Derivatives Markets

Leonidas Rompolis

Chapter 4: Hedging Strategies Using Futures

Many of the participants in futures markets are hedgers. Their aim is to use futures
markets to reduce a particular risk that they face. This risk might relate to fluctuations
in the price of oil, a foreign exchange rate, the level of the stock market, or some other
variable. A perfect hedge is one that completely eliminates the risk. Perfect hedges are
rare. For the most part, therefore, a study of hedging using futures contracts is a study
of the ways in which hedges can be constructed so that they perform as close to
perfect as possible.
In this chapter we consider a number of general issues associated with the way hedges
are set up. These issues concerns the choice of long or short position, the kind of the
futures contract used and the optimal size of the futures position. We initially treat
futures contracts as forward contracts. Later we explain an adjustment known as
tailing that takes account of the difference between futures and forwards.

4.1. Basic strategies

A short hedge is a hedge that involves a short position in futures contracts. A short
hedge is appropriate when the hedger already owns as asset and expects to sell it at
some future time. A short hedge can also be used when an asset is not owned right
now but will be owned at some time in the future.
Example: Assume that today an oil producer has just negotiated a contract to sell 1
million barrels of crude oil three months later. It has been agreed that the price that
will apply at the contract is the market price at the delivery day. Suppose that the
current spot price is $60 per barrel and the crude oil futures price on NYMEX for
delivery in 3 months is $59 per barrel. Because each futures contract on NYMEX is
for delivery of 1,000 barrels, the company hedges its exposure by shorting 1,000
futures contract.
Suppose that the spot price three months later proves to be $55 per barrel. The
company realizes $55 million for the oil under its sale contract. The company also
realizes a gain of $59 - $55 = $4 per barrel from the short position in the futures
contract, or $4 million in total. The total amount realized from both the futures
position and the sales contract is therefore $59 per barrel, or $59 million in total.
Suppose that the spot price three months later proves to be $65 per barrel. The
company realizes $65 million for the oil and loses $65 - $59 = $6 per barrel on the
short futures position. Again, the total amount realized is $59 million. It is easy to see
that the company ends up with $59 million.
Hedges that involve taking a long position in a futures contract are known as long
hedges. A long hedge is appropriate when a company knows it will have to purchase
a certain asset in the future and wants to lock in a price now.
Example: Suppose a copper fabricator knows it will require 100,000 pounds of
copper three months later to meet a certain contract. The spot price of the copper is
$3.40 per pound, and the futures price for delivery three months later is $3.20 per

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Leonidas Rompolis

pound. The fabricator hedges it position by taking a long position in four futures
contracts on the COMEX division of NYMEX. Each contract is for a delivery of
25,000 pounds of copper. The strategy has the effect of locking in the price of the
required copper at $3.20 per pound.
Suppose that the spot price of copper three months later proves to be $3.25 per pound.
The fabricator gain from the long position on the futures contract is 100,000 (3.25
3.20) = $5,000. It pays 100,000 3.25 = $325,000 for the copper, making the net cost
$325,000 - $5,000 = $320,000.
For an alternative outcome, suppose that the spot price is $3.05 per pound. The
fabricator loses 100,000 (3.20 3.05) = $15,000 on the futures contract and pays
100,000 3.05 = $305,000 for the copper. Again, the net cost is $320,000. It is easy
to see that in all cases the company ends up to pay $320,000.
Note that it is better for the company to use futures contracts than to buy the copper
today in the spot market. If it does the latter, it will pay $3.40 per pound instead of
$3.20 per pound and will incur both interest costs and storage costs. For a company
using copper on a regular basis, the disadvantage would be offset by the convenience
of having the copper on hand. However, for a company that knows it will not require
the copper for the next three months, the futures contract alternative is likely to be
preferred.
Long hedges can be used to manage an existing short position. Consider an investor
who has shorted a certain stock. Part of the risk faced by the investor is related to the
performance of the whole stock market. The investor can neutralize the risk with a
long position in index futures contracts. This type of hedging strategy will be
discussed later.
The examples we have looked at assume that the futures position is closed out in the
delivery month. However, making or taking delivery can be costly and inconvenient.
For this reason, delivery is not usually made even when the hedger keeps the futures
contracts until the delivery month. Hedgers with long positions usually avoid any
possibility of having to take delivery closing out their positions before the delivery
month.
The arguments in favor of hedging are obvious. Companies, which do not have
particular skills or expertise in predicting variables such as interest rates, exchange
rates and commodity prices, can avoid the random fluctuations of these variables by
hedging. However, there are some issues that we should take into account when we
decide to hedge.
1. Hedging and competitors. If hedging is not the norm in a certain industry, it may
not make sense for one particular company to choose to be different from all
others. Competitive pressures within the industry may be such that the prices of
the goods and services produced by the industry fluctuate to reflect raw materials,
interest rates, exchange rates, and so on. A company that does not hedge can
expect its profits margins to be roughly constant. However, a company that does
hedge can expect its profits margins to fluctuate.
2. Hedging can lead to a worse outcome. It is important to realize that a hedge
using futures contracts can result in a decrease or increase in a companys profits
relative to the position it would be in with no hedging. In the example involving
the oil producer considered earlier, if the price of oil goes down, the company
loses money and the futures position leads to an offsetting gain. If the price goes
up, the company gains from the sale of the oil, and the futures position leads to an

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Leonidas Rompolis

offsetting loss. The company is in worse position than it would be with no

hedging.

4.2. Basis risk

In the examples considered so far the hedger was able to identify the precise date in
the future when an asset would be bought or sold. The hedger was then able to use
futures contracts to remove almost all the risk arising from the price of the asset on
that date. In practice, hedging is often not quite as straightforward. Some of the
reasons are as follows:
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 the delivery
month.
These problems give rise to what is termed basis risk, which will now be explained.

4.2.1. The basis

The basis, denoted as bt, in a hedging situation is defined as follows:
bt = St Ft
where St is the spot price of the asset to be hedged at time t, and Ft is the futures price
of the contract used at time t. If the asset to be hedged and the asset underlying the
futures contract are the same, the basis should be zero at the expiration of the futures
contract. Prior to expiration, the basis may be positive or negative. As time passes, the
spot price and the futures price do not necessarily change by the same amount. As a
result, the basis changes.
Assume that a hedge is put in place at t1 and closed out at time t2. From the definition
of the basis we have
b t1 =
St1 Ft1 and b t 2 =
St 2 Ft 2
Consider first the situation of a hedger who knows that the asset will be sold at time t2
and takes a short futures position at time t1. The price realized for the asset is St 2 and
the profit on the futures position is Ft1 Ft 2 . The effective price that is obtained for the
asset with hedging is therefore
St 2 + Ft1 Ft 2 = Ft1 + b t 2
The value of Ft1 is known at time t1. If b t 2 were also known at time t1, a perfect hedge
would result. The hedging risk is the uncertainty associated with b t 2 and is known as
basis risk. Consider next the situation where the company knows it will buy the asset
at time t2 and initiates a long hedge at time t1. The price paid for the asset is St 2 and
the loss on the hedge is Ft1 Ft 2 . The effective price that is paid with hedging is
therefore
St 2 + Ft1 Ft 2 = Ft1 + b t 2

Derivatives Markets

Leonidas Rompolis

This is the same expression as before. The value of Ft1 is known at time t1, and the
term b t 2 represents basis risk.
The asset that gives rise to the hedgers exposure is sometimes different from the asset
underlying the futures contract that is used for hedging. This increases the basis risk.
Define S*t2 as the price of the asset underlying the futures contract at time t2. By
hedging, a company ensures that the price that will be paid (or received) for the asset
is:
St 2 + Ft1 Ft 2 = Ft1 + b t 2 + St 2 S*t 2

The terms b t 2 and St 2 S*t 2 represent the two components of the basis. The first term
is the basis that quantifies the uncertainty of the futures position when it is closed out.
The second term is the basis arising from the difference between the two assets.

4.2.2. Choice of contract

One key factor affecting basis risk is the choice of the futures contract to be used for
hedging. This choice has two components:
1. The choice of the asset underlying the future contract
2. The choice of delivery month
If the asset being hedged exactly matches an asset underlying a futures contract, the
first choice is generally fairly easy. In other circumstances, we must determine which
of the available futures contracts has futures prices that are most closely correlated
with the price of the asset being hedged.
The choice of a delivery month is influenced by several factors. In fact, a contract
with a later delivery month is usually chosen. The reason is that futures prices are
quite erratic during the delivery month. Moreover, a long hedger runs the risk of
having to take delivery of the physical asset if the contract is held during the delivery
month. This could be expensive and inconvenient. However, basis risk increases as
the time difference between the hedge expiration and the delivery month increases. A
good rule of thumb is therefore to choose a delivery month that is as close as possible
to, but later than, the expiration of the hedge.
This rule of thumb assumes that there is sufficient liquidity in all contracts to meet the
hedgers requirements. In practice, liquidity tends to be greatest in short-maturity
futures contracts. Therefore, in some situations, the hedger may be inclined to use
short-maturity contracts and roll them forward. This is done by closing out one futures
contract and taking the same position in a futures contract with a later maturity.
Example: It is March 1. A US company expects to receive 50 million Japanese yen at
the end of July. Yen futures contracts on the CME have delivery months of March,
June, September, and December. One contract is for delivery of 12.5 million yen. The
company therefore shorts four September yen futures contracts on March 1. When the
yen are received at the end of July, the company closes out its position. We suppose
that the futures price on March 1 in cents per yen is 0.78 and that the spot and futures
prices when the contract is closed out are 0.72 and 0.725, respectively.
The gain on the futures contract is 0.78 0.725 = 0.055 cents per yen. The basis is
0.72 0.725 = -0.005 cents per yen when the contract is closed out. The effective

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Leonidas Rompolis

price obtained is the final spot price plus the gain on the futures (which can also be
written as the initial futures price plus the final basis): 0.72 + 0.055 = 0.775.
The total amount received by the company for the 50 million yen is 50 0.775 =
$387,000.

4.3. Cross hedging

In the examples considered up to now, the asset underlying the futures contract has
been the same as the asset whose price is being hedged. Cross hedging occurs when
the two assets are different. Consider, for example, an airline that is concerned about
the future price of jet fuel. Because there is no futures contract on jet fuel, it might
choose to use heating or crude oil futures contracts to hedge its exposure.
The hedge ratio is the ratio of the size of the position taken in futures contracts to the
size of the exposure. The hedge ratio we have used so far was equal to 1. When cross
hedging is used, setting the hedge ratio equal to one is not always optimal. The hedger
should choose a value for the hedge ratio that minimizes the variance of the value of
the hedged position.
Suppose that we expect to sell NA units of an asset at time t2 and choose to hedge at
time t1 by shorting futures contract on NF units of another asset. Using the same
notations as before we can write the total amount realized for the asset when the profit
or loss on the hedge is taken into account by:
Y =N ASt 2 N F Ft 2 Ft1

or

Y= N ASt1 + N A St 2 St1 N F Ft 2 Ft1

Because St1 is known at time t1 the variance of Y can be written as:

2
=
N 2A 2 S + N 2F 2 F 2N A N FS F
Y

where 2S and 2F is the variance of S= St 2 St1 and F = Ft 2 Ft1 , respectively.

denotes the correlation between S and F . The minimum variance with respect to
NF is achieved when

2Y
= 2N F2F 2N A S F = 0 N F = S
N F
F
1
Thus the optimal hedge ratio is:

N
H* = F = S
(1)

F
If = 1 and F =
S , the hedge ratio is 1. This result is to be expected, because in
this case the futures price mirrors the spot price perfectly (see previous example).
If = 1 and F =2S , the hedge ratio is 0.5. This result is also as expected, because
in this case the futures price always changes by twice as much as the spot price.
The optimal hedge ratio H* is the slope of the best-fit line when S is regressed
against F . This is intuitively reasonable, because we require H* to correspond to the
ratio of changes in S to changes in F . The hedge effectiveness can be defined as
1

The solution is the same if we go long futures contracts.

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Leonidas Rompolis

the proportion of the variance that is eliminated by hedging. This the R2 from the
regression of S against F and equals 2 or,
2
H*2 2 F
S
The parameters , F and S in equation (1) are usually estimated from the
historical data on S and F (the implicit assumption is that the future will in some
sense be like the past).
If we define as QF the size of one futures contract (units) then the optimal number of
futures contract for hedging is:
H* N A
N* =
(2)
QF
When futures are used for hedging, a small adjustment, known as tailing the hedge,
can be made to allow for the impact of daily settlement. In practice this means that
equation (2) becomes
H*VA
N* =
(3)
VF
where VA is the dollar value of the position being hedged and VF is the dollar value of
one futures contract (the futures price times QF).
Example: Jet fuel futures do not exist in the US, but firms sometimes hedge jet fuel
with crude oil futures along with futures for related petroleum products (for example
heating oil futures). If we own a quantity of jet fuel and hedge by holding H crude oil
futures contracts, our mark-to-market profit depends on the change in the jet fuel price
and the change in the futures price:
(St St 1 ) + H ( Ft Ft 1 )
We can estimate H by regressing the change in the jet fuel price (denominated in
cents per gallon) on the change in the crude oil (denominated in dollars per barrel).
Doing so using daily data for January 2000 January 2004 gives
St St 1 = 0.009+ 2.037 ( Ft Ft 1 )
R 2 = 0.287
(0.069)

(0.094)

The coefficient on the futures price change tells us that, on average, when the crude
oil futures price increase by $1, a gallon of jet fuel increases by $0.02.
An airline expects to purchase 2 millions gallons of jet fuel in 1 month and decides to
use crude oil futures for hedging. From the previous regression the optimal hedge
ratio is 2.037. Each crude oil contract traded on NYMEX is on 42,000 gallons (1000
barrels) of crude oil. Thus the optimal number of contracts, given by equation (2), is
2.037 2, 000, 000
= 97
42, 000
Suppose that the spot price and the futures price are 1.94 and 1.99 dollars per gallon.
Then VA = 2,000,000 1.94 = 3,880,000 while VF = 42,000 1.99 = 83,580, so that
when tailing the hedge the optimal number of contracts is
2.037 3,880, 000
= 94.59
83,550
If we round this to the nearest whole number, the optimal number of contracts is now
95 rather than 97.

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Leonidas Rompolis

4.4. Stock index futures

Stock index futures can be used to hedge a well-diversified portfolio. If the portfolio
mirrors the index, the optimal hedge ratio equals 1. When the portfolio does not
exactly mirrors the index, that is the two assets are not perfectly correlated, we can
use the parameter beta () from the CAPM to determine the appropriate hedge ratio.
The CAPM implies that the return of our portfolio, denoted as rp, is related to the
return of the index (which duplicates the market portfolio), denoted as rI, through its
beta p, by
rp = r + p(rI r)
where r is the risk-free rate. When p = 1, the return on the portfolio tends to mirror
the return on the market; when p = 2, the excess return on the portfolio tends to be
twice as great as the excess return on the market; when p = 0.5, it tends to be half as
great; and so on.
The CAPM implies that the beta coefficient is the slope of the best-fit line obtained
when excess return on the portfolio is regressed against the excess return of the index.
Therefore, following the theory elaborated in Section 4.3 the optimal hedge ratio is
equal to the beta, i.e.
H* = p
It Vp is the current value of the portfolio and VF is the current value of one futures
contract (the futures price times the contract size) then equation (3) gives that the
optimal number of futures contract is:
V
N* = p p
(4)
VF
This formula assumes that the maturity of the futures contract is close to the maturity
of hedge.
Example: Suppose that the S&P 500 futures contract with 4 months to maturity is
used to hedge the value of a portfolio over the next 3 months. We obtain the varianceminimizing position in the S&P 500 by using equation (4). A 5-year regression (from
June 1999 to June 2004) of the daily portfolio return on the S&P 500 return gives
rp r =0.0001+ 1.5 ( rS&P500 r )
R 2 =0.7188
(0.0003)

(0.0262)

Suppose that the value of the portfolio is $5,050,000 the value of the S&P 500 index
is 1,000 and the S&P 500 futures price is 1,010. One futures contract is for delivery of
$250 times the index. It follows that VF = 250 1,010 = 252,500 and from equation
(4), the number of futures contracts that should be shorted to hedge the portfolio is
5, 050, 000
1.5
= 30
252,500
Suppose that the index turns to be 900 in 3 months and the futures price is 902. The
gain from the short futures position is then
30 (1,010 902) 250 = $810,000
The loss of the index is 10%. The index pays a dividend of 1% per annum, or 0.25%
per 3 months. When dividends are taken into account, an investor in the index would
therefore lose 9.75% in the 3-months period. The 3-month risk-free interest rate is
1%. The CAPM gives that the expected return on the portfolio is:
rp =
0.01 + 1.5 ( 0.0975 0.01) =
0.1512
The expected value of the portfolio at the end of the 3 months is therefore

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Leonidas Rompolis

5,050,000 (1 0.1512) = $4,286,187

It follows that the expected value of the hedgers position, including the gain on the
hedge is
4,286,187 + 810,000 = $5,096,187
Table 1 summarizes these calculations together with similar calculations for other
values of the index at maturity. It can be seen that the total expected value of the
hedgers position is almost independent of the value of the index.

Table 1: Performance of stock index hedge.

Table 1 shows that the hedging scheme results in a value for the hedgers position at
the end of the 3-month period being about 1% higher than at the beginning of the 3month period. The risk-free rate is 1% per 3 months. The hedge results in an
investors position growing at the risk-free rate. Why therefore the hedger should go
to the trouble of using futures contract? To earn the risk-free rate, the hedger can
simply sell the portfolio and invest the proceeds in risk-free instruments. One answer
to this question is that hedging can be justified if the hedger feels that the stocks in the
portfolio have been chosen well. In these circumstances, the hedger might be very
uncertain about the performance of the market as a whole, but confident that the
stocks in the portfolio will outperform the market (after appropriate adjustments have
been made for the beta of the portfolio). Algebraically, this means that the return of
stock X is given by:
rX = X + r + X(rI r)
where X represents the expected abnormal return on X. A hedge using index futures
removes the risk arising from the market and leaves the hedger exposed only to the
performance of the portfolio relative to the market. The result for the hedged position
will be that, on average, we earn X + r. Another reason for hedging may be that the
hedger is planning to hold the portfolio for a long period of time and requires shortterm protection in an uncertain market situation.

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Leonidas Rompolis

Some exchanges do trade futures contracts on selected individual stocks, but in most
cases a position in an individual stock can only be hedged using stock index futures
contracts. Hedging an exposure to the price of an individual stock using index futures
contracts is similar to hedging a well-diversified portfolio. The optimal number of
index futures contracts that the hedger should short is given by equation (4), where p
is the beta of the stock, Vp is the total value of the shares owned, and VF is the current
value of one index futures contract. The hedge provides protection only against the
risk arising from market movements, and this risk is a relatively small proportion of
the total risk in the price movements of individual stocks. The hedge is appropriate
when an investor feels that the stock will outperform the market but is unsure about
the performance of the market (see also previous paragraph).

Exercises
1. Suppose that the S&P 500 index currently has a level of 1,100. The 6-month riskfree rate is 5% and the dividend yield on the index is 3%. You wish to hedge a
$300,000 portfolio that has a beta of 1.2 and a correlation of 1 with the S&P 500.
One futures contract is for delivery of $250 times the index.
(a) How many S&P 500 futures contracts should you short to hedge your
portfolio?
(b) What is the expected return of the hedged portfolio?
2. The standard deviation of monthly changes in the spot price of corn is 1.9. The
standard deviation of monthly changes in the futures price of corn for the closest
contract is 2.3. Each contract is for delivery of 5,000 bushels of corn. The
correlation between the futures price changes and the spot price changes is 0.75.
A food industry needs to buy 2,000,000 bushels of corn in 1 month. What
strategy can the industry use to hedge its risk?
3. Discuss the following viewpoints.
(a) A corn farmer argues. I dont think that I should use corn futures for
hedging. My real risk is not the price of corn. It is that my whole crop can be
destroyed by the weather.
(b) An airline executive argues. There is no point to use oil futures. There is an
equal chance that the price of oil in the future will be more or less than the
futures price.
4. A fund manager has a portfolio worth $35 million with a beta of 0.71. The
manager is concerned about the performance of the market over the next 2
months and plans to use 3-month futures contracts on the S&P 500 to hedge the
risk. The current level of the index is 980 and one contract is 250 times the index.
The risk-free rate is 5% and the dividend yield on the index is 2%.
(a) What position should the fund manager take to hedge all exposure to the
market risk over the next 2 months?
(b) Calculate the effect of your strategy on the fund managers returns if the
index in 2 months is 950 and 1,100.
5. The file S&P500 Data.xls contains settlement prices of the S&P 500 futures
contract with maturity period December 2012.
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Leonidas Rompolis

(a) Download to a separate spreadsheet in this file, daily prices for the same
period to that of the futures price data for two stocks with a ticker symbol
which is close to your family name and the S&P 500 index from
finance.yahoo.com or from google.com/finance.
(b) Calculate daily returns for the two stocks and the S&P 500 index.
(c) Calculate daily returns of a portfolio with equal investments in each of the
two stocks (If r1 and r2 are the returns of the two stocks, respectively, then
the return of the portfolio is equal to rp = 0.5r1 + 0.5r2).
(d) Calculate the beta of the portfolio. Beta is calculated by the Excel function
SLOPE where y range refers to the portfolio returns and x range refers to
the returns of the S&P 500 index.
(e) Consider that you make a $1,000,000 investment in this portfolio. How many
S&P 500 futures contracts should you short to hedge your portfolio at the
beginning of the period?
(f) Calculate daily values for the portfolio with and without the position in the
futures contract. Present these results in a joint graph. Discuss these results.

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