Hedging Strategies Using Futures: Options, Futures, and Other Derivatives 6

Hedging Strategies Using
Futures
Chapter 3
Options, Futures, and Other Derivatives 6th Edition, Copyright © John C. Hull 2005 3.1
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
Example of short hedge
 In May 15 an oil producer has negotiated a contract
to sell 1 million barrels of crude oil. The price that will
apply is the market price on August 15.
 He will gain $10.000 for each 1 cent increase in the
price of oil over the 3 months
 We will lose $10.000 for each 1 cent decrease in the
price of oil over the period
 On May 15 the spot price is $19 per barrel.
 The crude oil futures price for August delivery is
$18.75
 Each futures contract is for delivery of 1000 barrels
(continued)
 The company hedge its exposure by shorting

1000 futures contracts
 The effect of the strategy should be to lock in

a price close to $18.75
(continued)
1. Suppose that the spot price on August 15 is
$17.50 The company realizes $17.5 million for
the oil under its sales contract. The gain from
the futures contracts is $18.75-
$17.50=$1.25 per barrel. Total amount is
$17.5+$1.25=$18.75 million
2. Suppose that the spot price is $19.50 on
August 15. The company realizes $19.50
million from the contract and loses $19.50-
$18.75=$0.75 per barrel. Total amount is
$19.5-$0.75=$18.75 million
Example of long hedge
 In January 15 a copper fabricator has
negotiated a contract to buy 100.000 pounds
of copper on May 15.
 On January 15 the spot price of copper is 140
cents per pound
 The copper futures price for May delivery is
120 cents per pound
 Each futures contract is for delivery of 25.000
pounds of copper
Example of long hedge
(continued)
 The company hedge its exposure by going

long 4 futures contracts
 The effect of the strategy should be to lock in

a price close to 120 cents per pound
Example of long hedge (continued)
1. Suppose that the spot price on May 15 is 125.
The company pays 100.000*1.25=125.000 for
the copper. The gain from the futures
contracts is 100.000*(1.25-
1.20)= 5.000 Total cost is 125.000-
5.000=120.000
2. Suppose that the spot price is 105 on August
15. The company pays 100.000*1.05=105.000
The losses from the futures contracts are
100.000*(1.20-1.05)= 15.000 Total
cost is 105.000+15.000=120.000
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
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
Basis Risk
In practice, hedging is often not quite as
straightforward:
1. The asset whose price is to be hedged may
not be exactly the same as the asset
underlying the futures contract
2. The hedger may be uncertain as to the exact
date when the asset will be bought or sold
3. The hedge may require the futures contract to
be closed out before its delivery month
Basis Risk
 Basis is the difference between spot &
futures
Basis =Spot price of asset to be hedged-
Futures price of contract used
 Basis risk arises because of the
uncertainty about the basis when the
hedge is closed out
Variation of basis over time
Futures
Price
Spot
Price
Time
t1 t2
The basis
 Suppose that
F1 : Initial Futures Price at time t1
F2 : Final Futures Price at time t2
S1 : Spot Asset Price at time t1
S2 : Final Asset Price at time t2
 b1 = S1 - F1
 b 2 = S 2 – F2
 The hedging risk is the uncertainty
associated with b2 = basis risk
Example
 Suppose that
F1 = $2.20
F2 = $1.90
S1 = $2.50
S2 = $2.00
 b1 = S1 - F1 = 0.30
 b2 = S2 – F2 = 0.10
Long Hedge
 Suppose that a hedger knows that he
will buy an asset at time t2.
 He hedges the future purchase of the
asset by entering into a long futures
contract at time t1.
 The price paid for the asset is S2 and the
loss on the hedge is F1 – F2
 Cost of Asset=S2 + F1– F2 = F1 + Basis =
$2.30
Options, Futures, and Other Derivatives 6 Edition, Copyright © John C. Hull 2005
th
3.16
Short Hedge
 Suppose that a hedger knows that the
asset will be sold at time t2.
 He hedges the future sale of the asset
by entering into a short futures contract
at time t1.
 The price realized for the asset is S2 and
the profit on the hedge is F1 – F2
 The price that is obtained is: S2 + F1 – F2
= F + Basis = $2.30
Options, Futures, 1and Other Derivatives 6 Edition, Copyright © John C. Hull 2005
th
3.17
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. This is
known as cross hedging.
Example
 In June 8 a company knows that will purchase 20.000
barrels of crude oil in October or November.
 It takes a long position in 20 December contracts
 The futures price on June 8 is $18.00 per barrel.
 The company purchases the crude oil on November
10, when the spot and futures prices are S2 = $20.00
and F2 = $19.10.
 The gain on the futures contract is 19.10-18.00=1.10.
 The basis is 20.00-19.10=0.90. The price paid is
20.00-1.10=18.90 = 18.00+0.90
 The total price paid is 18.90*20.000=378.000
Cross Hedging
Cross Hedging occurs when the asset
underlying the contract is different than the asset
whose price is being hedged
Hedge Ratio is the ratio of the size of the

position taken in futures contracts to the size of
the exposure.
When the asset is the same, the hedge ratio is 1.

Optimal Hedge Ratio
Proportion of the exposure that should optimally be
hedged is
h  S
where F
DS is the change in spot price during the life of hedge
DF is the change in futures price during the life of hedge
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.
Optimal Number of Contracts
the optimal number of Futures contracts
required for hedging is
N hN A
QF
where
ΝA is the size of position being hedged (units)
QF is the size of one futures contracts (units)
N is the optimal number of futures contracts for
hedging
Example
An airline expects to purchase 2 million gallons of jet
fuel in 1 month and decides to use heating oil futures
for hedging.
The variances of the spot and futures prices are
calculated: sS = 0.026, sF = 0.0313, and r =0.928.
h  S 0.928*0.0263/0.03130.78
F
Each heating oil contract is on 42.000 gallons of oil.
N  hN A 0.78*2.000.000/42.00037.14
QF
Hedging Using Index Futures
(Page 63)
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, b is
its beta, and A is the value of the assets
underlying one futures contract
In general, h=b
Example
Value of S&P 500 index is 1,000
Value of Portfolio is $5 million
Beta of portfolio is 1.5
Risk free interest rate is 4% per annum
Dividend Yield on index is 1% per annum
A 4 months futures contract is used to hedge the
portfolio over the next 3 months
The current futures price of the contract is 1.010
One futures contract is for delivery of $250 times
the index, so A=250*1.000=250.000
Continued
 The number of futures contracts that should be
shorted to hedge the portfolio is
1.5*(5.000.000/250.000)=30
 Suppose in 3 months Value of S&P 500 index is
900, and the futures price is 902
 The gain from the short futures position is then
30*(1010-902)*250=810.000
 The loss on the index is 10%. When dividends
are taken into account, an investor in the index
earn –0.975% (dividends 0.25% / 3m)
Continued
 The CAPM gives E(R )=Rf+β(RM - Rf) =
1.0 +[1.5*(-9.75-1.0)]=-15.125
 The expected value of the portfolio at the end of
the 3 months is therefore 5.000.000*(1-
0.15125)=4.243.750
 It follows that the expected value of the
hedger’s position, including the gain on the
hedge is 4.243.750+810.000=5.053.750
Performance of Stock Index Hedge
Value of index in 3 months 900 950 1000 1050 1100

Futures price of Index today 1010 1010 1010 1010 1010
Futures price of Index in 3 months 902 952 1003 1053 1103
Gain on futures position 810000 435000 52500 -322500 -697500
Return on Market -9.75% -4.75% 0.25% 5.25% 10.25%
Expected return on portfolio -15.125% -7.625% -1.125% 7.375% 14.875%
Expected portfolio value in 3 months 4.243.750 4.618.750 4.993.750 5.368.750 5.743.750
Total expected value in 3 months 5.053.750 5.053.750 5.046.250 5.046.250 5.046.250
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 outpeform the
market.)
Hedging Price of an Individual
Stock
 Similar to hedging a portfolio
 Does not work as well because only the
systematic risk is hedged
 The unsystematic risk that is unique to the
stock is not hedged
Rolling The Hedge Forward (page 67-
68)
 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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Hedging Strategies Using

 A long futures hedge is appropriate when

 The company hedge its exposure by shorting

 The effect of the strategy should be to lock in

 The company hedge its exposure by going

 The effect of the strategy should be to lock in

Companies should focus on the main

 Shareholders are usually well diversified

 Choose a delivery month that is as close

Hedge Ratio is the ratio of the size of the

When the asset is the same, the hedge ratio is 1.

To hedge the risk in a portfolio the

Value of index in 3 months 900 950 1000 1050 1100

 We can use a series of futures

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