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Hedging Strategies Using Futures

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Spot & Futures Prices

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Convergence of Futures to Spot

Futures
Price Spot Price

Spot Price Futures

Price

Time Time
(a) (b)

During the delivery period, the futures price and spot price must converge

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Example 1: Futures Price > Spot Price in Delivery Period

Arbitrage opportunity:
1. Short a futures contract
2. Buy the asset
3. Make delivery (immediately)
Spot Price will rise and Futures Price will fall

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Example 2: Futures Price < Spot Price in Delivery Period

1. Producers will buy the Futures 1. Traders short sell the asset
• To acquire the asset 2. Buy Futures & Hold till delivery
• Futures prices will rise Spot Price will fall and Futures Price will rise
• Spot price may fall

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Introduction to Hedging

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Definition

A hedge is an investment to reduce the risk of adverse price movements

in an asset. Normally, a hedge consists of taking an offsetting position in
a related security*
A hedge can help lock in profits / price / rates

http://www.investopedia.com/terms/h/hedge.asp
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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 and want to lock in the price

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Example 3
Asset: Oil Delivery Month: August, Target Date T: Aug 15, S0 = $60, F0 = $59
Compute the payoffs for each of the following strategies and each of the following traders
when ST = $55 / $65.
Producer: S1: Signs a contract to sell at ST OR S2: Sells a Futures Contract
Consumer: S1: Signs a contract to buy at ST OR S2: Buys a Futures Contract
Payoff:
ST Producer Consumer
Strategy S1: $55 -5 +5
Strategy S1: $65 +5 -5
Strategy S2: $55 +4 -4
Locked in Price: 59
Strategy S2: $65 -6 +6
Strategy S2 $ST 59 – ST ST – 59
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Arguments For & Against Hedging
FOR
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

AGAINST
Explaining a situation where there is a loss on the hedge and a gain on the
underlying can be difficult

What do the competitors do?

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Example 4

Two views on this

1. The executive may be right especially if there is no clarity on the price
movement.
2. On the other hand, the airlines’ core competence should be in the flying
business and not in forecasting oil prices. By hedging, the variability in the
price movement is controlled.

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Basis Risk

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 Basis Risk
Hedging is often not quite 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 hedge may require the futures contract to be closed out before its delivery month.
These problems give rise to what is termed basis risk.

Basis is defined as the spot price minus the futures price Si – Fi

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Long Hedge for Purchase of an Asset
Asset mismatch or Date mismatch
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

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Short Hedge for Sale of an Asset
Asset mismatch or Date mismatch
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

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Hedge Ratio

The ratio of the value of futures contracts purchased or sold to the value of the cash
commodity being hedged.

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Example 5
A company will buy 1000 units of a certain commodity in one year. It decides to hedge 80% of its
exposure using futures contracts. The spot price and the futures price are currently $100 and $90, per
unit respectively. Each futures contract is for one unit of the commodity.
A. What is the hedge ratio?
B. What position does the company take in the Futures market?
C. If the spot price and the futures price in one year turn out to be $112 and $110, respectively.
What is the total cost?
A. 80%
B. Buy 800 futures contracts
C. 1000 units @112 = 112,000
Gain on Futures = 800 * (110 – 90) = 16,000
Total Cost = 112,000 – 16,000 = 96,000
Using the formulas:
Cost for unhedged position = (20% of 1000)*112) = 22,400
Cost for hedged position = 800 * (F1 + b2) = 800 * (90 + 2) = 73,600
Total Cost = 96,000
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Hedging: Choice of Contracts

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Choice of Contract
The delivery month of the futures contract may not match with the business
requirements
• Choose a delivery month that is as close as possible to, but later than, the end of
the life of the hedge

The futures market in the required asset is illiquid

• Choose the contract whose futures price is most highly correlated with the asset
price. This is known as cross hedging.

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Choice of Contracts: Date Mismatch

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Example 6
On March 1, a US company expects to receive ¥50 million on July 25
• Yen futures contracts have delivery months of Mar/Jun/Sep/Dec
• With prices 0.7600 /0.7700 /0.7800 /0.8000 c/¥ respectively
• One contract is for the delivery of ¥12.5 million
Explain how the company would hedge.

• The company shorts four September yen futures contracts @ 0.7800 c/¥
• When the yen are received on July 25, the company closes out its position

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Example 7*
On March 1, a US company expects to receive ¥50 million on July 25
The company therefore shorts four September yen futures contracts @ 0.7800 c/¥
When the yen are received on July 25, Spot and futures prices are 0.7200 and 0.7250
respectively and the company closes out its position
A. Compute the effective price of ¥.
B. Explain why this is not a perfect hedge.
Part A
The gain on the futures contract: 0.7800 – 0.7250 = 0.0550 c
The effective price: 0.7200 + 0.0550 = 0.7750c

Or,
The basis is b2: 0.7200 – 0.7250 = -0.0050 c
The effective price: F1 + b2 = 0.7800 + (-0.0050) = 0.7750c
Part B
The position is not being closed out in the delivery month. Therefore b2 ≠ 0.
Hence not a perfect hedge
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Stack and Roll

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 an replace them with new contracts
& so on

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Example 8
In April 1992, a company realizes that it will have 100,000 barrels of oil to sell in June 1993
and decides to hedge its risk with a hedge ratio of 1.0. The current spot price is $19.
Although futures contracts are traded for every month of the year up to 1 year in the future,
only the first 6 months have sufficient liquidity.
The company therefore shorts 100 October 1992 contracts. In September 1992, it rolls the
hedge forward into the March 1993 contract. In February 1993, it rolls the hedge forward
again into the July 1993 contract. Compute the effective price realized assuming interest rate
is almost 0%
Date Oil price Futures price Gain
Apr 1992 $19 $18.20 (Oct)
Sep 1992 $17.40 (Oct), $17.00 (Mar) 0.80
Feb 1993 $16.50 (Mar), $16.30 (Jul) 0.50
Jun 1993 $16 $15.90 (Jul) 0.40
Effective Price $17.70
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Choice of Contracts: Cross Hedging

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A Digression on Regression

Y1 = 1 ⇒ E(Y2) = 3 & Y1 = 4 ⇒ E(Y2) = 9. That is, Δ(Y1) = 3 ⇒ Δ(Y2) = 6 = 2 * Δ(Y1)

Conversely (with a little fudging)
Y2 = 3 ⇒ Y1 = 1 & Y2 = 9 ⇒ Y1 = 4. That is, Δ(Y2) = 6 ⇒ Δ(Y1) = 3 = Δ(Y2) / 2

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Regression: Matching changes in Y1 and Y2
Suppose Y1 and Y2 are the prices of 2 assets Y1 & Y2 (?)
• When (price of) Y2 increases by Δ, price of Y1 increases by Δ / 2

Suppose we have QY2 of Y

What is the value of QY1 so that when the prices increases by Δ & Δ / 2
• Increase in QY2 * Y2 equals Increase in QY1 * Y1

For example, if QY2 = 5, then 5*Y2 increases by 5 Δ

∴ To match the increase in Y2, we need 10 units of Y1 = 5*2

QY1 = (Slope of Line)* QY2 / 1

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 Cross Hedging
A cross hedge is the act of hedging ones position by taking an offsetting position in
another good with similar price movements.

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Optimal Hedge Ratio (Minimum Variance)
Proportion of the exposure that should optimally be hedged is
𝛔𝐒
𝐡∗ = 𝛒
𝛔𝐅

= Slope of Regression Line

𝐓𝐡𝐞 𝐜𝐡𝐚𝐧𝐠𝐞 𝐢𝐧 𝐬𝐩𝐨𝐭 𝐩𝐫𝐢𝐜𝐞
=
𝐓𝐡𝐞 𝐜𝐡𝐚𝐧𝐠𝐞 𝐢𝐧 𝐟𝐮𝐭𝐮𝐫𝐞𝐬 𝐩𝐫𝐢𝐜𝐞

where
• σS is the standard deviation of ΔS, the change in the spot price during the hedging
period,
• σF is the standard deviation of ΔF, the change in the futures price during the
hedging period
• ρ is the coefficient of correlation between ΔS and ΔF.

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Optimal Number of Contracts
σS
Proportion of the exposure that should optimally be hedged is h∗ = ρ
σF

Optimal Number of Contracts

𝐡 ∗ 𝐐𝐀
𝐍∗ =
𝐐𝐅
Where
• QA is the size of position being hedged (units)
• QF: Size of 1 futures contract (units)

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Example 9: Cross Hedging
Air Jet 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
Explain how Air Jet will hedge if the size of one heating oil contract is 42,000 gallons
0.0263
ℎ∗ = 0.928 ∗ = 0.7798
0.0313
The size of one heating oil contract is 42,000 gallons
Optimal number of contracts is = 0.78 * 2,000,000 / 42,000 = 37.1333 ~ 37
Air Jet will go long on 37 heating oil futures contracts

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Example 10
Air Jet will purchase 2 million gallons of jet fuel in one month and hedges using heating oil
futures
Given sF =0.0313, sS =0.0263, and r= 0.928 & the size of one heating oil contract is 42,000
gallons, Air Jet will buy 37 heating oil futures contracts.
A. Find the expected loss / gain if jet fuel goes up (down) by $1.
B. Explain why there is no perfect hedge.

• Jet fuel goes up by $1: Then Futures on heating oil goes up by 1/0.7798 = 1.2824
Loss on Jet Fuel = 2,000,000 & Gain on Futures = 1.28*42,000 * 37 = 1,992,850
• Jet fuel goes down by $1: Then Futures on heating oil goes down by 1/0.7798 = 1.2824
Gain on Jet Fuel = 2,000,000 & Loss on Futures = 1.28*42,000 * 37 = 1,992,850
• Expected Loss / Gain in both cases = 7150
Not a perfect hedge because of rounding off errors
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Example 11

The optimal hedge ratio = (0.8 * 0.65) / 0.81 = 0.642

This means that the size of the futures position should be 64.2% of the size of the
exposure in a 3-month hedge

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Tailing The hedge

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Tailing the Hedge
To factor in the impact of marking to market – the daily settlement of futures
Consider a long hedger and consider the case where the futures price starts falling
• There is a daily cash outflow if the futures price falls
• This outflow would be recouped when the hedge is closed
• But there is the cost of interim cash outflows
• And this interim cash outflow could accumulate to wipe out the reserves*

Hence we need to tail the hedge

Metallgesellschaft
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Tailing the Hedge
ෝ
σ
Optimal hedge ratio is h෠ = ρො ෝ S
σF
where
ρො : Correlation between percentage daily changes for spot and futures
σ
ෝS : SD of percentage daily changes in spot
σ
ෝF : SD of percentage daily changes in futures

V
Optimal number of contracts is h෠ A
VF

Where
VA: Value of position being hedged (= spot price * QA)
VF: Value of one futures contract (= futures price * QF)

In theory, we need to change the position every day.

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 Example 12
Air Jet will purchase 2 million gallons of jet fuel next month and wants to hedge using heating oil futures.
• The spot price is $1.94 and the futures price is $1.99 (both gallon)
• From historical data 𝜎ො𝐹 = 0.0310, 𝜎𝑆 = 0.0260, 𝜌ො = 0.9
• The size of one heating oil contract is 42,000 gallons
Explain what position Air Jet will take if it wants to tail the hedge.

0.0260
ℎ∗ = 0.9 ∗ = 0.7548
0.0310
VA = 1.94 * 2,000,000 = 3,880,000 & VF = 1.99 * 42,000 = 83,580
Optimal number of contracts = 0.7548 * 3,880,000 / 83,580 = 35.04 ~ 35
Air Jet will go long on 35 heating oil futures contracts

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Index Futures*

Dubofsky Options and Financial Futures

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Stock Index Futures & Institutional Money Management

Stock Index futures have revolutionized portfolio management as practiced by:

• mutual funds
• pension plans
• endowments
• insurance company

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Details
A futures contract on a stock market index represents the right and obligation to
buy or to sell a portfolio of stocks characterized by the index.

Stock index futures are cash settled.

• There is no delivery of the underlying stocks.
• The contracts are marked to market daily.
• On the last trading day, the futures price is set equal to the spot index level and
there is a final mark to market cash flow.

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Stock Index Futures as Surrogates
Instead of Equity when the portfolio manager:
• has received an inflow of cash but has not decided which stocks or market
sectors in which to invest.
• has a growing bullishness about the market.
• wants to get market exposure in advance of a near-term expected cash inflow.
• wants an investment that can be quickly liquidated to raise cash, if needed.

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Long Synthetic Stock Position
Buy the stock index futures and invest the funds in T-Bills at rf
• The transaction costs are lower
• Ease of execution
• Especially when the futures price is undervalued

+c – p, with same strike price and time of expiry, is also a synthetic stock

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Example 13
Currently the investor has $9,000,000 in bonds which will grow to $10 million in 1
year. He now believes that the equity market will turn bullish
• He can liquidate the investment in bonds and invest in equity. There will be
transactions costs in both the sale and the purchase
• He can buy index futures with an underlying value = $9,000,000. The round-trip
transaction costs is very much less.
Suppose
• t = 0: Spot index is 1325, Index futures is 1375, Futures contract multiplier is 250
• t = 1: Spot index is 1500, Index futures is 1500
Ignoring the transaction costs and expected dividends, calculate the return on both
strategies

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Example 13
• t = 0: $9,000,000 in bonds which at time t = 1 will be $10 million
Spot index is 1325, Index futures is 1375, Futures contract multiplier is 250
• t = 1: Spot index is 1500, Index futures is 1500
• Ignore the transaction costs & expected dividends

At t = 0:
Strategy 1 requires liquidating the bond portfolio and investing the proceeds in the index
Strategy 2 requires buying 9,000,000/(1375*250) ~ 26 Index Futures

At t = 1:
Strategy 1: Capital appreciation on Index: (1500-1325)/1325 = 13.208%
Strategy 2: +10 million from bonds; 125*26*250 = 812,500 ⇒ Returns = 20.14%

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Synthetic T Bills
Long T-Bills + Long Stock Index Futures = Long Index Portfolio

When would you do this?

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Hedging with Index Futures*

Slightly different from the book

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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.

Hedging 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

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Changing the Beta of a Portfolio
Capital Market Theory predicts that rational investors will only hold combinations of
two assets:
• The market portfolio of all assets, (by definition, has a beta of 1.0)
• A risk-less asset, (by definition, has a beta of 0.0)

If investors are bearish about the prospects for the stock market, investors will lower
the beta of their portfolio by shifting a portion of their assets into risk-less securities.

If investors are bullish about the market, investors will raise their portfolio's beta by
borrowing additional capital and investing the borrowed funds in risky securities.

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The Market Model

E R p =α + β*RM

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Equation to Adjust Beta
β∗ − β Portfolio Value
N= ∗
βF Futures Price ∗ Multiplier
VA
= (β∗ − β)
VF
VA is the value of the portfolio,
β is its beta
β* is the target beta
VF is the value of one futures contract (Futures price * Contract Size)

Note:
1. Generally, βF = 1
2. A negative number indicates that futures should be sold in order to lower the
portfolio beta. A positive number means that futures should be bought.
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Effectiveness of the Hedge
Is dependent on the basis

The basis on the date the hedge is lifted is unknown

• Unless it is a delivery date

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Example 14
A portfolio manager is concerned that the stock market will temporarily decline in the
next few days. The manager does not wish to incur the commission costs and price
pressure of selling stocks and then repurchasing them after the anticipated decline.
Thus, the manager decides to use futures contracts to hedge against the expected
market decline.
Her portfolio is $20 million in stocks with a portfolio beta of 1.20. The S&P 500 index
level is 1275 and the futures price is 1280. Each Futures contract is $250 times the
price. What is the risk-minimizing position?

VA 20,000,000
N = 𝛽∗ − β = 0.0 − 1.20 ∗ = −75
VF 1280∗250

The portfolio manager must short 75 futures contracts

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Example 15
Recall from the previous example, the portfolio manager wants to exit the market
temporarily.
Her portfolio is $20 million in stocks with a portfolio beta of 1.20. The S&P 500 index
level is 1275 and the futures price is 1280. Each Futures contract is $250 times the
price. She has sold 75 futures contract.
Suppose the manager was right about the market's movement, and the S&P 500
declines to 1224. Compute the effectiveness of the hedge

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Example 15
Suppose the manager was right about the market's movement, and the S&P 500
declines to 1224. Compute the effectiveness of the hedge

The market declined by (1224 – 1275)/1275 = -4%

(If beta is correct), the value of the equity portfolio should decline by 4.8% (1.20 times 4%).
This results in a loss in the capital value of the portfolio of $960,000

Now assume that the futures price also declines by 4%, to (1 – 0.04)*1280 = 1228.80
Gain on Futures contracts = 75 * 250 * (1280 – 1228.8) = 960,000

Here, the hedge eliminated the effects of the market decline.

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Example 16
Suppose that a futures contract with 4 months to maturity is used to hedge the value
of a portfolio over the next 3 months in the following situation:
Value of S&P 500 index: 1,000
S&P 500 futures price: 1,010
Each Futures contract: $250 times the price
Value of portfolio: $5,050,000
Risk-free interest rate: 4 % per annum
Beta of portfolio: 1.5

A. What position should be taken to eliminate the exposure to the market over the
next 3 months?
B. Calculate the effect of the strategy if in 3 months, the index is at 900 and the
futures price is 909

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Example 16
VA
A. Number of contracts N = 𝛽∗ − β = -β(VP/VF) =
VF
-1.5*(505,0000 / 1010*250) = -1.5*5050000/252,500 = -30

B. Gain on Futures = N* (F1-F2) * 250 = 30 (1010 - 909) * 250 =$757,500

Return on Index = (1000 - 900)/1000 = -0.10 = -10%
Expected % Loss on portfolio = -1.5 * 10 = -15%
Expected Loss on Portfolio = -15%*5050,000 = 757,500

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Example 17

The current value of the portfolio is $5 million and its beta is 1.5. The futures price
is 1000 and each Futures contract is $250 times the price
1. What position is necessary to reduce the beta of the portfolio to 0.75?
2. What position is necessary to increase the beta of the portfolio to 2.0?

1. N* = (β* – β) (VP/VF) = (0.75 - 1.5) * (5000000/(250 * 1000)) = -15 (short position)

2. N* = (β* – β) (VP/VF) = (2.0 - 1.5) * (5000000/(250 * 1000)) = 10 (long position)

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Contango & Normal Backwardation

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Contango
An investor buys a 1-year futures contract at $50.
• If the expected future spot price is $35, the market is in contango
• The futures price will have to fall (unless the future spot price changes) to converge
with the expected future spot price.

Refers to a situation where people are willing to pay more for the commodity at some
point in the future than the actual expected price of the commodity.
This may be due to people's desire to pay a premium to have the commodity in the
future rather than paying the costs of storage and the carry costs of buying the
commodity today.
• Usually true for investment assets

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Backwardation

Normal backwardation is when the futures price is below the expected future spot
price.

This occurs:
1. When there is a demand-and-supply imbalance
2. The underlying asset is required for production

This is desirable for speculators who are net long in their positions: they want the
futures price to increase. So, normal backwardation is when the futures prices are
increasing.

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