futures market. Concerning the number
of contracts:
* 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
So COV = . A.B, Then Beta = =
We can obtain beta with regression, or
through excel command, =slope(y,x)
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.
Hedge Ratio: Example 2
Running the following regression equation results in
an estimate of the hedge ratio:
S = + F +

Then, = S/F, is an estimate of the hedge ratio.
Suppose you have a long position of 410,000
gallons of heating oil.
You are concerned heating oil prices are going to ___
(rise or fall?), and you want to protect your
inventory value. Therefore, you ___ (buy or sell?)
heating oil futures).
Example 2, Cont.

There are 42,000 gallons of heating oil in one futures

contract.

You estimate the following regression equation:

S = 0.0177 + 0.9837 F
R22 Q
= 0.80
* 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

So, sell either 9 or 10 contracts for a

risk-minimizing hedge.
 Rolling the hedge forward
Sometimes the expiration date of the
hedge is later than the delivery dates of all
the futures contracts that can be used.
The hedger must then roll the hedge
forward by closing out one futures contract
and taking the same position in a futures
contract with a later delivery date.
Hedges can be rolled forward many times.
But that would give rise to basis risk
Risk hedging in financial
contracts
Nadeem Raza owns a mortgage-banking company. On
Feb 1 he made a commitment to loan a total of Rs. 1
million to various homeowners on April 1. The loans
are 20-year mortgages carrying a 12-percent coupon.
Like many mortgage bankers, he has no intention of
paying the Rs.1 million out of his own pocket. Rather,
he intends to sell the mortgages to an insurance
company. He will reach an insurance company March
30 to sell the mortgage to. Though Mr. Raza will earn
profitable fees on the loan, he bears interest-rate risk.
He loses money if interest rates rise. What would you
suggest to him for hedging this risk?
Solution: Use short-hedge
To hedge this risk, he sells 2-months
Treasury-bond futures contracts.
With rise in interest rates, the price of
mortgage as well as T-bonds will fall
His loss on mortgage is offset by the
profit on short-hedge of t-bons
But this is not a perfect hedge, why?
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?
Solution: use long hedge
Because he loses in the cash market when interest
rates fall, he should buys futures contracts to
reduce the risk.
When interest rates fall, the value of his futures
contracts increases.
The gain in the futures market offsets the loss in the
cash market.
Conversely, he gains in the cash markets when
interest rates rise. The value of his futures contracts
decreases when interest rates rise, offsetting his
gain.
This is called a long 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?
Solution to cattle example
The optimal hedge ratio is = .7*1.2/1.4
= .6
The beef producer requires a long
position in 200000x.6=120000 lbs of
cattle. The beef producers thus requires
a long position in December contracts,
closing out the position on November
15.
 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?
 Discussion on the farmers
view
If weather creates significant
uncertainity about volume of the crops,
then future contracts are not
appropriate
Future contracts plus the weather can
create further problems for him as the
prices are expected to rise in weather is
bad
 An airline executive has argued: "There
is no point in our using oil futures. There
is just as much chance that the price of
oil in the future will be less than the
futures price as there is that it will be
greater than this price." Discuss the
executive's viewpoint.
 What he is saying might be true, but the
firm is not in the business of speculating
on the oil prices and making profit from
rising/falling oil prices, it would be a lot
better if the company executives focus
on the main business.