Hedging Concepts

Short Hedge A short hedge means to hedge by going short in the futures market. A hedger who holds an asset and is concerned about a decrease in price might consider hedging it with a short position in futures. If the spot price and futures price move together, the hedge will reduce some of the risk.

Long Hedge When a party plans to purchase an asset at a later date, there exists a fear on increase in the asset’s price. Here the party might buy the futures contract. Then, if the price of the asset increases, the futures price also will increase and produce a profit on the futures position that will atleast partially offset the higher cost of purchasing the asset. As it involves an anticipated transaction, it is sometimes called an anticipatory hedge.

Basis Defined as the spot price minus the futures price. Hedging entails the assumption of basis risk, the uncertainty of the basis over the hedge period. The hedge profit is the change in the basis.

Hedging profitability and the risk Type of HedgeBenefits FromWhich occurs if Short Hedge (long spot, shot futures) Strengthening basisSpot price rises more than futures price rises or spot price falls less than futures price falls Long Hedge (short spot, long futures) Weakening basisSpot price rises less than futures price rises or Spot price falls more than futures price falls or Spot price falls and futures price rises

Some risks of hedging Cross Hedging – Involves an additional source of basis risk arising from the fact that the asset being hedged is not the same as the asset underlying the futures (example – Hedging of a corporate bond with Treasury bond futures contract) Quantity risk – Uncertainty over the size of the future cash flows Also, when the hedger does not know the horizon date, it will be more difficult to align the expiration date of the futures contract as a result of which the effectiveness of the hedge will be lower

Hedge Ratio Hedge ratio is the number of futures contract one should use to hedge a particular exposure in the spot market. The hedge ratio should be the one in which the futures profit or loss matches spot profit or loss. Though there is no exact method of determining the hedge ratio before performing the hedge, there are several ways to estimate it.

Minimum variance hedge ratio This gives the optimal number of futures when the objective is to minimize risk. Formula – Nf = -σΔSΔf / σ2 Δf The negative sign means that the hedger should sell futures. If the problem were formulated as a long hedge, the sign would be positive. We can estimate Nf by running a regression with ΔS as the dependent variable and Δf as the independent variable. (provided we know the actual values for the future)

Hedging strategies 1. Foreign currency hedging 2. Intermediate and long-term interest rate risk hedging 3. Stock hedging

Hedge situations – Foreign currency The ScenarioThe RiskThe Appropriate Action Plan to purchase a foreign currency with domestic currency The foreign currency will increase in value Buy forwards or futures Plan to convert a foreign currency into domestic currency The foreign currency will decrease in value Sell forwards or futures

Hedge Situations - Bonds The ScenarioThe RiskThe Appropriate Action Hold a bond or bond portfolio Interest rates will increase, decreasing the value of the bond Sell futures on notes or bonds Plan to purchase a bond Interest rates will decrease, increasing the value of the bond Buy futures on notes or bonds Plan to issue a bondInterest rates will increase, decreasing the value of the bond Sell futures on notes or bonds

Hedging situations - Stock The ScenarioThe RiskThe Appropriate Action Hold Stock PortfolioStock prices will fall, decreasing the value of the portfolio Sell stock index futures Plan to purchase a stock Stock prices will increase, increasing the cost to purchase Buy Stock index futures