4 Itds

Hedging strategies using futures
and interest rate futures

Chapter 6 & 3
Fundamentals of Futures and Options Markets, 8th Ed, Ch 6, Copyright © John C. Hull 2013 1
Chapter 3
HEDGING STRATEGIES USING FUTURES
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
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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
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
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
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 is the difference between spot & futures
 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.
 Can be negative or positive

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Basis Risk
 The basis in a hedging situation:
 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
 Prior to this it can be positive or negative
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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
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
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
Optimal Hedge Ratio
Proportion of the exposure that should optimally be hedged is
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
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)
Optimal number of contracts if no Optimal number of contracts

tailing adjustment after tailing adjustment to allow
or daily settlement of futures
N* N*
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:
sS is the standard deviation of DS

sF is the standard deviation of DF,
r is the coefficient of correlation between DS and
DF
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?
Optimal number of contracts if no

tailing adjustment
N*
QA Size of position being hedged (units)
QF Size of one futures contract (units)
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?
Optimal number of contracts after tailing

adjustment to allow or daily settlement of
futures:
N*
VA Value of position being hedged (=spot price time QA)
VF Value of one futures contract (=futures price times QF)
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)
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?
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.
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.
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?
The positive sign indicates to increase the

The negative sign indicates to lower the beta beta you would need to buy (go long) futures
you would need to short futures contracts contracts
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
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
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.....
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
Duration Hedging (page 144-148)
 Duration of a bond that provides cash flow ci at time ti is
where B is its price and y is its yield (continuously compounded)

 This leads to
Duration (Revision) Continued
 When the yield y is expressed with compounding m times per year
 The expression
is referred to as the “modified duration”
Duration-Based Hedge Ratio
VF Contract Price for Interest Rate Futures

DF Duration of Asset Underlying Futures at
Maturity
P Value of portfolio being Hedged
DP Duration of Portfolio at Hedge Maturity
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:
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

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Hedging strategies using futures

and interest rate futures

HEDGING STRATEGIES USING FUTURES

 Basis is the difference between spot & futures

 Can be negative or positive

 Prior to this it can be positive or negative

Proportion of the exposure that should optimally be hedged is

Optimal number of contracts if no Optimal number of contracts

sS is the standard deviation of DS

Optimal number of contracts if no

QA Size of position being hedged (units)

QF Size of one futures contract (units)

Optimal number of contracts after tailing

VA Value of position being hedged (=spot price time QA)

VF Value of one futures contract (=futures price times QF)

The positive sign indicates to increase the

 Duration of a bond that provides cash flow ci at time ti is

where B is its price and y is its yield (continuously compounded)

 When the yield y is expressed with compounding m times per year

is referred to as the “modified duration”

VF Contract Price for Interest Rate Futures

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