4 Itds
4 Itds
4 Itds
Fundamentals of Futures and Options Markets, 8th Ed, Ch 6, Copyright © John C. Hull 2013 1
Chapter 3
Fundamentals of Futures and Options Markets, 8th Ed, Ch3, Copyright © John C. Hull 2013 2
Hedging
Many participants in the futures markets are hedgers – reduce risk that they face
Can be partial or complete hedge
Perfect hedge completely reduces “risk” but rare
Usually partial or designed to be optimal
Things to consider:
What futures position is appropriate
How many contracts and what type
Static or dynamic strategies
3
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
Fundamentals of Futures and Options Markets, 8th Ed, Ch3, Copyright © John C. Hull 2013 4
Arguments in Favor of Hedging
Companies should focus on the main Shareholders are usually well diversified
business they are in and take steps to and can make their own hedging decisions
minimize risks arising from interest rates, It may increase risk to hedge when
exchange rates, and other market competitors do not
variables Explaining a situation where there is a loss
on the hedge and a gain on the underlying
can be difficult
Fundamentals of Futures and Options Markets, 8th Ed, Ch3, Copyright © John C. Hull 2013 5
Convergence of Futures to Spot
(Hedge initiated at time t1 and closed out at time t2; Figure 3.1, page 56)
Spot
Price
Futures
Price
Time
t1 t2
Fundamentals of Futures and Options Markets, 8th Ed, Ch3, Copyright © John C. Hull 2013 6
Basis Risk
Hedging is rarely perfect
1. asset to be hedged does not completely 100% match asset underlying futures contract
2. hedger may be uncertain as to date when asset is to be bought or sold
3. the hedge may require the futures contract to be closed out before delivery month
Basis risk arises because of uncertainty about the basis when the hedge is closed out
Basis risk is the risk that the value of a futures contract (or an over-the-counter (OTC) hedge)
will not move in line with that of the underlying exposure.
Basis = spot price of an asset to be hedged – Futures price of the contract used
If the asset to be hedged and the asset underlying the futures contract are the
same, the basis should be zero at expiration of the futures contract
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Long Hedge for Purchase of an Asset
Define
F1 : Futures price at time hedge is set up
F2 : Futures price at time asset is purchased
S2 : Asset price at time of purchase
b2 : Basis at time of purchase
Cost of asset S2
Gain on Futures F2 −F1
Net amount paid S2 + (F2 −F1) =F1 + b2
Fundamentals of Futures and Options Markets, 8th Ed, Ch3, Copyright © John C. Hull 2013 9
Short Hedge for Sale of an Asset
Define
F1 : Futures price at time hedge is set up
F2 : Futures price at time asset is sold
S2 : Asset price at time of sale
b2 : Basis at time of sale
Price of asset S2
Gain on Futures F1 −F2
Net amount received S2 + (F1 −F2) =F1 + b2
Fundamentals of Futures and Options Markets, 8th Ed, Ch3, Copyright © John C. Hull 2013 10
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.
There are then 2 components to basis
Fundamentals of Futures and Options Markets, 8th Ed, Ch3, Copyright © John C. Hull 2013 11
Optimal Hedge Ratio
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
Fundamentals of Futures and Options Markets, 8th Ed, Ch3, Copyright © John C. Hull 2013 12
Optimal Number of Contracts
QA Size of position being hedged (units)
QF Size of one futures contract (units)
VA Value of position being hedged (spot price x QA)
VF Value of one futures contract (futures price x QF)
N* N*
Fundamentals of Futures and Options Markets, 8th Ed, Ch3, Copyright © John C. Hull 2013 13
Example (Page 62)
Lets assume an Airline will purchase 2 million gallons of jet fuel in one month and hedges using
heating oil futures.
From historical data sF =0.0313, sS = 0.0263, and r= 0.928 the minimum variance hedge ratio is
therefore:
Fundamentals of Futures and Options Markets, 8th Ed, Ch3, Copyright © John C. Hull 2013 14
Example continued (No Tailing)
The size of one heating oil futures contract is 42,000 gallons. The spot price is 1.94 and the futures price is
1.99 (both dollars per gallon).The optimal hedge ratio found previously is 0.7777.
What is the optimal number of contracts to hedge 2 million gallons of jet fuel?
N*
Fundamentals of Futures and Options Markets, 8th Ed, Ch3, Copyright © John C. Hull 2013 15
Example continued (Tailing)
Sometimes when futures are used to hedge an adjustment called tailing the hedge is used.
The size of one heating oil futures contract is 42,000 gallons. The spot price is 1.94 and the futures price is
1.99 (both dollars per gallon). The optimal hedge ratio found previously is 0.7777
What is the optimal number of contracts to hedge 2 million gallons of jet fuel?
N*
Fundamentals of Futures and Options Markets, 8th Ed, Ch3, Copyright © John C. Hull 2013 16
Hedging Using Index Futures
(Page 65)
To hedge the risk in a portfolio the number of contracts that should be shorted is
where:
VA is the current value of the portfolio
b is its beta
VF is the current value of one futures (futures price x contract size)
Fundamentals of Futures and Options Markets, 8th Ed, Ch3, Copyright © John C. Hull 2013 17
Example
Futures price of S&P 500 is 1,000
Size of portfolio is $5 million
Beta of portfolio is 1.5
One contract is on $250 times the index
What position in futures contracts on the S&P 500 is necessary to hedge the portfolio?
Fundamentals of Futures and Options Markets, 8th Ed, Ch3, Copyright © John C. Hull 2013 18
Example
Futures price of S&P 500 is 1,000, Size of portfolio is $5 million
Beta of portfolio is 1.5. One futures contract is on $250 times the index.
Fundamentals of Futures and Options Markets, 8th Ed, Ch3, Copyright © John C. Hull 2013 19
Changing Beta Using Index Futures
(Page 65)
To hedge the risk in a portfolio the number of contracts that should be shorted is
where:
VA is the current value of the portfolio
bnew is the new beta
bold is the old beta
VF is the current value of one futures (futures price x contract size)
Note: I have adapted the above formula from the text so you only need one formula, not two.
Fundamentals of Futures and Options Markets, 8th Ed, Ch3, Copyright © John C. Hull 2013 20
Changing Beta
Futures price of S&P 500 is 1,000, Size of portfolio is $5 million. Beta of portfolio is 1.5. One
futures contract is on $250 times the index.
What position is necessary to reduce the beta What position is necessary to increase the
of the portfolio to 0.75? beta of the portfolio to 2.0?
Fundamentals of Futures and Options Markets, 8th Ed, Ch3, Copyright © John C. Hull 2013 21
Why Hedge Equity Returns
May want to be out of the market for a while. Hedging avoids the costs of selling and
repurchasing the portfolio
Suppose stocks in your portfolio have an average beta of 1.0, but you feel they have
been chosen well and will outperform the market in both good and bad times.
Hedging ensures that the return you earn is the risk-free return plus the excess
return of your portfolio over the market
Fundamentals of Futures and Options Markets, 8th Ed, Ch3, Copyright © John C. Hull 2013 22
Stack and Roll (page 69-70)
We can roll futures contracts forward to hedge future exposures
Initially we enter into futures contracts to hedge exposures up to a time horizon
Just before maturity we close them out and replace them with new contract reflect
the new exposure
etc
Fundamentals of Futures and Options Markets, 8th Ed, Ch3, Copyright © John C. Hull 2013 23
Liquidity Issues (See Business Snapshot 3.2)
In any hedging situation there is a danger that losses will be realized on the hedge
while the gains on the underlying exposure are unrealized
This can create liquidity problems
One example is Metallgesellschaft which sold long term fixed-price contracts on
heating oil and gasoline and hedged using stack and roll
The price of oil fell.....
Fundamentals of Futures and Options Markets, 8th Ed, Ch3, Copyright © John C. Hull 2013 24
Stock Picking vs Rolling The Hedge Forward
Picking:
If you think you can pick stocks that will outperform the market, futures contract can
be used to hedge the market risk
If you are right, you will make money whether the market goes up or down
Rolling:
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
Fundamentals of Futures and Options Markets, 8th Ed, Ch3, Copyright © John C. Hull 2013 25
Duration Hedging (page 144-148)
Fundamentals of Futures and Options Markets, 8th Ed, Ch 6, Copyright © John C. Hull 2013 26
Duration (Revision) Continued
The expression
Fundamentals of Futures and Options Markets, 8th Ed, Ch 6, Copyright © John C. Hull 2013 27
Duration-Based Hedge Ratio
Fundamentals of Futures and Options Markets, 8th Ed, Ch 6, Copyright © John C. Hull 2013 28
Example (page 150-151)
Three month hedge is required for a $10 million portfolio. Duration of the
portfolio in 3 months will be 6.8 years
3-month T-bond futures price is 93-02 so that contract price is $93,062.50
Duration of cheapest to deliver bond in 3 months is 9.2 years
Number of contracts for a 3-month hedge is:
Fundamentals of Futures and Options Markets, 8th Ed, Ch 6, Copyright © John C. Hull 2013 29
Limitations of Duration-Based Hedging
Assumes that only parallel shift in yield curve take place
Assumes that yield curve changes are small
When T-Bond futures is used assumes there will be no change in the
cheapest-to-deliver bond
Fundamentals of Futures and Options Markets, 8th Ed, Ch 6, Copyright © John C. Hull 2013 30