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Lecture 3. Hedging strategies using futures

1. Long hedge and short hedge
2. An important concept: basis risk
3. Optimal hedge ratio
4. Hedging an equity portfolio
5. Mini quiz

Reading
Hull: Chapter 3
Learning outcome
Be able to explain the concepts of long hedge, short hedge,
basis, basis risk, and convenience yield
Be able to explain how basis risk affects hedgers position
Be able to calculate the optimal hedge ratio, the optimal
number of contracts needed for hedging and the profit/gain
from trading futures contracts.
Understand the advantages and disadvantages of hedging.

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Long hedge and short hedge

Long Hedge:
involves taking a long position in a futures contract
appropriate when the hedger knows it will have to purchase a
certain asset in the future
Example

Short Hedge:
involves taking a short position in a futures contract
appropriate when the hedger owns an asset and expects to sell it at
some time in the future.
example
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Example of a long hedge with commodity futures
A producer of electricity cables requires 50 tonnes of copper in
3 months time to meet a certain contract. The spot price of
copper at the LME is $7724 per tonne, and the futures price for
3 months delivery is $7695 per tonne. The size of the contract is
25 tonnes.

The producer can hedge its position by :
1. taking a long position (a long hedge) in 2 futures contracts
today
2. closing out the futures position in 3 months time
3. buying 50 tonnes of copper at the spot market in 3 months

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Suppose the spot price of copper in 3 months time is $7710
per tonne. (Note: At maturity, the spot price equals the
futures price. F
T
=S
T
=$7710.)
How much does producer gain/lose on the futures
contracts?
50*($7710- $7695) = $750, which is a gain,
What is the total cost of the strategy?
It pays $7710*50 = $385,500 for 50 tonnes of
copper in the spot market,
making the total cost to be $385,500 - $750 =
$384,750

Payoff in the futures
market: random
Cost in the spot
market: random
Hedged cost: certain
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For an alternative outcome, assume the spot price in 3
months time is $7600 per tonne.
What is the gain/loss on the futures contracts?
50 * ($7600 - $7695) = - $4750, which is a loss

What is the total cost of the strategy?
It pays $7600*50 = $380,000,
making the total cost $380,000 + $4750 =
$384,750.

Payoff in the futures
market: random
Cost in the spot
market: random
Hedged cost: certain
Basis risk
Basis is usually defined as the spot price minus the futures price
Basis = Spot price - Futures price
At maturity basis equals zero.
Before expiration, the difference between the spot and the futures
changes randomly
Basis increasing is referred to as the basis strengthening;
Basis decreasing is referred to as the basis weakening;

Basis risk arises because of the uncertainty about the basis when the hedge
is closed out
The asset whose price is to be hedged is not the same as the asset
underlying the futures contract (cross hedging)
The maturity time of the futures contract used for hedging does not
match the hedging horizon.





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Basis risk for long hedgers
Define
F
1
: Futures price when hedge is set up
F
2
: Futures price when the asset is purchased
S
2
: Spot price at the time of purchase
b
2
: Basis at the time of purchase=S
2

F
2






So if the basis strengthens, the long hedgers position
worsens; if the basis weakens, the long hedgers position
improves.














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Cost of asset in the spot market S
2

Gain on Futures F
2
F
1

Effective amount paid for the asset S
2

(F
2
F
1
) =F
1
+ b
2


Basis risk for short hedgers
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Define
F
1
: Futures price at time hedge is set up
F
2
: Futures price at time asset is sold
S
2
: Spot price at time of sale
b
2
: Basis at time of sale =S
2

F
2





So if the basis strengthens, the short hedgers position
improves; if the basis weakens, the short hedgers position
worsens.



Price of asset received in the spot market S
2

Gain on Futures F
1
F
2

Effective amount received S
2
+

(F
1
F
2
) =F
1
+ b
2

A numerical example
It is March 1. A US company expects to receive 50 million Japanese
yen at the end of July. Yen futures contracts on the CME Group have
delivery months of March, June, September, and December. One
contract is for the delivery of 12.5million yen. The company therefore
took a short position in four September yen futures contracts on
March 1. When the yen are received at the end of July, the company
closes out its position. We suppose that the futures price on March 1
in cents per yen is 0.7800 and that the spot and futures prices when
the contract is closed out are 0.7200 and 0.7250, respectively. What is
the effective price obtained in cents per yen?
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Answer
The gain on the futures contract is
F
1
F
2
= 0.7800-0.7250=0.0550
The effective price obtained in cents per yen is the final
spot price plus the gain on the futures:
S
2
+

(F
1
F
2
) =0.7200+0.0550=0.7750
a 2
nd
way of calculating the effective price:
The basis when the contract is closed out is:
b= S
2
F
2
=0.7200-0.7250= -0.0050
The effective price is also equal to the futures price when the
contract is entered into adjusted by the basis:
S
2
+

(F
1
F
2
) = F
1
+ b
2
=0.7800+(-0.0050)=0.7750

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Choice of Contract
Choice of the delivery month
as close as possible to, but later than, the end of the life of the
hedge.
1) low basis risk
2) avoid erratic futures prices
3) eliminate the risk of having to take delivery
Choice of the underlying asset:
Cross hedging: Hedging an exposure to the price of one asset with
a contract on another asset.
the underlying asset of the chosen futures contract is most closely
correlated with price of the asset being hedged.
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Example
There is no futures contract on jet fuel. An airline company has to buy
3 million gallons of jet fuel in three months. Suppose you are in
charge of this companys hedging activity. You gather the following
data on the correlations between jet fuel cash price changes and some
near month energy futures prices:







Which energy futures contract will you choose for hedging jet fuel
purchase? Briefly explain.
Is it a long hedge or a short hedge? Briefly explain.

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Correlations
Heating oil 0.54
Gasoline 0.41
Crude oil 0.45
Optimal Hedge Ratio
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Hedge ratio: the ratio of the size of a position in a hedging
instrument to the size of the position being hedged.

The optimal hedge ratio is :

s
S
is the standard deviation of DS, the change in the
spot price during the hedging period,
s
F
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.


F
S
h
s
s
r
*
Derivation of the optimal hedge ratio
the change in the value of the portfolio is
S- hF when the hedge is long asset + short futures contract
hF-S when the hedge is short asset + long futures contract
In both cases the variance of the hedged portfolio is:


Optimal hedge ratio is the value of h that minimizes the
variance of the hedging portfolio.
The first order condition with respect to h:

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2 2 2 2
2
s F s F
h h s s s rs s
F
S
F S F
h
h
h
s
s
r
s rs s
s

0 2 2
2
2
Optimal Number of Contracts
Q
A
Size of position being hedged (units)
Q
F
Size of one futures contract (units)
V
A
Value of position being hedged (=spot price time Q
A
)
V
F
Value of one futures contract (=futures price times Q
F
)
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Optimal number of contracts if
no tailing adjustment





F
A
Q
Q h
*

Optimal number of contracts

after tailing adjustment to
allow for daily settlement of
futures
F
A
V
V h
*

Example question
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An airline needs to purchase 2 million gallons of jet
fuel in three months and hedges using heating oil
futures. The spot price is $1.94/gallon and the
futures price is $1.99/gallon. The size of one heating
oil futures contract is 42,000 gallons. From historical
data, the airline calculated the following:
F
=0.0313,

S
=0.0263, and r= 0.928. Please help the airline to
calculate the optimal hedge ratio, the optimal number
of contracts with and without tailing adjustment.

Example continued
The optimal hedge ratio:


Optimal number of contracts assuming no daily settlement



Optimal number of contracts after tailing

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03 . 37
000 , 42
000 , 000 , 2
7777 . 0
*

F
A
Q
Q
h
7777 . 0
0313 . 0
0263 . 0
928 . 0
*

F
S
h
s
s
r
10 . 36
99 . 1 000 , 42
94 . 1 000 , 000 , 2
7777 . 0
*

F
A
V
V
h
Hedging an equity portfolio
The number of index futures contracts that should be shorted
to hedge an equity portfolio is:



: the parameter beta from the CAPM
P: the current value of the portfolio,
F=futures price*contract size
Daily settlement is taken into consideration
An important assumption of using this formula: the index
has a beta equal to one.

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F
P
N
*
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Example
A fund manager runs a 2,280,000 fund and he is concerned
the market will drop over the next 3 months but believes that
the market would perform well over the long run. Transaction
costs of selling the portfolio now and buying it back is
unacceptably higher than transaction costs in the futures
market. The FTSE 100 index is at 5714.3 in the spot market.
The 3-month futures price is 5700 and every point in the
index is worth 10. Dividend payment is zero. The fund has a
beta of 1.2.
What strategy would you suggest she to use for hedging the
short term risk of market going down?
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The formula to calculate the required number of contracts when
daily settlement is taken into consideration is:


So 48 index futures needs to be sold in order to hedge the
portfolio.
Note: when the market performs poorly, the loss in the
portfolio will be compensated by the gain from the futures
position.
Is there any assumption that you are making when suggesting
to do so?
48
10 * 5700
000 , 280 , 2
* 2 . 1
*

F
P
N

Reasons for hedging an equity portfolio

The hedger may be
1. confident with his well constructed portfolio but
pessimistic about the market
2. planning to hold a portfolio for a long period of time
and requires short-term protection in an uncertain
market situation.

Note: selling and buying the portfolio back later might
involve unacceptably high transaction costs.

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Convenience yield
Definition: the benefits from ownership of an asset that are
not obtained by the holder of a long futures contract on the
asset.

It reflects the markets expectation concerning the future
availability of the commodity.

The greater the possibility that shortage will occur, the
higher the convenience yield, at which the futures price will
be discounted. Vice versa.


Mini Quiz

1. The basis strengthens unexpectedly. Which of the following
is true (circle one)
(a) A short hedger's position improves.
(b) A short hedger's position worsens.
(c) A short hedger's position sometimes worsens and
sometimes improves.
(d) A short hedger's position stays the same.


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2. On March 1 the spot price of a commodity is $20 and the
July futures price is $19. On June 1 the spot price is $24 and
the July futures price is $23.50. A company entered into a
futures contracts on March 1 to hedge the purchase of the
commodity on June 1. It closed out its position on June 1.
What is the effective price paid by the company for the
commodity? .

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3. On March 1 the price of a commodity is $300 and the
December futures price is $315. On November 1 the price is
$280 and the December futures price is $281. A producer
entered into a December futures contracts on March 1 to
hedge the sale of the commodity on November 1. It closed
out its position on November 1. What is the effective price
received by the producer?


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4. A derivative security:
a. is useful only for speculation
b. is useful only for hedging
c. is useful only for arbitrage
d. can be used for all of these purposes
e. is useful for none of these purposes

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5. Suppose that the standard deviation of monthly changes in the
price of commodity A is $2. The standard deviation of monthly
changes in a futures price for a contract on commodity B (which
is similar to commodity A) is $3. The correlation between the
futures price and the commodity price is 0.9. What hedge ratio
should be used when hedging a one month exposure to the price
of commodity A? ..
6. A company has a $36 million portfolio with a beta of 1.2. The
S&P index is currently standing at 900. Futures contracts on
$250 times the index can be traded. What trade is necessary to
eliminate all systematic risk in the portfolio. (Indicate the
number of contracts that should be traded and whether the
position is long or short.)



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7. Which of the following is true (circle one)
a) The convenience yield is always positive or zero.
b) The convenience yield is always positive for an investment asset.
c) The convenience yield is always negative for a consumption asset.
d) The convenience yield measures the average return earned by
holding futures contracts.



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