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Hedging: Long and Short

Long futures hedge appropriate when
you will purchase an asset in the future
and fear a rise in prices
If you have liabilities now, what do you fear?
Short futures hedge appropriate when
you will sell an asset in the future and
fear a fall in price
If you expect to issue liabilities, what do you
fear?
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Arguments For Hedging
Companies should focus on their main
business and minimize risks arising from
interest rates, exchange rates, and other
market variables
Non-intrusive risk management tool
Hedging may help smooth income and
minimize tax liabilities
Hedging may help smooth income and
reduce managerial salaries
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Arguments Against Hedging
Well-diversified shareholders can make
their own risk management decisions
It may increase business risk to hedge
when competitors do not
Explaining a loss on the hedge and a
gain on the underlying can be difficult
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Basis Risk
Basis is the difference between spot and
futures prices
Basis risk arises because of uncertainty
about the price difference when the
hedge is closed out
Basis risk usually less than the risk of
price or rate level changes
Basis risk depends on futures pricing
forces
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Choice of Hedging Contract
Delivery month should be as close
as possible to, but later than, the
end of the life of the hedge
If no futures contract hedged
position, choose the contract whose
futures price is most highly
correlated with the asset price
Called cross-hedging
Additional basis risk
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Naive Hedge Ratio
Divide the face value of the cash position
by the face value of one futures contract
Problems:
Market values should be focus
Ignores differences between the cash and
futures instruments
Variation: divide the market value of the
cash position by the market value of one
futures contract
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h
2
F
F , S
F
S
o
o
o
o
= =
Minimum Variance Hedge
Ratio
Proportion of the exposure that
should optimally be hedged is


hedge per dollar of cash market value
Hedge ratio estimated from:

FP CP
t t
c A | o A + + =
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Hedging Stock Portfolios
If hedging a well-diversified stock portfolio
with a well-diversified stock index futures
contract, what are implications?
No diversifiable risk in the cash stock portfolio
and futures hedge removes systematic risk
Since no risk, systematic or unsystematic,
what can an investor expect to earn by
hedging a well-diversified stock portfolio?
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But has all risk been eliminated?
Problems:
Stock portfolio being hedged may have
a different price volatility than the
stock-index futures
Hedging goal is not to reduce all
systematic risk
Price sensitivity to market
movements determined by beta
Hedging Stock Portfolios
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contract futures one of MV
portfolio spot of MV

) (
F
*
S

|
| |
Hedging Stock Portfolios
Optimal number of contracts to
hedge a portfolio is


Future contracts can be used to
change the beta of a portfolio
If |* >(<) |
S
, hedging implies a long
(short) stock index futures position
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Rolling The Hedge Forward
What if hedging further in the future than
available delivery dates?
Series of futures contracts used to
increase the life of a hedge
Each time a futures contract matures,
switch position into another, later
contract
Basis risk, cash flow problems possible