Hedging Strategies

with
Futures

Lecture IV

By:

Muhammad Afraz Abdur Rahman

 Basic Principles
• Many of the participants in futures markets are hedgers.
• Their aim is to use futures markets to reduce a particular risk that they face.
• This risk might relate to fluctuations in the price of oil, a foreign exchange rate,
the level of the stock market, or some other variable.
• A perfect hedge is one that completely eliminates the risk.
• A number of issues have to be considered when going for hedging such as:
• When is a short futures position appropriate?
• When is a long futures position appropriate?
• Which futures contracts should be used?
• What is the optimal size of futures position for reducing risk?
 Basic Principles
• When hedging a risk, the objective is usually to take a position that neutralizes the
risk as far as possible.
• 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.
• Two types of hedges:
• Short Hedge
• Long 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.
 Example
• Assume that it is May 15 today and that an oil producer has just negotiated a
contract to sell 1 million barrels of crude oil. It has been agreed that the price that
will apply in the contract is the market price on August 15.

• When the oil producer can expect a gain from this transaction?
• What should the oil producer be worried about?
• Which position he should take in the futures to offset his worries?
 Example
• On May 15 the spot price is Rs.60 per barrel and the crude oil futures price for
August delivery is Rs.59 per barrel.
• Suppose that spot price on August 15 proves to be Rs.55 per barrel and that futures
price settled on the same day is also close to this price or assume it to be Rs.55.
 Example
• For an alternative outcome, suppose that the price of oil on August 15 proves to be
Rs.65 per barrel.
• Hedging, therefore, reduces risk from either position, i.e. if one side weakens, the
other offsets.
 Long Hedges
• Hedges that involve taking a long position in a futures contract are known as long
hedges.
• A long hedge is appropriate when a company knows it will have to purchase a
certain asset in the future and wants to lock in a price now.
• A long hedge can also be used when an asset is sold short today and is expected to
be bought in future at a low price.
 Example
• Consider a Pakistani exporter Mr. Umer who knows that he will receive pounds
(£’s) in 3 months. Mr. Umer will realize a gain if the pound increases in value
relative to Pakistani rupee.

• What should Mr. Umer be worried about?

• Which position he should take in the futures to offset his worries?
 Example
• Suppose that it is now January 15. A copper fabricator knows it will need 100,000
pounds of copper on May 15 to meet a certain contract. The spot price of copper is
$3.40 per pound (today) and the futures price for May delivery is $3.20 per pound.

• When the copper fabricator can expect a gain from this transaction?
• What should the copper fabricator be worried about?
• Which position he should take in the futures to offset his worries?
 Example
• Suppose that the spot price of copper on May 15 proves to be $3.25 per pound and
futures price also to be $3.25.
• Suppose that the spot price of copper on May 15 proves to be $3.05 per pound and
futures price also to be $3.05.
 Summary of Hedging Situations

Condition Today Risk Appropriate Hedge

Hold asset Asset price may fall Short hedge

Expects to own asset Asset price may fall Short hedge

Plan to buy asset Asset price may rise Long hedge

Sold short asset Asset price may rise Long hedge

 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.
• As time passes, the spot price and the futures price do not necessarily change by
the same amount. As a result, the basis changes.
• An increase in the basis is referred to as strengthening of the basis; a decrease in
the basis is referred to as weakening of the basis.
The Basis
 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
spot price on June 8 is $67.9 per barrel and futures price is $67.2 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 $68.5
per barrel and $68.00 per barrel.
• What is the gain/loss on futures contract?
• What is the overall profit/loss from this hedge?
• What is the basis when the contract is closed out?
• What is the final effective price paid by the company for the oil purchased on November
10?
 Formulae
• Overall profit from long hedge:
• π (long hedge) = (S0 – ST) + (FT – F0)
• Overall profit from short hedge:
• π (short hedge) = (ST – S0) + (F0 – FT)
• Basis risk:
• Spot price – Futures price
• Effective price received/paid
• ST + (F0 – FT)
 Solution to Example
• Gain from futures contract:
• π = 68 – 67.2 = 0.8
• Overall profit from long hedge:
• π = (67.9 – 68.5) + (68 – 67.2) = 0.2
• Basis risk at closing date:
• Basis = 68.5 – 68 = 0.5
• Effective price paid:
• Effective price = 67.2 + 0.5 = 67.7
 How to reduce the 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:
• The choice of the asset underlying the futures contract
• The choice of the delivery month
 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.
 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 because
of two reasons:
• Volatility of futures prices in the delivery month
• The long hedger runs the risk of taking delivery of the asset
 Question
• It is March 1. A US company expects to receive 50 million Japanese yen at the end
of July. Yen futures contracts have delivery months of March, June, September,
and December. One contract is for the delivery of 12.5 million yen. When the yen
are received at the end of July, the company closes out its position. Suppose that
the spot the futures prices on March 1 in cents per yen is 0.7800 and 0.775, and
that the spot and futures prices when the contract is closed out are 0.7200 and
0.7250, respectively.
• Which delivery month the company should choose?
• What position the company should take in futures?
• What is the gain/loss on futures contract?
• What is the gain/loss on the spot market?
• What is the overall profit/loss from this hedge?
 Cross Hedging
• Cross hedging occurs when the asset or underlying to be hedged is not the same as
the one available in futures market.
• 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.
 Cross Hedging
• 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 hedger should choose a value for the hedge ratio that minimizes the variance
of the value of the hedged position. This is done by calculating a minimum
variance hedge ratio.
 Minimum Variance Hedge Ratio
• ΔS: Change in spot price, S
• ΔF: Change in futures price, F
• σS: Standard deviation of ΔS
• σF: Standard deviation of ΔF
• ρ: Coefficient of correlation between ΔS and ΔF
• h: Hedge ratio that minimizes the variance of hedger’s position

σS
h=ρ
σF
 Minimum Variance Hedge Ratio
• The optimal hedge ratio, h, is the slope of the best-fit line when ΔS is regressed
against ΔF, i.e.
ΔS = α + β ΔF + ε
• Then β = ΔS / ΔF, is an estimate of the hedge ratio or,
h = ΔS / ΔF
 Example
• An airline expects to purchase 1000 gallons of jet fuel in 1 month and decides to
use heating oil futures for hedging. The standard deviation of change in futures
price and spot price are 0.0313 and 0.0263, respectively. The correlation between
the change in prices of two assets is 0.928. Calculate the hedge ratio.
 Example
• An airline expects to purchase 1000 gallons of jet fuel in 1 month and decides to
use heating oil futures for hedging. The standard deviation of change in futures
price and spot price are 0.0313 and 0.0263, respectively. The correlation between
the change in prices of two assets is 0.928. Calculate the hedge ratio.
σS
h=ρ
σF
0.0263
h = 0.928 ˟
0.0313
h = 0.78
 Optimal Number of Contracts
• QA: Size of position being hedged (units)
• QF: Size of one futures contract (units)
• N: Optimal number of futures contracts for hedging
• The futures contracts should be hQA units of the asset. The number of futures
contracts required is therefore given by:
𝑄𝐴
N=h
𝑄𝐹
 Example
• Keeping in view the previous example, suppose that each heating oil contract
traded on exchange is on 100 gallons of heating oil, calculate the optimal number
of contracts for this hedge.
 Example
• Keeping in view the previous example, suppose that each heating oil contract
traded on exchange is on 100 gallons of heating oil, calculate the optimal number
of contracts for this hedge.
𝑄𝐴
N=h
𝑄𝐹
1000
N = 0.78 ˟
100

N = 7.8 contracts
 Question
• 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?
 Question
• 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 cattle 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
• 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?
 Example
• 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?
σS
h=ρ
σF
0.65
h = 0.8 ˟
0.81
h = 0.64
 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.