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LONG Hedge
Spot Market: asset will be bought (lose when price increases); Futures Market: LONG position (gain when price increases).
SHORT Hedge
Spot Market: asset will be sold (lose when price decreases); Futures Market: SHORT position (gain when price decreases).
Risk Factor
Variable that determines the possible loss
2.
3.
August 15 (possibility 1)
Spot market:
SA15 = $17.50 which means + $17.5 mil. FA15 = $17.50 ~ close to the spot price because August is the delivery month
Futures market:
Profit: $18.75 - $17.50 = $1,25 / barrel i.e. + $1.25 mil. from the Futures position Result: $18.75 mil.
August 15 (possibility 2)
Spot market:
SA15 = $19.50 which means + $19.5 mil. FA15 = $19.50 ~ close to the spot price because August is the delivery month
Futures market:
Loss: $18.75 - $19.50 = $0.75 / barrel i.e. - $0.75 mil. from the Futures position Result: $18.75 mil.
Usually companies make no prediction of market variables they need their cash flow to be certain.
They hedge to avoid unpleasant price movements; Thus they focus on their main activities.
(Ex. build portfolio of copper producer and copper user companies.) However hedging might be more expensive for shareholders.
It may increase risk to hedge when competitors do not hedging becomes risky Explaining a situation where there is a loss on the hedge and a gain on the underlying can be difficult hedging strategies should be set by a companys board of directors and clearly communicated to companys management and shareholders.
b1
$2.20 $2.00 $1.90 Futures price
b2
t1
t2
Choice of Contract
Choose a delivery month that is as close as possible to, but later than, the end of the life of the hedge;
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. When the correlation is different from 1 we have the 2 components of basis.
+
The payoff of S i.e. the hedged asset
S0-S
S0
S0+S S Price of underlying
Spot Market
Futures Market
- (S2 S1) - S
+ (S2 S1) + S
Hedgers payoff
We need to make the hedgers payoff as certain as possible i.e. we need to minimize its variance.
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.
sS hr sF
QF
P N A
*
where P is the value of the portfolio, b is its beta, and A is the value of the assets underlying one futures contract
P N b A
*
21
Example
Value of S&P 500 is 1,000 Value of Portfolio is $5 million Beta of portfolio is 1.5
What position in futures contracts on the S&P 500 is necessary to hedge the portfolio?
Desire to be out of the market for a short period of time. (Hedging may be cheaper than selling the portfolio and buying it back). Desire to hedge systematic risk (Appropriate when you feel that you have picked stocks that will outperform the market.) Can do the same with a single stock when the investor feels the stock will outperform the market or an investment bank wants to protect its new issue against market moves.
2.
3.
P * P N b b A A
*
P P N b b A A
* *
Each time we switch from 1 futures contract to another we incur a type of basis risk (rollover basis).
Can postpone the rollover in the hope the basis will improve.
Close:
+$0.80 Short: FM=$17.00 +$1.70 for a loss of $3
Close:
+$0.50 Short: FJul.=$16.30
Profit margin
Hedged company
Price of output