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Hedging Strategies Using Futures- from net

The document discusses hedging strategies using futures, emphasizing long and short hedges for locking in prices when purchasing or selling assets. It outlines the arguments for and against hedging, the convergence of futures to spot prices, and the concept of basis risk. Additionally, it explains the minimum variance hedge ratio and provides examples of hedging stock portfolios using index futures.

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Devika Arul
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© © All Rights Reserved
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Download as PPT, PDF, TXT or read online on Scribd
3 views

Hedging Strategies Using Futures- from net

The document discusses hedging strategies using futures, emphasizing long and short hedges for locking in prices when purchasing or selling assets. It outlines the arguments for and against hedging, the convergence of futures to spot prices, and the concept of basis risk. Additionally, it explains the minimum variance hedge ratio and provides examples of hedging stock portfolios using index futures.

Uploaded by

Devika Arul
Copyright
© © All Rights Reserved
Available Formats
Download as PPT, PDF, TXT or read online on Scribd
You are on page 1/ 27

1

Hedging Strategies
Using Futures

Chapter 3
2

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
& want to lock in the price
• A short hedge is also appropriate if you
currently own the asset and want to be
protected against price fluctuations
3

Arguments in Favor 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
4

Arguments against Hedging


• 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
5
• It's a fairly safe bet that as the delivery month of a futures contractapproaches, the
future's price will generally inch toward or even come to equal the spot price as time
progresses. This is a very strong trend that happens regardless of the contract's
underlying asset. This convergence can be easily explained by arbitrage and the law
of supply and demand.
For example, suppose the futures contract for corn is priced higher than the spot
price as time approaches the contract's month of delivery. In this situation, traders
will have the arbitrage opportunity of shortingfutures contracts, buying the underlying
asset and then making delivery. In this situation, the trader locks in profit because the
amount of money received by shorting the contracts already exceeds the amount
spent buying the underlying asset to cover the position.
In terms of supply and demand, the effect of arbitrageurs shorting futures contracts
causes a drop in futures prices because it creates an increase in the supply of
contracts available for trade. Subsequently, buying the underlying asset will causes
an increase in the overall demand for the asset and the spot price of the underlying
asset will increase as a result .

• As arbitragers continue to do this, the futures prices and spot prices will slowly
converge until they are more or less equal. The same sort of effect occurs when spot
prices are higher than futures except that arbitrageurs would short sell the underlying
asset and long the futures contracts.
6

Convergence of Futures to Spot

Futures
Spot Price
Price
Spot Price Futures
Price

Time Time

(a) (b)
7

Basis Risk
• Basis is the difference
between spot & futures
• Basis risk arises because of
the uncertainty about the
basis when the hedge is
closed out
8

Long Hedge
• Suppose that
F1 : Initial Futures Price
F2 : Final Futures Price
S2 : Final Asset Price
• You hedge the future purchase of an asset
by entering into a long futures contract
• Exposed to basis risk if hedging period
does not match maturity date of futures
9

Long Hedge
• Cost of Asset = Future Spot Price - Gain on Futures
• Gain on Futures = F2 - F1
• Future Spot Price = S2
• Cost of Asset= S2 - (F2 - F1)
• Cost of Asset = F1 + Basis2
• Basis2 = S2 - F2
• Future basis is uncertain
• Therefore, effective cost of asset hedged is
uncertain
10

Short Hedge
• Suppose that
F1 : Initial Futures Price
F2 : Final Futures Price
S2 : Final Asset Price
• You hedge the future sale of an asset
by entering into a short futures contract
11

Short Hedge
• Price Realized = Gain on Futures + Future Spot Price
• Gain = F1 - F2
• Future Spot Price = S2
• Price Realized = S2 + F1 - F2
• Price Realized = F1 + Basis2
• Basis2 = S2 - F2
• Price Realized = Cost of Asset
• Same Formula
12

Example
• Hedging period 3 months
• Futures contract expires in 4 months
• We’re exposed to basis risk
• Suppose F1 = $105 and S1 =100
• Current basis = 100 - 105 = -5
• Basis in 3 months is uncertain
• What is basis in 4 months?
13

Example
• If F2 = 110 and S2 = $102
• Long Hedge
– Gain = 110 - 105 = $5
– Effective cost = 102 - 5 = $97
• Short Hedge
– Gain = 105 - 110 = $ -5
– Realized (effective) price = 102 + (-5) = $97
• Future basis = 102 - 110 = -8
• Formula: Realized Price = F1 + basis2
• Realized Price = 105 + (-8) = $97
14

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.
15

Minimum Variance Hedge Ratio


• Hedge ratio is the ratio of the futures to
underlying asset position
• A perfect hedge requires that futures
and underlying spot asset price
changes are perfectly correlated
• For imperfect hedge, set hedge ratio to
minimize variance of hedging error
16
Minimum Variance Hedge Ratio
Proportion of the exposure that should optimally be
hedged is

h  S
F
where
S is the standard deviation of S, the change in the
spot price during the hedging period,
F is the standard deviation of F, the change in the
futures price during the hedging period
 is the coefficient of correlation between S and F.
17
Minimum Variance Hedge
Ratio Continued
• Error =S - hF
• Perfect hedge: Error = 0 at all times
 S = hF + Error
• Choose h to minimize var(Error)
• Therefore, h = slope of regression
• Or h = cov(S, F)/var(F)
18

Hedging Using Index Futures


• P: Current portfolio value
• A: Current value of futures contract on index
• F: Current futures price of index
• S: Current value of underlying index
• A = F x multiplier
• For S&P 500 futures, multiplier = $250
• If F=1000, A = 250,000
19

Hedging Using Index Futures


• Naive hedge: N = - P/A
• Match dollar value of futures to dollar
value of portfolio
• Suppose you wish to hedge $1M
portfolio with S&P 500 hundred futures
• Sell 1,000,000/250,000 = 4 contracts
20

Hedging Using Index Futures


• Remember total risk can divided up into
systematic and unsystematic risk
• Systematic risk is measured by the
portfolio beta
• Hedging with futures allows us to
change the systematic risk
• But not the unsystematic risk
21

Hedging Using Index Futures


• To hedge the risk in a portfolio the
number of contracts that should be
shorted is P

A
• where P is the value of the portfolio,
is its beta, and A is the value of the
assets underlying one futures contract
22

Hedging Stock Portfolios


• Hedge reduces systematic -- not
unsystematic risk
  is computed with respect to the index
underlying the futures contract
• Futures should be chosen on underlying
index that most closely matches the
investor’s portfolio
23

Changing Beta
• Let * = desired beta
• Let  = portfolio beta
• Then N = (* - )(P/A) (N < 0: sell)
• N > 0: buy
• If we adopt the above convention, this
formula textbook generalizes
24
Reasons for Hedging an Equity
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.)
25

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?
A = 1000x250 = $.25 M
N = (0 – 1.5)(5)/.25 = - 30 contracts (sell)
26

Changing Beta
• What position is necessary to reduce the
beta of the portfolio to 0.75?
N = (.75 – 1.5)(5)/.25 = -15 contracts (sell)

• What position is necessary to increase the


beta of the portfolio to 2.0?
N = (2 – 1.5)(5)/.25 = 10 contracts (buy)
27

Rolling The Hedge Forward


• We can use a series of futures
contracts to increase the life of a
hedge
• Each time we switch from 1 futures
contract to another we incur a type of
basis risk

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