Hedging Strategies Using Futures Chapter 4 Hedging Strategies Using Futures

Long & 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 Basis Principles:- Main principal to use future markets is take a position that neutralizes the risk as far as possible means if price of the commodity goes down, the gain in the future offset the loss on the rest of the company business

Arguments in Favor/ Against of Hedging Companies should focus on the main business they are in and take steps to minimize risks arising from interest rates, exchange rates, and other market variables Against: 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 can be difficult

Convergence of Futures to Spot (Hedge initiated at time t1 and closed out at time t2) Futures Price Spot Price Time t1 t2

Basis Risk Basis is the difference between the spot and futures price at time t. It should be zero at the expiration of the future contract. Prior to it, it can be negative or positive When SP>FP it means strengthening of the basis When SP<FP it means weakening of the basis Basis risk arises: uncertainty about the basis when the hedge is closed out The hedger may be uncertain as to the exact date when asset will be bought & sold The hedger may require the futures contract to be closed out well before its expiration

Basis Risk Basis risk is the risk associated with imperfect hedging. It arises because of the difference between the price of the asset to be hedged and the price of the asset serving as the hedge, or because of a mismatch between the expiration date of the hedge asset and the actual selling date of the asset (calendar basis risk), Under these conditions, the spot price of the asset, and the futures price, do not converge on the expiration date of the future. The amount by which the two quantities differ measures the value of the basis risk. That is, Basis = Spot price of hedged asset - Futures price of contract Options, Futures, and Other Derivatives, 7th Edition, Copyright © John C. Hull 2008

Basis Risk To examine the nature of Basis risk: F1 : Initial Futures Price F2 : Final Futures Price S1 : Initial Asset Price S2 : Final Asset Price B1 : basis at time t1 B2 : basis at time t2 from the definition of basis: B1= S1-F1 the hedging risk is uncertainty associated with b2. This is known as basis risk B2= S2-F2

Long /Short Hedge If you hedge the future purchase (Long Hedge) of an asset by entering into a long futures contract then Cost of Asset=S2 – (F2 – F1) = F1 + Basis If you hedge the future sale (Short Hedge) of an asset by entering into a short futures contract then Price Realized=S2+ (F1 – F2) = F1 + Basis

Choice of Contract One key factor affecting basis risk is the choice of the future contract used for hedging consist of : Choice of the asset underlying the future contract Choose a delivery month 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. Basis risk increases as the time difference between hedge expiration & delivery month increases, so choose a month that is as close as possible to, but later than, the end of the life of the hedge

Optimal Hedge Ratio Hedge ratio is the ratio of the size of the position taken in future contracts to the size of exposure.. Proportion of the exposure that should optimally be hedged is hedge ratio(h) where sS is the standard deviation of DS, the change in the spot price during the hedging period, sF is the standard deviation of DF, the change in the futures price during the hedging period r is the coefficient of correlation between DS and DF.

Optimal Hedge Ratio Hedge ratio is to determine the relationship between SP& FP Hedge effectiveness is estimated by how much variance that is eliminated by portfolio If r =1, and sF= sS, the hedge ratio = 1 it means future price mirrors the spot price perfectly. It is considered ideal but our main objective is to minimize risk, so setting hedge ratio equal to one is not necessarily optimal If r =1, and sF=2 sS, the hedge ratio = 0.5 it means future price always changes by twice as much spot price. Optimal Number of Contracts

Rolling The Hedge Forward Sometimes, the expiration date of the hedge is later than the delivery date of all the future contracts that can be used. The hedger must than roll the hedge forward by closing out one future contracts & taking same position in a future contract with a late delivery date Time t1= Short future contract 1 Time t2= Close out future contract 1 Short future contract 2 Time t3= Close out future contract 2 Short future contract 3………so on