Future Hedging

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Future Hedging

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- Chapter 23 - Fundamentals of Corporate Finance 9th Edition - Test Bank
- An.introduction.to.Derivative.securities.financial.markets.and.Risk.management.1st.edition.2013.Jarrow.chatterjea
- Derivatives (2)
- commodity
- Original AeFT SwapRent Paper Written by Ralph Y Liu in 2006
- ch17
- 1 - Introduction to Derivatives.ppt
- Chapter 8 The Structure of Forward and Futures Markets
- DRM_Hedging With Future Index
- Following the Tracks of Lions
- Introduction to derivative
- nifty_futures
- Describe the major features of valuing Futures, Forwards and Swaps
- Questions Ch 10
- Financial Instruments (Recognition and Measurement)
- Currency Derivatives in India
- kasar nya.docx
- ifmm
- AKL Chap 13
- IRM Assignment

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13

Futures Hedging

13.1 Introduction

Computing h

Hedge?

The Costs and Benefits of Corporate

Hedging

EXTENSION 13.1 Airlines and Fuel

Price Risk

EXTENSION 13.2 A Hedged Firm

Capturing a Tax Loss

Perfect and Imperfect Hedges

Basis Risk

Guidelines for Futures Hedging

The Mean-Variance Approach

Limitations of Risk-Minimization Hedging

13.7 Summary

13.8 Appendix

Deriving the Minimum-Variance Hedge

Ratio (h)

Computing the Minimum-Variance

Hedge Ratio (h)

Statistical Approach

Econometric Approach: A Linear

Regression Model

13.9 Cases

13.10 Questions and Problems

308

13.1

Introduction

The novelist Dostoyevsky perceptively observed in The Gambler: as for profits and

winnings, people, not only at roulette, but everywhere, do nothing but try to gain

or squeeze something out of one another. This aptly defines a zero-sum game of

which, excluding transaction costs, futures trading is an excellent example. There

is a pool of talented futures traders who earn a living from this business thereby

depressing the chances of winning for ordinary traders who lose money on average.

Then, why trade futures?

Cynics give a facile explanation: people are into commodities because its as

thrilling as going to the casinos. True to circus-owner P. T. Barnums immortal

quote that theres a sucker born every minute, these gamblers gladly lose for the

joy of the ride. Perhaps others believe that they really can win the futures game. We

know no surefire strategy. Even if you stumble on such a strategy, repeated use will

destroy its efficacy. So, why trade futures?

In reality, most futures contracts are traded to hedge risks that preexist in some

line of business, and hedgers are willing to give up expected returns as payment for

this insurance. We discussed this issue in the context of normal backwardation

in chapter 12. For example, Figure 13.1 shows a man selling goods on some tourist

spot, perhaps a beach. If he chooses his wares wisely, say, by carrying an assortment

of umbrellas and sunglasses, then he has hedged well. Come rain or come shine,

he has something to sell. If this is not possible, he could use futures to manage

these risks. For example, he could sell only umbrellas and buy futures on a sunglass

companys stock, instead of selling sunglasses.

Who hedges? A majority of the Fortune 500 companies and a growing number

of smaller firms hedge risk. Farmers often hedge the selling price of their produce.

Many producers hedge input as well as output price riskchapter 1 gave us an

inkling of derivatives usage by the consumer product giant Procter & Gamble.

This chapter explores the reasons for hedging, discusses its cost and benefits,

and introduces futures hedging strategies. We discuss perfect and cross hedges,

long and short hedges, and risk-minimization hedging using standard statistical

techniques.

13.2

to the immortal William Shakespeare) to hedge or not to hedgethat is the question.

We can only discuss hedgings benefits and costs.

The classic Modigliani and Miller (M&M) papers argued that debt policies do

not affect firm value. This irrelevance follows because a shareholder can replicate

such policies herself by trading stocks in otherwise identical firms. Therefore the

no-arbitrage principle ensures that these companies, differing only in their debt

Has Something to Sell*

Umbrellas $10

Umbrellas $10

Sunglasses $15

Inspired by a 1980s newspaper advertisement.

policies, must have equal value. The same argument can be applied to a firm hedging its balance sheet risks giving intellectual support to the irrelevance of hedging.

However, the M&M results rely on several key assumptions, including no market

frictions (including bankruptcy costs), no taxes, and no information asymmetry.

In the real world, these assumptions fail to hold. Consequently, if reducing the

firms risk is in the shareholders best interest, then a firm can usually do a better

job of hedging than individual investors. Indeed, a company (1) is likely to have

lower transaction costs; (2) can trade larger contracts than a shareholder; (3) can

dedicate competent personnel to hedging; (4) can hedge by issuing a whole range

of securities, which individuals cannot; (5) may have private information about the

companys risks; and (6) can hedge for strategic reasons that lie beyond an ordinary

investors knowledge. In all these cases, a company creates more value than an individual investor hedging on her own. But hedging is costly to implement, both in

developing and retaining the relevant expertise within the firm, and in executing

the transactions.

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A hedged business has fewer risks to worry about, but exactly why is this an advantage? Arent businesses supposed to take risks? We answer these questions next,

and although we focus on the use of futures, many of these same benefits can be

obtained with other derivatives such as forwards, options, and swaps:

1. Hedging locks in a future price. Recall chapter 8, in which we discussed the establishment of the Chicago Board of Trade. The CBOT built orderly markets for grain

trading to avoid price crashes at harvest times and booms afterward. Hedging

with futures helps smooth such demandsupply imbalances. It allows traders to

lock in stable prices and plan production and marketing activities with greater

certainty.

2. Hedging permits forward pricing of products. For example, many airlines routinely

hedge aviation fuel prices, which is a major input cost. If fuel costs can be fixed

(and other costs, such as staff salary, airplane depreciation, airport gate rental

charges, and travel agents commissions, can be estimated in advance), then the

airline can better set a profit margin and determine future seat prices. Customers

like knowing travel costs far in advance.

3. Hedging reduces the risk of default and financial distress. Default means a failure

to pay a contractual payment, such as debt, when promised. Default triggers unfavorable outcomes such as lawyer fees, potential bankruptcy costs and liquidation fees, losing control over the companys assets, and increased costs of doing

business because suppliers fear that they may not be paid and customers may

worry about quality and service. These are called financial distress costs. A company can reduce the likelihood of incurring these costs by hedging some of the

risks it faces.

4. Hedging facilitates raising capital. Because of the decreased risk of default, bankers allow hedgers to borrow a larger percentage of a commoditys value at a lower

interest rate than nonhedgers. This same logic applies to firms.

5. Hedging enables value-enhancing investments. Froot et al. (1994) argue that if external sources of funds (like stock and bond issuances) are costlier to corporations than internally generated funds, then hedging can help stabilize internal

cash flows and make them available for attractive investment opportunities.

6. Hedging reduces taxes. A hedge may be used to capture the benefits of a tax loss

or take advantage of a tax credit. The basic intuition is simple. Because one can

use a tax loss or a credit only when the company has positive profits, it may be

worthwhile to smooth out profits by hedging rather than letting them fluctuate.

See Extension 13.2 for an example that illustrates this notion.

However, hedging also incurs costs. When trading with a speculator, a hedger

often pays an implicit fee by trading at a price inferior to the expected future

payoff. Of course, brokers must also be paid. The presence of these trading costs

constitutes a basic argument against futures hedging. Moreover, businesses must

allocate valuable personnel to devise hedging strategies, set up adequate checks and

balances to prevent rogue employees from ruinously speculating with the firms

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money, ensure compliance with the laws of the land, and meet the governments

accounting requirements in this regard.1

Hedging is analogous to purchasing an insurance policy on some commoditys

spot price. It pays off when spot prices move in an adverse direction. However, as

with all insurance policies, there is a costthe premium. If the spot price does not

move adversely, one pays for insurance not used. Risk-averse individuals buy insurance despite this cost, and analogously, firms often hedge.

To hedge or not to hedge remains an unsettled question that must be resolved

on a case-by-case basis. One often hears any number of catchy maxims: no risk,

no gain alongside risk not thy whole wad. Which to choose requires expertise,

finesse, and knowledge, which are acquired through study and experience.

In August 2006, US president George W. Bush gathered his economic team in the picturesque retreat of

Camp David. Although the economic outlook was strong, the newly appointed secretary of the treasury,

Henry M. Paulson Jr., previous chairman and CEO of the Wall Street firm Goldman Sachs, was worried

about the likelihood of a financial crisis. If you look at recent history, there is a disturbance in the capital

markets every four to eight years, observed Paulson, as he painted a picture of how an enormous amount

of leverage and risk had accumulated in the financial system. In reply to a presidential query as to how this

risk can be reduced, the secretary gave a quick primer on hedging. He cited as an example that airlines

might want to hedge against rising fuel costs by buying futures to lock in todays prices for future needs

(Paulson, 2010).

Indeed, fuel costs can hit the airlines hard. Fuel is a major cost of the airline business; it can be between 10

percent (in good times) and more than 35 percent (in bad times) of their average expenses.2

When the going gets tough, the tough get going goes a familiar saying. As the oil price went up, the airlines

adopted a wide range of measures, some prudent and others drastic, to reduce fuel consumption. Most of these

approaches aimed at lowering the aircrafts weight because a lighter plane is cheaper to fly. Other steps included

flying more fuel-efficient planes and reducing the time that plane engines stay on. Some started trading commodities. Many commercial airlines as well as companies like FedEx (which uses its extensive fleet to quickly deliver

packages to numerous locations around the globe) use derivatives on crude oil to hedge. The hedged amount varies. Sometimes they hedge little or none of their exposure; at other times they hedge much more (see Table 13.1 for

a description of the fuel hedging situation in early 2005 for major US airlines, ranked in terms of passenger traffic).

Annual reports of companies mention their derivatives exposure. Southwest Airlines maintained its long

track record of profitability into the new millennium by extensive hedging even at a time when many other

airlines were reeling from losses and operating under bankruptcy protection. Consider the 2007 annual report

of Southwest Airlines, which gleefully gloats,

2

www.iata.org/index.htm.

Barings Bank, one of Englands oldest and most prestigious merchant banks, founded in 1762 by Sir

Francis Baring, collapsed in 1995 after a rogue employee, Nick Leeson, lost $1.4 billion of company

money speculating in futures contracts. Nowadays, most companies have stronger oversight of the

firms overall risk situation through the office of a chief risk management officer, who often reports

directly to the chief executive officer.

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TABLE 13.1: Fuel Hedge and Potential Impact of Fuel Price Increases for Leading

Airlines

American

Airlines

at all in remaining quarters

United Airlines

$1.27 per gallon, excluding taxes

Delta Airlines

Not hedged

Every 1 cent rise in the average jet fuel price per gallon

increases its liquidity needs by about $25 million per year

Northwest

Airlines

quarter and 6% for the full year

operating expenses by about $1.6 million per month

Continental

Airlines

Not hedged

increase in crude oil prices (rose by about $14 a barrel in

2005); also liable to pay regional carrier ExpressJets fuel

costs above 71.2 cents a gallon

Southwest

Airlines

that cap prices at $26 a barrel

(current market price: over $57

a barrel)

quarters 89.1 cents average price per gallon

US Airways

31, 2004

4% of its 2005 jet fuel requirements

America West

Airlines

year and 2% hedged for 2006

annual operating expense by $5.7 million

Alaska Airlines

annual operating expenses by about $4.0 million

JetBlue Airways

increase in jet fuel in 2004: $1 billion

Based on US Airlines Face Billions in Extra Fuel Costs, Airwise News, March 17, 2005.

We were well prepared and recorded our 35th consecutive year of profitability, a record unmatched in commercial

airline history. . . . Jet fuel prices have been rising every year for the last five years. Our fuel hedging program has

consistently mitigated such price increases dating back to year 2000. Since then, in each year, we have striven to

hedge at least 70 percent of our consumption. In 2007, we were approximately 90 percent protected at approximately $51 a barrel. That protection saved us $727 million last year and limited us to an 11.3 percent increase in

the economic cost per gallon, year-over-year. . . . A year ago, crude oil was hovering around $50 a barrel. By fourth

quarter 2007, crude oil prices had skyrocketed to $100 a barrel. Fortunately, we are again well hedged for 2008 with

approximately 70 percent of our fuel needs protected at approximately $51 a barrel.

Buoyed by a successful derivatives hedging program, Southwest did a brand-strengthening exercise in 2008

that hit the competition hard. It ran newspaper ads boasting its low airfare with no hidden fees, and its website

took snipes at the rivals by proudly proclaiming, Low fares. No hidden fees. No first checked bag fee. No

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second checked bag bee. No change fee. No window or aisle seat fee. No curbside check-in fee. No phone

reservation fee. No snack fee. No fuel surcharge.3

Its hard to question successful hedging programs! But Southwest is also a very well-run company. The

annual report notes that its on-time performance, few flight cancellations (less than 1 percent of flights scheduled), and small number of complaints filed with the US Department of Transportation placed it in the front

rank in the airline industry.

Unfortunately, the tables turned. For the first quarter of 2009, Southwest reported a net loss of $91 million,

including special charges totaling $71 million (net), relating to non-cash, mark-to-market and other items

associated with a portion of the Companys fuel hedge portfolio.4 The companys CEO, Gary C. Kelly, stated

in a press release dated April 16, 2009,

We benefited from significantly lower year-over-year economic jet fuel costs in first quarter 2009. Even with $65

million in unfavorable cash settlements from derivative contracts, our first quarter 2009 economic jet fuel costs

decreased 16.2 percent to $1.76 per gallon. With oil prices rising, we have begun to rebuild our 2009 and 2010 hedge

positions, using purchased call options, to provide protection against significant fuel price spikes.

The Company has derivative contracts in place for approximately 50 percent of its second quarter 2009 estimated

fuel consumption, capped at a weighted average crude-equivalent price of approximately $66 per barrel; approximately 40 percent for the remainder of 2009 capped at a weighted average crude-equivalent price of approximately $71 per barrel; and approximately 30 percent in 2010 capped at a weighted average crude-equivalent price

of approximately $77 per barrel. The Company has modest fuel hedge positions in 2011 through 2013.

Southwests hedging experience demonstrates the difficulties in distinguishing hedging from speculation

and illustrates that even well-considered actions do not always deliver favorable outcomes.

3

www.southwest.com.

Hedging with derivatives expands a companys choices and may allow it to take advantage of tax situations.

The next example shows how futures contracts can be used to stabilize earnings so that a company can utilize

past losses to reduce current taxes.

O

Goldmines Inc. (fictitious name) mines, refines, and sells gold in the world market. The companys profits

move in tandem with gold price movements. Assume that the pretax profit is $100 million when gold prices

go up (which happens with a 50 percent chance) and 0 if gold prices go down (which also happens with a 50

percent chance). Alternatively, Goldmines can hedge with gold futures and have a known profit of $48 million.

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O

Figure 13.2 shows these payoffs. We label them as event 1 (profit $100) and event 2 (profit $0). These events

are shown in a binomial tree, where the payoff $100 is placed on the upper branch of the tree, while $0 is

placed on the lower branch.

O

To compute the companys expected profit multiply each events payoff by its respective probability and

then add across events:

The expected payoff

[(Probability of high gold price) (Payoff $100)] [(Probability of low gold price)

(Payoff $0)]

0.50 $100 0.50 0

$50

for the unhedged company.

O

We can show the superiority of the hedging strategy by computing the expected after-tax profits for the

unhedged and hedged firm under different scenarios.

O

Assume that the tax rate is 30 percent. When the gold price is high, $100 million pretax profit gives an aftertax profit of 100 (1 tax rate) $70 million. When the gold price is low, the pretax profit is 0, and so is

the after-tax profit. After-tax profits are shown in Figure 13.2.

Expected after-tax profit for unhedged firm

[(Probability of high gold price) (After-tax profit when the gold price is high)]

[(Probability of low gold price) (After-tax profit when the gold price is low)]

0.50 70 0.50 0

$35 million

O

The hedged firm makes a profit of $48 million irrespective of the gold price:

After-tax profit for hedged firm

48 0.7

$33.6 million

O

The company can choose either. The actual choice depends on the risk preferences of the companys

management and shareholders.

After-Tax Expected Profits (When $25 Million Tax-Deductible Loss Is Carried Forward)

O

Now suppose that the company has accumulated losses totaling $25 million. It can deduct this loss from

this years profit and thus lower the tax burden. Such strategies of tax reduction are known as tax shields.

O

Assume that if unutilized, this one-shot opportunity disappears. We will show that the hedged firm can

always utilize the losses to lower its taxes, but the unhedged firm can only do this half the time.

O

For the unhedged firm, total tax when the gold price is high is

(Pretax profit Loss deducted)(Tax rate)

(100 25)0.3

$22.5 million

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Pre-Tax Profit

0.5

$100.00

Hedged Firm

Unhedged Firm

$48

0.5

0

Expected profit of the unhedged firm = 0.5 100 + 0.5 0 = $50 million

Expected After-Tax Profit (with No Loss Carried Forward)

0.5

$70.00

Hedged Firm

Unhedged Firm

$33.60

0.5

0

Expected profit = $35 million

0.5

$77.50

Unhedged Firm

Hedged Firm

$41.10

0.5

0

Expected profit = $38.75 million

The total tax when the gold price is low is 0. Consequently, the after-tax profit is (100 22.5) $77.5 million

when the gold price is high and zero when it is low (see Figure 13.2):

Expected after-tax profit for the unhedged firm

[(Probability of high gold price)(After-tax profit when gold price is high)]

[(Probability of low gold price)(After-tax profit when gold price is low)]

0.5077.5 0.50 0

$38.75 million

O

By contrast, the total tax for the hedged firm is (48 25) 0.3 $6.90:

After-tax profit for the hedged firm

(48 6.90)

$41.10 million

O

Clearly hedging is a superior strategy: not only does the hedged firm generate greater after-tax profit but it

also removes swings and stabilizes this amount.

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13.3

Chapter 4 gave us an inkling of how a company can use forward contracts for

hedging input and output price risks. Now that you are more familiar with the

workings of a futures contract (which are easier to use than forward contracts),

let us explore hedging with futures.

Ours is an imperfect world, in which it is hard to find perfect hedges. A perfect

hedge completely eliminates spot price risk for some commodity. This happens

when (1) the futures is written on the commodity being hedged, (2) the contract

matures when you are planning to lift the hedge, and (3) the contract size and the

other characteristics of a futures unerringly fit the hedgers need. Imperfect or

cross hedges occur when these three conditions are not satisfied. For example, a

bank may reduce the price risk of its loan portfolio, which is vulnerable to interest rate changes, by trading Treasury bond futures contracts. This is a cross hedge

because the futures is written on US Treasury bonds, whereas the loans being

hedged consist of, say, house mortgages, car loans, and certificates of deposit. Even

when futures on the same commodity are available, the issue of a timing mismatch

may occur. Consequently, basis risk emerges as a paramount concept in analyzing,

setting, and managing a futures hedge.

Basis Risk

Basis risk is a focal point in understanding futures hedges. The basis is defined

as the difference between the spot and the futures price. It is written as

Basis Cash price Futures price. The next example shows how crucial basis

risk is when hedging a commoditys spot price risk. We illustrate this in the

context of two companies using buying and selling hedges to offset input and

output risks, respectively.

O

O

Today is January 1, which is time 0. Consider the gold futures contract trading on the COMEX

Division of the CME Group described in chapter 8. The prices are reported on a per ounce basis.

Figure 13.3 gives the timeline and the various prices. For simplicity, we assume that no interest is

earned on margin account balances.

On todays date, the spot price of gold S $990, and the June contracts futures price F(0) $1,000.

The basis is

b(0) Spot price S(0) Futures price F(0)

990 1,000

$10

FIGURE 13.3: Timeline and Prices for Gold Futures Hedging Example

O

Start date

(January 1)

Time 0

Closing date

(May 15)

Time T

Delivery period

(June)

Futures price, F(0) = $1,000

Basis, b(0) = S(0) F(0) = $10

S(T) = $950

F(T) = $952

b(T) = S(T) F(T) = $2

The delivery period for the contract is in June. For the subsequent discussion, suppose that on May

15, time T, the spot price S(T) is $950 and the June futures price F(T) is $952. The new basis is

b(T) S(T) F(T)

950 952

$2

O

Suppose that the mining company Goldmines Inc. goes short June gold futures contracts on January

1 to hedge its output price risk. The company sells gold and lifts the hedge by closing out the futures

position on May 15.

O

Goldmines sells gold for $950, but it makes [F(T) F(0)] (952 1,000) $48 on the futures

position. So the effective selling price on May 15 is (see expression [9.1b] of Chapter 9)

Spot cash flow Futures cash flow

950 48

$998

O

Spot (Change in futures prices)

S(T) [F(T) F(0)]

[S(T) F(T)] F(0)

New basis Old futures price

(13.1)

No matter when the company closes its position, the old futures price is fixed, and only the new basis

affects profits.

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318

O

Now look at the same problem from the perspective of a jewelry maker, Jewelrygold Inc. As discussed

in chapter 4, the company can reduce input price risk by setting up a long hedge (a buying hedge) and

going long gold futures. When it is time to buy gold in the spot market, the company sells these futures

and removes the hedge.

O

On January 1, Jewelrygold goes long a June gold futures contract to hedge input price risk. On May

15, the company buys gold for $950 and simultaneously sells futures for $952 to end the hedge.

Although Jewelrygold pays less for gold, it has to surrender nearly all of its gains through the hedge.

The cash flow from the futures position is [F(T) F(0)] 952 1,000 $48.

O

Jewelrygolds effective price on May 15 is $998. By looking at the cash flows, the buying price is

Spot (Change in futures prices)

S(T) [F(T) F(0)]

[S(T) F(T)] F(0)

(New basis Old futures price)

(13.2)

This is the same value as in the previous example, except for the minus sign.

This example shows that a futures hedged spot commoditys portfolio value can

always be viewed as the sum of the old futures price and the new basis. Consequently,

hedgers are interested in how the basis evolves randomly through time. This randomness gives rise to basis risk in hedging, which is often measured by computing the basiss variance (or standard deviation). Basis risk is, thus, fundamental

to futures hedging, and hedgers often talk about the widening or narrowing of

the basis in passionate terms. Many of them have extensive charts depicting the

historic behavior of the basis, looking for a crystal ball to foretell the future.

Real life is far more complex than textbook examples. Exchanges offer only a

handful of futures, whereas there are thousands of commodities. The specter of an

imperfect hedge visits us again. When setting up a hedge, its natural to ask, which

contract and for what maturity? The next example discusses the issues involved in

answering this question.

Suppose that a new alloy Alloyum (a fictitious name) is developed that can replace precious metals in

industrial and ornamental use. Let Alloyum trade in the spot market. Alloyum futures may or may not

trade, and we discuss both possibilities. If you produce thirty thousand ounces of Alloyum, how would

you hedge output price risk?

Alloyum Futures Trade, and You Know When to Lift the Hedge

This case happens when the Alloyum futures contracts maturity date exactly matches the delivery

date of the spot commodity commitment. Then, sell [(Spot position)/(Alloyum futures contract

size)] 30,000/50 600 Alloyum futures, assuming a contract size of fifty ounces. Basis risk eventually disappears because the spot converges to the futures price at maturity. This can be shown by

setting S(T) F(T) in Expression (13.1). With zero basis risk, you fix the selling price at maturity,

which is none other than todays futures price. Congratulations, you have set up a perfect hedge. (This

perfect hedge ignores the interest rate risk from marking-to-market. Such reinvestment risks will be

considered later in the chapter.)

Alloyum Futures Trade, and You Do Not Know When to Lift the Hedge

In this case, one way to proceed is to compute the variance of the basis for different maturity futures

contracts on Alloyum and select the one that scores the lowest. Lower basis risk means that the futures

price deviates less from the spot price. You are likely to find that the futures contract maturing in the

same month as the spot sale is the best candidate. In this case, hedge with the smallest basis risk futures

contract. The number of contracts to be shorted may be found by the risk-minimization hedging strategy discussed later in this chapter.

Alloyum Futures Do Not Trade, and You Know When to Lift the Hedge

In this case, you may first like to select a similar commodity on which a futures contract is written and

decide on the maturity month. Collect price data for Alloyum and for contender commodity futures

contracts maturing in the same month as the spot sale, and compute correlations of price changes as

in Tables 13.2a and 13.2b. On the basis of these tables, we select the platinum futures because it has the

highest correlation to Alloyum each year as well as in the overall period.

Alloyum Futures Do Not Trade, and You Do Not Know When to Lift the Hedge

This is the worst case for hedging. First, select a commodity futures contract as in the previous

case. Then, select a maturity month, and find the futures contract with the largest correlation with

Alloyum spot price changes and that minimizes the variance of the basis. Consider the data given in

Table 13.2a (Example 13.4 shows how to compute correlations) and Table 13.2b. The futures contract

that matures in the spot sale month is the best performer both in terms of the largest correlation and

the lowest variance of the basis. It is closely followed by the futures contract maturing a month after

the spot sale date.

The preceding analysis recommends the spot sale month futures contract. There is, however, a

famous saying in economics that there are no solutions, only trade-offs (Sowell 1995, p 113). The

other futures contracts may have lower transaction costs. Liquidity is another concern because it often

increases as the contract approaches maturity, but dries up in the delivery month. Furthermore, if

you happen to be holding a long futures position during the delivery month, then you run the risk

of accepting a truckload of the underlying commodity if the short decides to deliver. Thus the next

months futures contract, despite (slight) inferiority in terms of correlation and variance of the basis,

may be the better choice.

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320

Futures

Years 13

Year 1

Year 2

Year 3

Platinum futures

0.78

0.73

0.89

0.83

Gold futures

0.70

0.72

0.73

0.70

Silver futures

0.59

0.58

0.65

0.58

Platinum Futures Contracts6

Futures Contracts

Variance of Basis

Previous-month futures

0.79

3.20

Spot-month futures

0.89

0.88

Next-month futures

0.87

0.99

Sixth-month futures

0.71

9.80

You can create Table 13.2a by (1) recording on a specific day of each month the Alloyum spot price and the precious metal

futures price for contracts that mature on that month (this will give four series of observations), (2) noting month-to-month

price differences for each of these four series, and finally, (3) computing (by a computer program such as Excel or by hand

calculation) the correlations among the Alloyum price and futures price differences for each of these series (this will give three

correlations). Alternatively, you can use daily or weekly data for computations.

You can create Table 13.2b by recording on a specific day of each month the Alloyum spot price and the four futures prices

(for contracts that matured in the previous month, will mature in the spot month, will mature the following month, and will

mature six months from the current month, respectively) and then proceeding as in Table 13.2a. There will be four different

series for each basis, each of which is created by subtracting from the Alloyum spot price the relevant futures price.

13.4

Risk-Minimization Hedging

Suppose that you want to hedge a long spot commodity position by shorting futures

contracts. Using a statistical or econometric model, assuming that past price patterns repeat themselves enables you to find the optimal number of contracts to

minimize the variance of the hedging error. This section discusses this statistical

approach to hedging.

The mean-variance approach to risk-minimization hedging (or optimal hedging)

determines the optimal number of contracts needed to minimize the variance of

RISK-MINIMIZATION HEDGING

the portfolios price changes. The intuition of this approach can be understood by

first considering a perfect hedge:

O

A perfect hedge. Suppose you are holding a long position in the spot commodity.

You need to short futures contracts to hedge the spot commoditys price risk.

In the pristine world of a perfect hedge, any change in the spot position will

be exactly offset by an equal and opposite change in the futures position.

Consequently,

Change in portfolio value

Change in spot position Change in futures position 0

(13.3)

The minus sign before the change in the futures position is because we are short

the futures contract and the spot and futures prices move in the same direction.

With minor modifications, we can recast the problem to focus on how changes

in the spot and futures prices per unit are related. Using data from Example 13.2,

we can hedge a long position of thirty thousand ounces of Alloyum production

by selling [(Cash position)/(Alloyum futures contract size)] 30,000/50 600

Alloyum futures. We can write this as follows:

Change in portfolio value (30,000 Change in spot price per ounce)

(600 50 Change in futures price per ounce)

0

(13.4)

There is no change in the portfolio value because the spot and the futures price

changes exactly match.

O

An imperfect hedge. In reality, the hedge will be imperfect because the spot and

the futures price changes do not exactly match. Here you can find the riskminimizing number of futures contracts. Consider hedging our spot exposure

of n ounces by selling q futures contracts of size f ounces per contract. Then we

can rewrite the left side of expression (13.4) as

Change in portfolio value (n Change in spot price per ounce)

(q f Change in futures price per ounce)

n[S(t) S] qf [F(t) F]

n$S q f$F

(13.5)

where S(t) and S are the spot prices per ounce on some future date (time t) and

today (time 0), F(t) and F are futures prices per unit on those same respective

dates, and $ compactly denotes the price change. Note that this change does

not equal zero because it is an imperfect hedge. To find the number of contracts

to sell to risk-minimize hedge the spot portfolio, compute the variance of the

portfolio and select n to minimize this variance. You can do this by taking the

partial derivative of the portfolio variance with respect to q, setting it equal

to zero, and solving for q (see the appendix to this chapter). This leads to the

following result.

321

322

RESULT 13.1

for Hedging a Spot Commodity Position

To minimize the risk of a long portfolio of a spot commodity, sell short q

contracts where

q(n/f )h

(13.6)

and n is the size of the spot position, f is the number of units of the underlying commodity in one futures contract, and h is the optimal hedge ratio

(or minimum-variance hedge ratio or risk-minimized hedge ratio).

The optimal hedge ratio is given by

covS,F

sdS

corrS,F

(13.7)

varF

sdF

where covS,F is the covariance between changes in the spot price ($S) and

the futures price ($F), varF is the variance of the change in the futures

price, sdS is the standard deviation (or volatility) of the change in the spot

price (standard deviation is the positive square root of the variance), sdF is

the standard deviation of change in the futures price, and corrS,F is the correlation coefficient between $S and $F.7

h

7

The second part of the formula follows from the result: covariance equals the product of

the standard deviations and the correlation coefficient or covS,F sdS sdF corrS,F.

Considering various cases reveals the intuition behind this result. Suppose

that the price changes for the spot commodity and the futures contract are

perfectly correlated (i.e., corrS,F equals 1) and their standard deviations match

(i.e., sdS sdF). Then the optimal hedge ratio h equals 1. This is the holy grail of

a perfect hedge, which is nearly impossible to attain in practice but is useful as

an illustration.

Next assume that there is a high correlation between the price changes (corrS,F

is close to one) and the spot price change has a lower volatility than the futures

price change (i.e., sdS sdF). Then a unit of spot is hedged with less than a unit

of futures. Conversely, if the spot price change fluctuates more than the futures

price change (i.e., sdS sdF), then one unit of spot needs more than one unit of the

futures to hedge.

The optimal hedge ratio gives us an easy formula for setting up a futures hedge.

Example 13.3 shows how to implement this by utilizing spot and futures price

data, which can be easily collected from business newspapers or Internet data

sources.

RISK-MINIMIZATION HEDGING

O

Suppose that you are planning to sell thirty thousand ounces of Alloyum at some future date. To

start, you collect Alloyum spot price and platinum futures price data for sixteen consecutive trading

days (see Table 13.3).

O

Begin by computing the price differences for each of these two series of price observations. Next

use a spreadsheet to compute the parameter estimates needed for the optimal hedge ratio. (The

appendix to this chapter discusses related issues and demonstrates how to find h with the help of a

simple calculator; section 13.6 shows how to do these calculations using the spreadsheet program

Microsoft Excel.) We get

the standard deviation of changes in the futures price per unit, sdF 14.3368

the standard deviation of changes in the spot price sdS15.5002

the correlation coefficient between the spot and futures price changes, corrS,F0.7413

O

Use these estimates in the second part of expression (13.7) of Result 13.1 to compute the minimumvariance hedge ratio:

h

O

sdS

15.5002

corrS,F

0.7413 0.80158

sdF

14.3368

To hedge n30,000 ounces of Alloyum with a platinum futures contract (contract size f 50), you

need to sell

q(n/f )h

(30,000/50)0.8015

480.9 or 481 contracts (with integer rounding)

Or, you can use the first part of Result 13.1 to determine the optimal hedge ratio, h covS,F /varF 18.3048/22.8381 0.8015.

Alternatively, you can compute the hedge ratio by suitably framing the problem

and estimating a linear regression (see the appendix to this chapter).

Comedian Rodney Dangerfield often chuckled, I dont get no respect. Doesnt

this comment apply to risk-minimization hedging? It is purely computational, and

except for some ad hoc adjustments, it is a single-shot exercise with no prescription

for modifying the hedge over time. It works well if a closely related commodity can

be found and you know when to lift the hedge. It works less well otherwise and if

the hedge needs to be rolled over or rebalanced.

323

324

Day t

1,215

1,233

1,209

1,236

1,239

1,245

1,245

1,254

1,254

1,272

1,227

1,254

1,230

1,248

1,224

1,242

1,239

1,260

1,251

1,263

10

1,227

1,254

11

1,215

1,227

12

1,209

1,221

13

1,203

1,230

14

1,185

1,203

15

1,194

1,209

which involves regular adjustments to a perfect hedge over time. Dynamic hedging requires sophisticated analytical tools, and it applies in a complete market. It

is impossible to implement in an incomplete market (see Duffie [1989] and Jarrow

and Turnbull [2000] for examples and issues related to dynamic hedging). In complete markets (remember chapter 8), all kinds of securities trade that generate

future payoffs contingent on all possible future events. In reality, the markets are

incomplete, and it may be difficult to develop good futures pricing models to which

dynamic hedging applies. Consequently, risk-minimization hedging, despite all its

limitations, starts looking respectable again. In incomplete markets, it continues to

attract serious research interest.

13.5

Its common practice in many circles to treat forwards and futures as equivalent and

interchangeable contracts. However, this is incorrect for many reasons. Although a

forward is easy to price, ordinary investors rarely trade in the organized forward

market. Big banks, large corporations, and other institutions with excellent credit

ratings dominate this market, and to guarantee execution of the contracts, these

financial institutions usually need to post collateral. These trading restrictions are

imposed to reduce counterparty credit riskthe nonexecution of the contract

terms. Counterparty credit risk is a big concern in the trading of over-the-counter

derivatives, as recently evidenced by the related regulatory reforms following the

325

2007 credit crisis in the DoddFrank Wall Street Reform and Consumer Protection

Act (see chapter 26 for more discussion of these issues). Second, given that forward

contracts are bilateral negotiated agreements, forward markets are illiquid and

subject to significant liquidity risk. For example, if a counterparty closes a forward

contract early, significant closing costs are incurred.

By contrast, a futures (1) is an exchange-traded, standardized contract; (2)

has margins and daily settlement, which makes it safer than a forward due to the

absence of credit risk; (3) allows small traders, weaker credits, and complete strangers to participate; and (4) usually trades in a liquid market, where traders can enter

or unwind their positions with ease.

But there is another important difference between futures and forward contracts due to the marking-to-market of a futures contract. Marking-to-market a

futures contract introduces risks involved with reinvesting the cash flows before

the contract matures. These same reinvestment risks are not faced by a forward

contract. Tracking the cash flows to these contracts, the futures trader, unlike the

forward trader, earns random and uncertain interest on margin balances.

As discussed in chapter 9, the interest earned on a futures margin account is

dependent on the futures price changes. In addition, interest rate changes also

affect the interest earnings. Indeed, if interest rate changes are positively correlated

with futures price changes, then the futures position benefits from interest rate

movements because as cash flows are received, more interest is earned. In this case,

the risk of a futures position is reduced slightly. Conversely, if interest rate changes

are negatively correlated with futures price changes, then the futures position suffers from interest rate movements. In this latter case, the risk is increased. This

interest rate risk affects hedging performance because of the random cash flows

received. This same risk is not present in a forward contract.

13.6

Spreadsheet Applications:

Computing h

You can easily compute the optimal hedge ratio (h) by using a standard spreadsheet

program such as Microsoft Excel. Next we demonstrate this for Example 13.3.

EXAMPLE 13.3: Computing the Optimal Hedge Ratio (Solved Using Microsoft Excel)

Consider the same data as in Example 13.3. Type in the numbers and the terms exactly as follows in an

Excel spreadsheet (see Table 13.4):

O

Type Day t in cell A1, 0 in A2, 1 in A3, 2 in A4, and so on up to 15 in cell A17. You may speed up data

entry by using the Auto Fill feature: type 0 in A2 and 1 in A3, highlight the cells A2 and A3, and

then drag down the bottom right hand corner of the cursor so that the desired values get filled in

cells A4 to A17.

326

O

O

Type S(t) in B1 and then fill out the Alloyum spot prices as given in Table 13.3: 1,215 in B2, 1,209 in

B3, and so on, up to 1,194 in B17.

Type F(t) in C1 and then fill out the platinum futures prices F(t) as given in Table 11.2 for sixteen

consecutive trading days.

O

Type $S(t) in D1 and then type B3 B2 in D3, B4 B3 in D4, and so on. You may speed this

up by using the Auto Fill feature: type B3 B2 in D3 and then drag down the bottom right hand

corner of the cursor so that the desired values fill in cells D4 to D17.

O

Type $F(t) in E1 and then type C3 C2 in E3. Use Auto Fill as we have just mentioned and fill

out the desired values in cells E4 to E17.

A

Day t

S(t)

F(t)

$S(t)

$F(t)

$S(t)

$S(t)

$F(t)

$F(t)

$S(t)

$F(t)

1,215

1,233

1,209

1,236

6

36

18

1,239

1,245

30

900

81

270

1,245

1,254

36

81

54

1,254

1,272

18

81

324

162

1,227

1,254

27

18

729

324

486

1,230

1,248

6

36

18

1,224

1,242

6

6

36

36

36

1,239

1,260

15

18

225

324

270

1,251

1,263

12

144

36

10

1,227

1,254

24

9

576

81

216

11

1,215

1,227

12

27

144

729

324

12

1,209

1,221

6

6

36

36

36

13

1,203

1,230

6

36

81

54

14

1,185

1,203

18

27

324

729

486

15

1,194

1,209

81

36

54

Sums

21

24

3,393

2,916

2,340

VARA

240.2571

205.5429

STDEV

COVAR

15.50023

14.33677

164.7429

CORREL

0.74134

0.801501

0.801501

SUMMARY

327

Computing Estimates from the Sample and the Minimum-Variance Hedge Ratio

The entries in columns D and E are the two data series with which we work. You can do the computations

as follows (and verify that these are the same as the sample variances that you computed in Example 13.3):

O

Type in a name for the sample variance such as VARA in cell A20, type VARA(D3:D17) in D20

and hit return to get 240.2571, and type VARA(E3:E17) in E20 and hit return to get 205.5429.

O

Type STDEV in A21, type STDEV(D3:D17) in D21 and hit return to get 15.50023, and type

STDEV(E3:E17) in E21 and hit return to get 14.33677.

O

As Excels covariance formula is given for the population, you need to multiply the estimator by n/(n 1) to get the sample estimate. Accordingly, type COVAR in A22, and type

COVAR(D3:D17,E3:E17)*(15/14) in D22 and hit return to get 164.7429.

O

Type CORREL in A23 and CORREL(D3:D17,E3:E17) in D23 and hit return to get 0.74134.

O

Type h in A24 and D22/E20 in D24 and hit return to get 0.801501. This is the expression (13.6)

given in Result 13.1. You may also get h via the second result in (13.6) by typing D23*D21/E21 in

E24 and hitting returnits the same answer.

13.7

Summary

1. Most futures contracts are traded to hedge spot commodity price risk. Producers may set up a long hedge (or a buying hedge) to fix the buying price for

an input and a short hedge (or a selling hedge) to fix the selling price of an

output.

2. As with any other derivatives, the costs and the benefits must be carefully weighed

before hedging a spot commodity with futures. They involve direct and indirect

costs: the brokers must be paid, and a trade may fetch a bad price. But hedging

also has many potential benefits: it can stretch the marketing period, protect inventory value, permit forward pricing of products, reduce the risk of default and

financial distress costs, and perhaps facilitate taking advantage of a tax loss or tax

credit.

3. A perfect hedge completely eliminates price risk. It happens when (1) the

futures is written on the commodity being hedged and (2) the contract matures when you are planning to lift the hedge. Generally, there is basis risk.

The basis is defined as the difference between the spot price and the futures

price.

4. For a seller of a futures contract who hedges output price risk, the effective

selling price is (new basis old futures price). For a buyer of a futures contract

who hedges input price risk, the effective buying price is the negative of (new

basis old futures price).

5. We can use a statistical model, assuming past price patterns repeat themselves,

to set up a risk-minimization hedge. To minimize the risk of a long portfolio

328

of the spot commodity, sell short q (n/f)h contracts, where n is the size

of the spot position, f is the contract size, and h is the optimal hedge ratio

(or minimum-variance hedge ratio) defined as covS,F /varF, where covS,F is the

sample covariance between the change in the spot price ($S) and the change

in the futures price per ($F) and varF is the variance of the change in the

futures price.

13.8

Appendix

Suppose you are planning to sell n units of a spot commodity at some future date

and decide to hedge this exposure by selling short q futures contracts today.

O

Rewrite the change in the portfolio value between today (time 0) and some

future date (time t) as

$Portfolio

(n Change in spot price) (q f Change in futures price)

n[S(t) S(0)] q f [F(t) c(0)]

n$S qf$F

(13.8)

where f is the number of units of the futures contract, S(t) is the spot price at

date t, F(t) is the futures price at date t, and $ denotes a price change.

O

Select q so as to minimize the change in the portfolio value. First, use statistics

to compute the variance of the portfolios price change:

variance(aX bY) , a2variance(X)

b2 variance(Y) 2ab[covariance(X, Y)]

(13.9)

where a and b are constants and X and Y are random variables. As n, q, and f are

constant parameters, set an, bq f, X$S, and Y$F in expression (13.9)

to get

var($Portfolio)n2varS(q f )2varF 2nq f covS,F

(13.10)

where varS is the variance of change in the spot price ($S), varF is the variance

of change in the futures price ($F ), and covS,F is the sample covariance between

the change in the spot and futures prices.

O

with respect to q and setting it equal to zero:

[var($Portfolio)]2q f 2 varF 2nf covS,F0

q

APPENDIX

The second partial derivative is a positive number, which indicates that this

minimizes the expression. Rearrange terms to get the number of futures contracts to sell short (or go long in case you are setting up a buying hedge):

q (n/f )h

(13.11)

Example 13.3 shows how to input the values into a business calculator or a computer

to determine the minimum variance hedge ratio (h). Here we show how to directly

calculate h.

Statistical Approach

Start by deciding how frequently and over what time interval you collect your data.

Standard practice is to fix a time interval (daily, weekly, or monthly) and use the

end of the intervals settlement prices.

DATA SERIES

O

basic inputs. These are reported in Table 13.5 (Appendix), whose first three columns are as follows:

- The first column is labeled Day t, and it keeps track of the days. There are

(T 1)16 observations corresponding to sixteen consecutive trading days,

where t runs from day 0 to day t 15.

- Columns 2 and 3 record the Alloyum spot price S(t) and the platinum futures

price F(t), respectively, for these sixteen consecutive trading days. All prices

are reported for one unit of the respective commodity.

PRICE DIFFERENCES

O

- Column 4 reports changes in the value for Alloyum spot. Denote the spot

price change from date (t 1) to date t as $S(t) , S(t) S(t 1). Label column 4 as x(t) for convenience. For example, when t 6,

x(6) , $S(6) , S(6) S(5) 1,230 1,227 3

- Column 5 does the same for platinum futures. Label this as y(t). For example,

y(6) , $F(6) $F(t) , F(t) F(t 1)

F(6) F(5) 1,248 1,254 6

O

Notice that when computing the difference, you lose the first observation. We

now have T 15 observations. We denote them by t, where t 1, 2, . . . , 15.

O

We can now forget our second and third columns. We use the fourth and fifth

columns to compute the minimum-variance hedge ratio h.

329

330

$F(t) , F(t)

F(t 1) , y(t)

[$S(t)]2

, x(t)2

6

36

18

1,245

30

900

81

270

1,245

1,254

36

81

54

1,254

1,272

18

81

324

162

1,227

1,254

27

18

729

324

486

1,230

1,248

6

36

18

1,224

1,242

6

6

36

36

36

1,239

1,260

15

18

225

324

270

1,251

1,263

12

144

36

10

1,227

1,254

24

9

576

81

216

11

1,215

1,227

12

27

144

729

324

12

1,209

1,221

6

6

36

36

36

13

1,203

1,230

6

36

81

54

14

1,185

1,203

18

27

324

729

486

15

1,194

1,209

81

36

54

jx 21

jy 24

jx2 3,393

jy2 2,916

Day t

Alloyum

Spot S(t)

Platinum

Futures F(t)

1,215

1,233

1,209

1,236

1,239

Sums

$S(t) , S(t)

S(t 1) , x(t)

T

= x(t) 21

t1

15

= y(t) 24

1

2

= x(t) 3,393

2

= y 2,916

15

= x(t)y(t) 2,340

t1

[$F(t)]2

, y(t)2

$S(t) $F(t)

, x(t)y(t)

jxy 2,340

APPENDIX

COMPUTATION-SIMPLIFYING TECHNIQUES

O

- Columns 6 and 7 record the square of the price changes reported in columns

4 and 5, respectively. Finally, column 7 reports the product of the values in

columns 5 and 6. For example, when t 6, we get

[x(6)]2329

[y(6)]2(6)236

x(6)y(6)18

STATISTICAL ESTIMATES

O

To compute h from historical data, modify our formulas for covariance and variance by replacing the T with (T 1) in the denominator to get an unbiased estimate.9

O

We get the following parameter estimates to help us compute h (see Table 13.6

[Appendix]):

sample covariance, covS,F 164.7429

sample variance of $S, varS 240.2571

sample variance of $F, varF 205.5429

sample standard deviations, sdS 15.5002 and sdF 14.3367

correlation coefficient between $S and $F, corrS,F 0.7413

O

These estimates are used to compute the minimum-variance hedge ratio h. The

first part of equation (13.7) of Result 13.1 gives

covS,F

164.7429

h

0.8015

(13.12)

varF

205.5429

while the second part veries the same result:

h

O

sdS

15.5002

0.7413 0.8015

corrS,F

sdF

14.3367

(13.13)

If you are estimating these values over a longer period, then you run the risk that

a futures contract may mature and no longer trade. Suppose you are hedging with

the nearest maturity futures contract, whose price changes are likely to have the

best correlation with the spot price changes. Suppose this contract stops trading

on day 12. Select the futures contract that is going to mature next, get its futures

prices for days 12 and 13, and write the price difference $F (13) , F (13) F (12)

in the first table in the cell corresponding to day 13s price difference.

Econometrics is the branch of economics that studies relationships between

economic variables using mathematics and statistics. A staple of econometrics is

the linear regression model,10 in which a dependent variable may be determined

9

Such adjustments make the estimator BLUE, and statisticians love BLUEs (Best Linear Unbiased

Estimators). See DeGroot and Schervish (2011), or Mood et al. (1974).

10

See standard econometrics textbooks like Amemiya (1994) or Johnston and DiNardo (1997) for a

discussion of the linear regression model.

331

332

Hedge Ratio h

Statistical Estimate

Formula

Computations

Estimated

Value

a. Sample mean, x

1 T

x(t)

T t=

1

21/15

1.4000

b. Sample mean, y

1 15

y(t)

15 t=

1

24/15

1.6000

T

1

x(t) x y(t) y

T 1 t=

1

15

1

8 6 = x(t)y(t) 7 15xy 9

14 t 1

1

21

24

6 2,340 154

54

57

14

15

15

164.7429

d. Sample variance of

$S, varS

T

1

x(t) x 2

=

T 1 t1

1 15

6

x(t)2 15x2 7

14 t=

1

1

21 2

6 3,393 154

5 7

14

15

240.2571

e. Sample variance of

$F, varF

T

1

y(t) y 2

=

T 1 t1

1

24 2

6 2,916 154

5 7

14

15

205.5429

f. Sample standard

deviation of $S, sdS

varS

240.2571

15.5002

g. Sample standard

deviation of $F, sdF

varF

205.5429

14.3367

h. Correlation

coefficient between

$S and $F, corrS,F

covS,F

164.7429

15.5002 14.3367

0.7413

164.7429

205.5429

0.8015

c. Sample covariance of

i. Minimum-variance

hedge ratio, h

j. h (alternate

computation)

sdS sdF

covS,F

varF

sdS

corrS,F

sdF

0.74134

15.5002

5

14.3367

0.8015

from the values of one or more independent variables, under the assumption that

these variables are linearly related. In this case, the model takes the form

$S(t)A B$F(t) u(t)

(13.14)

where A and B are unknown parameters and u(t) are independent and identically

distributed error terms with an expected value of 0 and a constant variance.

Next you have to estimate these parameters. The most popular approach is the

least squares method, in which A and B are chosen so that the sum of squared

errors j[$S(t) A B$F(t)]2 is minimized. Interestingly, the value of B obtained

is identical to the hedge ratio h in Result 13.1. This makes life easy. Estimate the

MATHEMATICA, MINITAB, SAS, or TSP, and the estimated value of B will give you

the hedge ratio. Spreadsheet programs like Microsoft Excel can also run regressions.

13.9

Cases

A short case that explores the costs and benefits of hedging and the derivatives

that may be used for hedging purposes.

Enron Gas Services (Harvard Business School Case 294076-PDF-ENG). The case

considers the risks and opportunities of selling a variety of natural gas derivatives

by a financial services subsidiary of the largest US integrated natural gas firm.

Aspen Technology Inc.: Currency Hedging Review (Harvard Business School

Case 296027-PDF-ENG). The case examines how a small, young firms business

strategy creates currency exposure and how one can manage such risks.

13.1. Define a long hedge and a short hedge and give examples of each kind of hedge.

13.2. What are the benefits of a corporations hedging? In your answer, explain

why the corporation and not the corporations equity holders must do the

hedging. Are there any costs to a corporations hedging?

13.3. What is the difference between a perfect hedge and a cross hedge? Give

13.4. If one cannot create a perfect hedge, what are the alternatives? Give an

13.5. What is the basis for a futures contract? What happens to the basis on the

delivery date?

13.6. There is no futures contract on aviation fuel. Combo Air Inc. has to buy

3 million gallons of aviation fuel in three months. Suppose you are in charge

of Combo Airs hedging activities. You gather the following data:

TABLE 13A: Jet Fuel Cash Prices vs. Near Month Energy

198688

1986

1987

1988

0.54

0.76

0.89

0.32

Gasoline futures

0.41

0.74

0.73

0.19

0.45

0.70

0.72

0.25

a. Which energy futures contract will you choose for hedging jet fuel purchase?

b. Is this a long hedge or a short hedge?

333

334

13.7. The variance of monthly changes in the spot price of live cattle is (in cents per

pound) 1.5. The variance of monthly changes in the futures price of live cattle

for the April contract is 2. The correlation between these two price changes is

0.8. Today is March 11. The beef producer is committed to purchasing four

hundred thousand pounds of live cattle on April 15. The producer wants to

use the April cattle futures contract to hedge its risk. What strategy should

the beef producer follow? (The contract size is forty thousand pounds.)

13.8. Are hedging with forwards and futures contracts the same, or are there differ-

ent risks to be considered when using these two contracts? Explain your answer.

13.9. When you hedge a commoditys price risk using a futures contract, give an

example where the counterparty is also hedging. Give an example where the

counterparty is speculating.

13.10. Kellogg will buy 2 million bushels of oats in two months. Kellogg finds that

the ratio of the standard deviation of change in spot and futures prices over a

two-month period for oats is 0.83 and the coefficient of correlation between

the two-month change in price of oats and the two-month change in its

futures price is 0.7.

a. Find the optimal hedge ratio for Kellogg.

b. How many contracts do they need to hedge their position? (The size

of each oats contract is five thousand bushels; oats trades in the CME

Group.)

13.11. Explain why hedging is like buying an insurance policy. To buy an insurance

hedging? Give an example to clarify your answer.

13.12. Suppose that after you graduate, you plan to be a stock analyst for a major

financial institution. You know that if the stock market increases in value,

you will get a job with a good salary. If the stock market declines, you will

get a job, but the salary will be lower. How can you hedge your salary risk

using futures contracts? Is this a perfect or imperfect hedge?

13.13. Your company will buy tungsten for making electric light filaments in the

next three to six months. Suppose there are no futures on tungsten. How

would you hedge this risk? (Discuss the type of hedge, general hedging approach, and guidelines that you would like to follow.)

13.14. You are the owner of a car rental business. If gasoline prices increase, your

car rental revenues will decline. How can you hedge your car rental revenue

risk using futures contracts? Is this a perfect or imperfect hedge?

13.15. What commodity price risk does Southwest Airlines hedge, and why? Has it

13.16. What is risk-minimizing hedging? Briefly outline how you would set up a

hedge? Explain your answer.

13.17. Canadian American Gold Inc. (CAG) has half its gold production from

mines located in Canada, while the other half is from those in the United

States. CAG uses a quarter of its production for making gold jewelry sold at

a fixed price through stores in the two nations, and the rest is sold on the

world market, where the gold price is determined in US dollars. Canadian

profits are repatriated to the United States, where CAGs headquarters are

located. CAGs chief executive officer wants to use futures contracts to

hedge the entire production of ten thousand ounces of gold and as many

other transactions as possible. He communicates his desire to you but seeks

your opinion one last time before the orders go out. Devise a sensible hedging strategy that would still be in line with the CEOs wishes (assume x is

the quantity used for making gold jewelry in the United States).

13.18. The spot price of gold today is $1,505 per ounce, and the futures price for a

contract maturing in seven months is $1,548 per ounce. Suppose CAG puts

on a futures hedge today and lifts the hedge after five months. What is the

futures price five months from now? Assume a zero basis in your answer.

13.19. Suppose that Jewelry Company is planning to sell twenty thousand ounces

futures price per ounce sdF is 12.86, that for changes in the spot price per

ounce sdS is 14.38, and the correlation coefficient between the spot and futures price changes corrS,F is 0.80.

a. Compute the optimal hedge ratio for Jewelry Co.

b. How many contracts do they need to hedge their position? (The con-

c. Will this be a buying or a selling hedge?

13.20. (Microsoft Excel) Given the following data, compute the hedge ratio for a

Day

t

Alloyum Spot

S(t)

Platinum Futures

&(t)

1,233

1,245

1,219

1,256

1,118

1,130

1,246

1,264

1,250

1,280

1,219

1,223

1,230

1,248

1,227

1,280

1,249

1,260

1,225

1,289

10

1,227

1,254

11

1,223

1,255

12

1,211

1,223

13

1,203

1,267

14

1,189

1,213

15

1,199

1,219

335

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