Introduction to Futures Hedging

Hedging Linear Risk The traditional approach to market risk management is hedging. Hedging consist of tacking position that lower the risk profile of the portfolio. We distinguish between two hedging method: Static hedging – consists of putting on the position, and leaving it until the hedging horizon. Dynamic hedging – consists of continuously rebalancing the portfolio to the hedging horizon.

Hedging Linear Risk In general, hedging will create a basis risk. Basis risk arises when changes in payoffs on the hedging instruments do not perfectly offset changes in the value of the underlying asset. generally, hedging eliminates the downside risk but its also reduces upside in the position Thus, the profitability of hedging should be examined in the context of a risk-return tradeoff.

Futures Hedging Numerical Example Consider the situation of a U.S. exporter who has been promised a payment of Y125M in seven months. Two hedging alternatives: 1. Forward hedging – enter a 7-month forward contract in the OTC market – perfect hedge but with low liquidity. 2. Futures hedging – The CME lists yen contracts with face amount of Y12.5M that expire in 9 month – creates a Basis Risk but with high liquidity.

The P&L of the Hedged Position The exporter places an order to sell 10 contracts, with the intention of reversing the position in 7 months – when the contract will still have 2 months to maturity. The P&L of the Hedged Position Gain/Loss Exit Time Initial Time 2 9 Maturity 6% rUS 2% 5% rYEN -$166,667 0.006667 0.008 Spot ($/Y) $168,621 0.006711 0.00806 Futures ($/Y) $1,954 -0.000045 -0.00006 Basis ($/Y)

The P&L on unhedged position: The P&L on hedged position: where b=S-F which called the basis: The hedger objective is to minimize the basis risk

The Optimal Hedge Ratio Definitions S – the change in the dollar value of the unhedged position. F – the change in the dollar value of the one futures contract. N – the number of futures contracts. V – the total change in the dollar value of the hedged portfolio:

The Optimal Hedge Ratio The variance of the portfolio’s profits is: Minimizing the variance of the portfolio’s profits with respect to N, we obtain that optimal number of futures contracts is: Plugging N* in the variance equation, we obtain:

The Optimal Hedge Ratio-Rates of Changes The OHR also can be expressed in terms of rates of changes in unit prices. Definitions: Qs – number of units (shares, bonds…) in the cash position Qf – number of units in one futures contract s – unit spot prices f - unit forward prices S = Qs*s - the cash position F = Qf* f - the notional amount of one futures contract

The Optimal Hedge Ratio-Rates of Changes Rs – the rate of change in the spot price Rf – the rate of change in the futures price We than can write: Where b is the coefficient in the following regression

Numerical Example Consider the pervious example of a U.S exporter and assume the following data: What are the standard deviations in dollars? What is the optimal hedge ratio? What is the SD ($) of the full hedged portfolio? What is the SD ($) of the optimal portfolio?

Numerical Example The standard deviation in dollars: The optimal hedge ratio:

Numerical Example The SD($) of a full hedged portfolio (N=-10): The SD($) of the optimal portfolio (N=-7):

The Optimal Hedge Ratio

OHR It can be shown from the OHR equation that: which is the effectiveness of the hedge –the proportion of variance eliminated by the OHR.

Beta Hedging Beta is a measure of the exposure of the rate of return on a portfolio to movement in the market portfolio rate of return: Where  is the residual component and it is assumed to be uncorrelated with the market. Ignoring the residual component:

Beta Hedging Assume that there is a stock-index futures contract, which has a beta of unity (the stock-index represent the market portfolio). Thus: Thus, the total change in the dollar value of the hedged portfolio composed of some portfolio and a short of N stock-index futures contracts :

Beta Hedging As , V is set to zero when: Thus, the optimal number of contracts to short is: The quality of the hedge depends on the size of the residual risk – 2() The larger the portfolio the smaller the residual risk, as the individual stocks’ residual risk cancel each other.

Numerical Example A portfolio manager holds a stock portfolio worth $10M, with a beta of 1.5 relative to the S&P 500. The current S&P index futures price is 1400, with a multiplier of $250. What is the number of contracts to sell short for optimal protection?

Duration Hedging Modified duration can be viewed as a measure of the exposure of rates of changes in prices to movement in yields: We can rewrite this expression for the cash and the futures position

Duration Hedging The variances and the covariance are: Therefore the OHR:

Duration Hedging In the case we have a target duration of Dv, this can be achieved by:

Numerical Example A portfolio manager has a bond portfolio worth $10M with modified duration of 6.8 years. The current futures price is 93% with a notional amount of $100K and modified duration of 9.2 years. What is the number of contracts to sell for optimal protection