Chapter 7: Optimal hedges for the real world

Chapter objectives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
Section 7.1. Implementing the minimum-variance hedge in the real world . . . . . . . . . . . 3
Section 7.1.1. Hedging, contract maturity, and basis risk . . . . . . . . . . . . . . . . . . . 4
Section 7.1.2. Basis risk, the hedge ratio, and contract maturity . . . . . . . . . . . . . . 8
Section 7.1.3. Cross-hedging . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
Section 7.1.4. Liquidity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11
Section 7.1.5. Imperfect divisibility . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13
Section 7.1.6. The multivariate normal changes model: Cash versus futures prices
15
Section 7.2. The costs of hedging . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17
Section 7.3. Multiple exposures with same maturity. . . . . . . . . . . . . . . . . . . . . . . . . . . . 26
Section 7.4. Cash flows occurring at different dates. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34
Section 7.5. Metallgesellschaft . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 38
Section 7.6. Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 46
Key concepts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 48
Review questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 49
Questions and exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50
Figure 7.1. Variance of hedged payoff as a function of hedge ratio and variance of basis
risk. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 52
Figure 7.2. Total and marginal cost of CaR when CaR = CaR2. . . . . . . . . . . . . . . . . . . 53
Figure 7.3. Expected cash flow net of CaR cost as a function of hedge. . . . . . . . . . . . . . 54
Figure 7.4. Marginal cost and marginal gain from hedging. . . . . . . . . . . . . . . . . . . . . . . 55
Figure 7.5. Optimal hedge ratio as a function of the spot exchange rate and  when the
cost of CaR is *CaR2. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 56
Figure 7.6. Short position to hedge Export Inc.s exposure. . . . . . . . . . . . . . . . . . . . . . . 57
Technical Box 7.1. The costs of hedging and Daimler-Benzs FX losses. . . . . . . . . . . . 58
Technical Box 7.2. Derivation of the optimal hedge when CaR is costly. . . . . . . . . . . . 60
Literature note . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 62

Chapter 7: Optimal hedges for the real world

September 19, 2001

Ren M. Stulz 1996, 1999, 2001

Chapter objectives
With this chapter, you will:
1. Understand how market imperfections affect hedging policies.
2. Learn how to incorporate hedging costs in the hedging decision.
3. Find out how one can reduce hedging costs by taking advantage of diversification.
4. Understand why a widely publicized hedging strategy failed.

Chapter 7, page 1

In Chapter 6, we learned how to hedge with forward and futures. However, we ignored many
real world complications. We assumed that financial markets are perfect. Suppose that Mr. Hedge
considers eliminating an exposure of 100M euros in five years. He will be confronted with many
practical problems that would not arise in a world of perfect financial markets. In such a world,
contracts would be perfectly divisible, have the same maturity as the exposure, and liquidity would
never be a problem. The real world does not work like this. Mr. Hedge might not be able to trade a
futures contract that matures more than a few years in the future and if he attempted to trade that
contract, he would have to worry about the impact of his trade on prices because of a lack of
liquidity. In this chapter, we have to learn how to cope with such issues. They make the real world
challenging.
One key assumption when we assume that financial markets are perfect is that there are no
transactions costs. Suppose that Mr. Hedge finds that to hedge his euro exposure he has to incur
transaction costs of $1M. How would Mr. Hedge know if shareholders are better off if he hedges?
He would have to trade off the cost of laying off the exposure against the benefit of reducing risk.
We extend the analysis to consider the costs of hedging and how they affect the hedging decision.
Firms almost always are exposed to multiple risk factors. Firms with multiple risk factors can
actually reduce hedging costs by treating their exposures as a portfolio. The portfolio approach takes
advantage of the principle of diversification, which means that multiple exposures are in effect
offsetting to some degree, and the firm can put on a smaller hedge than if it hedges each exposure
separately.
To consider portfolios of exposures, we first assume all exposures have the same maturity.
We show how to adapt the approach of the previous chapter to construct a minimum-volatility hedge
Chapter 7, page 2

for the portfolio of exposures. In the next case, a firm has both multiple cash flows accruing at one
point in time and cash flows accruing at different times. In this case, diversification can take place
both across exposures at one point in time and across exposures with different maturities. We show
how the firm should measure the risk and hedge portfolios of exposures with different maturities.
To illustrate the practical difficulties of hedging in the real world, we conclude the chapter
with a famous real-world story, the Metallgesellschaft story. Metallgesellschaft had very large short
oil cash positions with maturities stretching out to ten years. It could not find futures contracts on
oil that it could trade in the quantities it needed to hedge with maturities beyond one year.
Metallgesellschaft therefore had to use short maturity futures to hedge long maturity exposures. To
construct a hedging strategy, Metallgesellschaft used some of the tools presented in Chapter 6 and
in this chapter. However, it also ignored some important ideas we addressed for instance, the result
presented in Chapter 6 that futures hedges have to be tailed and the result discussed in this chapter
that basis risk decreases the optimal volatility-minimizing hedge. Partly as a result of not taking
taking into account these ideas, Metallgesellschaft lost more than one billion dollars through its
hedging strategy.

Section 7.1. Implementing the minimum-variance hedge in the real world

There are many implementation details that arise when one wants to hedge an exposure with
a futures contract. All the issues we discuss arise because financial markets are imperfect. With
perfect financial markets, it would be costless to create new futures contracts and the demand for a
contract would be perfectly elastic, so that Mr. Hedge could hedge any exposure without having his
trade affect the futures price. A market where one can trade without any price impact regardless of
Chapter 7, page 3

the size of the trade is highly liquid. Most markets are not that way. Markets are made liquid by
liquidity providers market markers. The number and resources of liquidity providers are limited.
As a result, they focus on the markets where their resources are most valuable. When liquidity falls
in a market, the buyer or the seller have to sweeten the deal to make it worthwhile for a trader to be
the counterparty. This makes it expensive to trade in markets with poor liquidity. As a result,
liquidity begets liquidity people want to trade in liquid markets and flee illiquid markets. It will
therefore not be possible to trade futures contracts for some maturities and for some deliverable
goods because these contracts would have no liquidity and therefore are not offered by the
exchanges. At any time, there will only be a limited number of contracts that are liquid. This means
that firms and investors may not be able to trade a contract with a maturity or a deliverable good that
matches their exposure exactly.
Lets go back to Mr. Hedge. He has a five-year Euro exposure. Turning to the Chicago
Mercantile Exchange for a futures contract in August 2001, he would find that the contract with price
information with the longest maturity is December 2002. Hence, Mr. Hedge would have no choice
but to use contracts that mature before his exposure does to hedge with futures contracts.

Section 7.1.1. Hedging, contract maturity, and basis risk

Export Inc. expects to receive 1 million Swiss francs on June 1. We have seen that the Swiss
franc contracts traded at the Chicago Mercantile Exchange are for 125,000 Swiss francs. The
available maturities are for the months of March, June, September, and December. In Chapter 6, we
assumed that Export would use the June contract. It could also, however, take a position in the
March contract, close that position near the maturity of the contract, and then open a position in the
Chapter 7, page 4

June contract, or it could take a position in the September contract. If there are no financial markets
imperfections except for the absence of a contract maturing on June 1 and if there is no basis risk,
Export can use any futures contract to hedge as long as it adjusts the hedge in the way we now
demonstrate.
We write G(t, T) as the price at t for a futures contract that matures at T. If domestic and
foreign interest rates are constant so that there is no basis risk, we know that futures and forward
prices are the same. From Chapter 5, we know that in this example the futures price on June 1 for
a contract that matures at date T is:

G(June 1, T) = [PSFR(June 1, T)/P(June 1, T)]S(June 1),

(7.1.)

where PSFR(June 1, T) is the Swiss franc price on June 1 of a discount bond that pays one Swiss franc
at date T, S(June 1) is the dollar price of a Swiss franc on June 1, and P(June 1, T) is the price on
June 1 of a discount bond that pays $1 at date T.
Using equation (7.1.), a change in the exchange rate over the hedging period equal to S of
the exposure has an impact on the futures price as follows:

G = [PSFR(June 1, T)/P(June 1, T)]S

(7.2.)

Export wants a hedge ratio h so that S hG = 0. A position of P(June 1, T)/PSFR(June 1, T) in the

futures contract moves one for one with the spot exchange rate, so that going short that position in
the futures market hedges one Swiss franc. Consequently, if Export uses a hedge ratio of P(June 1,
Chapter 7, page 5

T)/PSFR(June 1, T) before tailing, it has a perfect hedge. For one Swiss franc of exposure, the payoff
of the hedged position is:

S hG = S P(June 1, T)/PSFR(June 1, T)G
= S P(June 1, T)/PSFR(June 1, T)[PSFR(June 1, T)/P(June 1, T)]S
= S S = 0

(7.3.)

This hedge insures that the hedged cash position is worth [P(June 1, T)/PSFR(June 1, T)]S(March 1)
per Swiss franc paid on June 1. The payoff of the hedged position does not depend on the exchange
rate at maturity of the hedge and is therefore riskless.
This analysis lets us express a general formula for the hedge ratio in the absence of basis risk.
Suppose then that we are at date t and hedge a payoff occurring at date t + i with a futures contract
that matures at date T, where T is later than t + i. Using the formulation for the futures price with a
convenience yield developed in Chapter 5, we have that the futures price at date t + i is:

G(t + i, T) = exp{[r(t + i, T) c(t + i, T)](T (t + i))}S(t + i)

(7.4.)

where the futures contract is on an underlying asset with price S(t + i) at t and expires at T. r(t + i,
T) is the continuously compounded yield from t + i on a discount bond maturing at T and c(t + i, T)
is the continuously compounded convenience yield over the interval of time from t + i to T. With this
formula, a change of S in the spot price increases the futures price by G = exp{[r(t + i, T) c(t
+ i, T)](T (t + i))}S. Hence, to balance the change of S in the cash position, we need a hedge
Chapter 7, page 6

ratio h = exp{-[r(t + i, T) - c(t + i, T)](T (t + i))} so that S = hG.

In the absence of basis risk, we can also create a perfect hedge by rolling over positions in
contracts that have a shorter maturity than the cash market exposure. To see this, suppose that we
use the March contract, and immediately before maturity of that contract we switch to the June
contract. March therefore denotes the maturity date of the March contract and G(March 1, March)
denotes the futures price for the March contract on March 1. We assume that interest rates are
constant since otherwise the basis is random. For each dollar of cash position, we go short a tailed
hedge of [P(March 1, March)/PSFR(March 1, March)] March contracts on March 1 at the price of
G(March 1, March) = [PSFR(March 1, March)/P(March 1, March)]S(March 1). Remember, though,
that we are hedging an exposure that matures on June 1. Hence, any cash flow from the futures
position is carried forward to June 1, so that the tailing factor must be a discount bond that matures
on June 1.
Suppose that we get out of this position on March 12, which is shortly before maturity of the
March contract. At that date, we will have gained P(March 12, June 1)[S(March 1) S(March 12)]
from the short position, but this gain becomes S(March 1) S(March 12) on June 1. We then go
short on March 12 a tailed hedge of P(March 12, June 1)/PSFR (April 15, June 1) of the June contract.
The tailing factor is again a discount bond that matures on June 1. On June 1, we exit our short
futures position after having gained S(March 12) S(June 1). Adding up the gains from the futures
position, we have S(March 1) S(June 1), which exactly offsets the losses from the cash position.
Hence, in the absence of basis risk, we can create a perfect hedge by rolling contracts over.

Chapter 7, page 7

Section 7.1.2. Basis risk, the hedge ratio, and contract maturity
In perfect markets, basis risk occurs in futures because of interest rate, convenience yield,
payout, and storage cost uncertainty. In imperfect markets, our pricing formulas do not hold exactly
which adds additional basis risk. Lets consider how basis risk affects the hedge ratio and the
volatility of the hedged position, so that we understand better which contract to use.
Let B(June 1, T) be the basis of the Swiss franc futures contract that matures at T on June 1
and G(June 1, T) the futures price on June 1 for a contract that matures at T. Remember that we
define the basis as the difference between the cash market price and the futures price. Consequently,
the futures price on June 1, G(June 1, T), is equal to S(June 1) - B(June 1, T). The optimal hedge
ratio is still the one we obtained earlier, but now we replace the futures price by the spot price minus
the basis to see directly the impact of basis risk on the hedge ratio:

Cov[S(June 1),G(June 1, T)]

Var[G(June 1, t)]
Cov[S(June 1), S(June 1) - B(June 1, T)]
=
Var[S(June 1) - B(June 1, T)]
Cov[S(June 1), S(June 1) - B(June 1, T)]
=
Var[S(June 1)] + Var[B(June 1, T)]
h=

(7.5.)

If the basis is uncorrelated with the spot exchange rate, the numerator is simply the variance of the
spot exchange rate. In this case, the optimal hedge ratio is the variance of the spot exchange rate
divided by the sum of the variance of the spot exchange rate and of the basis. Since variances are
always positive, the greater the variance of the basis the lower the optimal hedge ratio.
Chapter 7, page 8

To understand why basis risk reduces the optimal hedge ratio when the basis is uncorrelated
with the spot price, it is useful to consider the payoff of the hedged position per Swiss franc:

S(June 1) - h x [G(June 1, T) - G(March 1, T)]

= S(June 1) - h[S(June 1) - B(June 1, T) - G(March 1, T)]

(7.6.)

= (1 - h)S(June 1) + h x B(June 1, T) + h x G(March 1, T)

Suppose that we choose h = 1. In this case, the payoff of the hedged position does not depend on
the exchange rate at maturity, S(June 1). Yet, we do not have a perfect hedge because the payoff of
the hedged position increases one for one with the basis at maturity, B(June 1, T). Computing the
variance of the hedged position, we have:

Variance of hedged position = (1 h)2[Variance of spot exchange rate] + h2[Variance of basis]

(7.7.)
Figure 7.1. shows how the variance of the hedged position changes as the hedge ratio h and the
variance of basis risk change, keeping the variance of the spot exchange rate constant. As the hedge
ratio increases from zero, the contribution of the variance of the spot exchange rate to the variance
of the hedged position falls. At the same time, however, the contribution of the variance of the basis
to the variance of the hedged position increases. Close to h = 1, the contribution of the variance of
the cash position to the variance of the hedged position is quite small (because (1 h)2 is small) in
comparison to the contribution of the variance of the basis (because h2 is close to one).
Consequently, close to h = 1, one can decrease the variance of the hedged position by reducing the
Chapter 7, page 9

hedge ratio slightly.

If the basis covaries with the cash position, then a basis that covaries negatively with the cash
price increases h. The opposite takes place when the basis covaries positively with the cash price.
This is not surprising. A basis that is high when the spot price is high means that the futures price
has less covariance with the spot price. A larger futures position is therefore needed to achieve the
same covariance of the futures position with the cash position as in the case of no basis risk. The
opposite takes place if the basis is low when the spot price is high.

Section 7.1.3. Cross-hedging

So far, we have paid a lot of attention to the example of hedging a Swiss franc exposure with
a Swiss franc futures contract. Much of the hedging taking place is not as straightforward. There
might be no futures contract on the cash position we want to hedge. Remember the example of the
airlines which cannot use jet fuel contracts to hedge jet fuel because such contracts do not exist. We
saw that Delta uses heating oil contracts to hedge jet fuel. When one uses a futures contract to hedge
a cash position on a good which would not be deliverable with the futures contract, one uses a crosshedge. Our approach to finding the optimal hedge ratio is not different in the case of a cross-hedge.
We find that ratio by regressing the changes in the cash position on the changes in the futures price
of the contract we plan to use assuming that the multivariate normal changes model holds. If we have
a choice of contracts, we use the contract that provides the most effective hedge using our measure
of hedging effectiveness. Often, one might choose to use several different futures contracts. For
instance, while Delta uses only heating oil contracts to hedge jet fuel, many airlines use both heating
oil and crude oil contracts.
Chapter 7, page 10

Section 7.1.4. Liquidity

In perfect markets, we would always hold the contract that matures when our exposure
matures if such a contract is available. Otherwise, we would be taking on unnecessary basis risk.
In the presence of transaction costs, however, this need not be the case. When we open a futures
position, we have to pay a commission and deposit a margin. In addition, if our transactions are
large, they may affect prices; we may have to offer more advantageous prices than current market
prices so that somebody will be willing to take the opposite side of the transaction. This is called the
market impact of our trade.
The extent of the market impact depends on the liquidity of the market. In highly liquid
markets, most trades have no impact on prices. In futures markets, the shortest-maturity contract has
the greatest liquidity. Contracts that have the longest maturity are often extremely illiquid. This lack
of liquidity means that when we try to trade, we end up getting very unfavorable prices because we
have to offer substantial price concessions to get the trade done.
One measure of the liquidity of a futures market is the open interest. In the case of a futures
contract with a given maturity, we add up all the long positions to get the open interest of the
contract. Alternatively, we could add up the short positions and get the same number. Generally, the
open interest falls as one moves from contracts with short maturities to contracts with long
maturities.
Contracts with long maturities sometimes do not trade at all during a day. Consider the
situation of Export Inc. Export will receive a payment of 1M Swiss francs on June 1 and has to
decide on March 1 how to hedge its exposure. In Chapter 6, we assumed that Export would use the
June contract. Yet, on March 1, 1999, the open interest for the March Swiss franc contract was
Chapter 7, page 11

56,411 contracts, but only 6,093 for the June contract and 322 for the September contract (as
reported by the Wall Street Journal). Because contracts with long maturities are so illiquid, it might
be worth it to take a position in the shortest maturity contract and then roll it over into the next
contract as the shortest maturity contract matures. While it is true that proceeding this way presents
rollover risk, the benefit of trading in more liquid markets might more than offset the cost of the
rollover risk. Rollover risk is the risk that arises because the difference between the price of the
contract we close and the price of the contract we open is random.
Suppose that Export hedges first with the March contract and then rolls over its position into
the June contract. There is basis risk because Export does not know when it sets up the hedge what
the basis will be for the June contract when it rolls over on March 12. With a tailed position hedging
one Swiss franc to be received on June 1, the proceeds from the hedge on June 1 are G(March 1,
March) - S(March 12) from the position in the March contract and G(March 12, June) - G(June 1,
June) from the position in the June contract. An unexpectedly high basis of the June contract on
March 12 increases the payoff from the hedge; an unexpectedly low basis has the opposite effect.
When there is basis risk at the rollover date, Export cannot create a riskless position through futures
hedging. Since Export incurs basis risk by rolling over that it would not incur by using the contract
maturing in June only, it would seem that it makes no sense to first take a position in the March
contract and then a new position.
This argument would be reasonable in the case of Export, especially give the small size of
the required futures position. If Export required a very large futures position, it would have to think
about the price impact of its trading. However, this argument would make no sense for Mr. Hedge.
Whatever Mr. Hedge does, as long as he uses futures contracts, he will have to bear rollover risk
Chapter 7, page 12

since he cannot take a position in a five-year futures contract. As we saw, however, there is no
volume in the longest maturity quoted contract, so that trading that contract would move prices and
make hedging expensive. Mr. Hedge will be better off using short maturity contracts and rolling
them over.

Section 7.1.5. Imperfect divisibility

Throughout the discussion, we have assumed that futures contracts are perfectly divisible.
They are not. For instance, for the Swiss franc contract, we have to buy or sell Swiss franc futures
in units of 125,000 Swiss francs, and our exposure is not always in changes of 125,000 Swiss francs.
The fact that we have to trade contracts of fixed size is one disadvantage of futures relative to
forward contracts.
Lets see how we handle this problem in figuring out the optimal hedge. If the optimal hedge
is not divisible into a round number of contracts, we have to round out the hedge. In some cases,
however, rounding out means we might be better off not hedging at all. Suppose we have an
exposure of 62,500 Swiss francs expiring in three months and there is a futures contract expiring in
three months. In this case, the volatility of the hedged position when we go short one contract is the
same as the volatility of the unhedged position:

Volatility of unhedged position = Vol[62,500S(t + 0.25)]

Volatility of hedged position = Vol[62,500S(t + 0.25)-125,000{S(t + 0.25) - G(t,S(t + 0.25)}]
=Vol[-62,500S(t + 0.25)] = Vol[62,500S(t + 0.25)]

Chapter 7, page 13

(7.8.)

In this case, we are indifferent between hedging and not hedging if the exposure is 62,500 Swiss
francs. This is because our exposure is exactly equal to half a contract. Suppose the exposure is
50,000 Swiss francs. In this case, the volatility of the unhedged position is Vol[50,000S(t + 0.25)].
The volatility of the hedged position, however, is Vol[75,000S(t + 0.25)]. Therefore, one is better
off not hedging at all.
To minimize the risk of the hedged position, the solution is to take a position in the round
number of contracts closest in absolute value to the volatility-minimizing hedge. We can use the
example of Export Inc. to see that this intuitive solution is the right one. Using regression analysis,
the minimum-volatility hedge using the June contract is to go short 940,000 Swiss francs, or 7.52
contracts. The price of a T-bill that matures when the exposure matures is $98.8194 on March 1,
1999, so the tailing factor is slightly more than 0.9881. The optimal tailed hedge involves 7.44
contracts. Export has to decide whether to go short 8 or 7 contracts. With our solution, we would use
7 contracts. Lets compares the variance of the hedged position with 7 contracts and with 8 contracts.
Over the estimation period, the weekly standard deviation of the Swiss franc change is 0.01077; the
weekly standard deviation of the futures price changes is 0.01107; and the weekly covariance
between the two changes is 0.000115. Suppose Export evaluates the hedging position weekly.
Remember that marking to market increases the payoffs of a futures contract by the inverse of the
tailing factor. Export can take into account the marking-to-market by dividing the futures volatility
by 0.9881 for the first week. For seven contracts, the variance of the hedged position is:

Variance of hedged position with seven contracts for first week = (1,000,000 x 0.01077)2 + (7 x
125,000 x 0.01107/0.9881)2 2 x 1,000,000 x 7 x 125,000 x 0.000115/0.9881 = 8,416,120.70
Chapter 7, page 14

(7.9.)
The variance of the hedged position using eight contracts is 8,737,305.30. Given this, Export chooses
to go short seven contracts initially. Since the tailing factor falls over time, the optimal hedge
increases, so that eventually in this case the last week the number of contracts increases to 8.

Section 7.1.6. The multivariate normal changes model: Cash versus futures prices
Models are approximations, and the multivariate normal changes model is no different from
any other model. There are many reasons why it might not hold exactly. One reason has to do with
how futures contracts are priced. Remember from Chapter 5 that if the interest rate and the
convenience yield are constant, the futures contract is priced like a forward contract. In this case, the
futures price is equal to the price of the deliverable good times a factor that depends on the interest
rate and time to maturity. If the futures price depends only on the price of the deliverable good, the
interest rate, and the convenience yield, it must satisfy the formula:

G(t + i, T) = exp{[r c](T (t + i))}S(t + i)

(7.10.)

where G(t + i, T) is the futures price at t + i for a contract maturing at T, r is the annual continuously
compounded interest rate, c is the convenience yield, and S(t + i) is the spot price of the deliverable
good at t + i.1

We ignore payouts and storage costs for simplicity. Taking payouts and storage costs
into account changes the formula as shown in Chapter 5 but has no impact on the rest of the
analysis.
Chapter 7, page 15

The futures price change from t + i to t + i + k, where k is a period of time such that t + i +
k < T, is:
G(t + i + k,T) G(t + i, T) =
exp{[r c](T (t + i + k)}S(t + i + k) exp{[r c](T (t + i))}S(t + i)

(7.11.)

Since exp{[r c](T-(t + i))} changes over time if r c is different from zero, futures price changes
can be i.i.d. only if r c is equal to zero assuming that the change of the price of the deliverable good
is i.i.d. Otherwise, if r is greater than c, exp{[r - c](T-(t+i))} is greater than one and drops over time
to become closer to one as maturity approaches. Consequently, the futures price change for a given
spot price change falls over time as a proportion of the change of the price of the deliverable good.
The opposite occurs if r is smaller than c.
In our regression analysis, we effectively assume that basis risk due to the fact that we do not
hold the futures contract to maturity is a first-order phenomenon, while the impact of predictable
changes in the distribution of the futures price is not. If we hold a contract to maturity or if basis risk
due to the fact that we do not hold it to maturity is unimportant, we may be better off to use cash
price changes of the deliverable good rather than futures price changes in our regression. The reason
is that the multivariate normal changes model is more likely to hold exactly for changes in the price
of the deliverable good than for changes in the futures price.
Since the futures price is not the cash price, we then need to use the futures price formula to
adjust the hedge if we do not hold the futures contract to maturity (similar to the analysis of Section
7.1.1.). Hence, if the regression coefficient is , we use as hedge ratio before tailing /exp{[r c](T
(t*))}, where t* is the maturity of the hedge. This is because a change of S in the cash price
Chapter 7, page 16

changes the futures price by Sexp{[r c](T (t*))}, so that on average the futures price changes
more than the cash price if r is greater than c. We have to take that into account when constructing
our hedge.
Lets consider an example. Suppose we hold a contract close enough to maturity that the
contracts basis risk with respect to the deliverable good is trivial. The deliverable good is not the
good we are trying to hedge, though. We are planning to get out of a wheat contract immediately
before maturity, but the wheat grade we hedge is different from the wheat grade that is delivered on
the contract. The hedge has basis risk, in that the prices of the two grades of wheat at maturity might
be different from what we expect. In this case, what we care about at maturity of the hedge is not
how the futures price differs from the cash price, but how the cash price we hedge differs from the
cash price of the deliverable good. Hence, to estimate that relation, we are better off to estimate a
regression of changes in the cash price of our exposure on the cash price of the deliverable good if
we believe that cash prices follow the multivariate normal changes model.

Section 7.2. The costs of hedging

Risk is costly for Export. Consequently, if hedging has no cost, it chooses to minimize risk.
We saw that Export can eliminate its Swiss franc risk completely in the absence of basis risk.
Although it is possible for hedging to be costless, there are generally costs involved. Sometimes,
these costs are small enough compared to the benefits that they can be ignored. In other cases, the
costs cannot be ignored, and the firm must trade off the costs and benefits of hedging. We focus only
on the marginal costs associated with a hedge in our analysis. For a firm, there are also costs
involved in maintaining a risk management operation. These costs include salaries, databases,
Chapter 7, page 17

computer systems, and so on. We take these costs as sunk costs that do not affect the hedging
decision.
When exposure is measured exactly, as it is with Export, hedging can affect expected payoffs
for two reasons. First, ignoring transaction costs, the hedge can affect the expected payoff because
the price for future delivery is different from the expected spot price for the date of future delivery.
Second, putting on the hedge involves transaction costs.
If we know the beta of the Swiss franc, we can compute the markets expected spot exchange
rate for the maturity of the forward contract when the CAPM holds. If the beta of the Swiss franc is
zero, then the markets expected spot exchange rate is equal to the forward exchange rate. Lets
suppose that this is the case. If Export has the same expectation for the spot exchange rate as the
market, then there is no cost of hedging except for transaction costs. Suppose, however, that Export
believes that the expected price for the Swiss franc at maturity of the exposure is higher than the
forward exchange rate. In this case, Export believes that the forward exchange rate is too low. With
our assumptions, this is not because of a risk premium but because the market is wrong from
Exports perspective. By hedging, the firm reduces its expected dollar payoff by the exposure times
E (S(June 1)) - F, where E(S(June 1)) is Exports expectation of the price of the Swiss franc on June
1, S(June 1), as of the time that it considers hedging, which is March 1. This reduction in expected
payoff is a cost of hedging. Hence, the firm must decide whether it is worth it to eliminate all risk.
Box 7.1., The cost of hedging and Daimler-Benzs FX losses, shows how one company thought
through this issue at a point in time.
The firm faces costs of hedging in the form of transaction costs. Export would have to
consider the fact that the bid-ask spread is narrower on the spot market than on the forward market.
Chapter 7, page 18

This means that if there is no systematic risk, the expected spot exchange rate for a sale is higher
than the forward exchange rate for a short position. The difference between these two values
represents a transaction cost due to hedging. We can think of the transaction cost of hedging as
captured by a higher forward price for a firm that wants to buy the foreign currency forward and as
a lower forward price for a firm that wants to sell the foreign currency forward. There may also be
commissions and transaction taxes in addition to this spread.
When the manager of Export responsible for the hedging decision evaluates the costs and
benefits of hedging, she has to compare the benefit from hedging, which is the reduction in the cost
of CaR, with the cost of hedging. Suppose the manager assumes that one unit of CaR always costs
$0.5 and that hedging is costly because the forward exchange rate is too low by two cents. She could
conclude that the forward exchange rate is lower than the expected spot exchange rate by 2 cents
either because of transaction costs or because the market has it wrong. The forward exchange rate
quote in the Wall Street Journal for March 1, 1999, for delivery three months later is $0.6862.
Hence, if the forward exchange rate is too low by 2 cents, Export expects the spot exchange rate to
be $0.7062 on June 1. In this case, going short 1M Swiss francs on the forward market saves the
costs of CaR. In chapter 6, CaR for Export was estimated to be $71,789.20. Consequently, hedging
increases firm value by 0.5 x $71,789.20 = $35,894.60. At the same time, however, the manager of
Export expects to get $20,000 more by not hedging than by using the forward hedge. In this case,
the cost of CaR is so high that Export hedges even though the forward contract is mispriced. If the
forward contract is mispriced by four cents instead, the firm loses $40,000 in expected payoff by
hedging and gains only $35,894.60 through the elimination of the cost of CaR. It obviously does not
pay for the firm to hedge in this case, even though risk reduces firm value.
Chapter 7, page 19

Can the firm have valuable information that leads it to conclude that the markets expectation
is wrong? If markets are efficient, such information is hard to come by, but this does not mean that
it does not exist or that a firm cannot get it. The problem is that it is too easy to believe that one has
such information. Some individuals and institutions have tremendous resources at their disposal and
spend all their time searching for such mistakes. Individuals and institutions for whom watching the
markets is at best a part-time activity are not likely to have information that is valuable. Having
publicly available information, such as newspaper articles, analyst reports, or consensus economic
forecasts, is not worth much. Since everybody can trade on that information, it gets incorporated in
prices quickly.
A test of whether information is valuable, at least from the perspective of Exports manager,
is whether she is willing to trade on that information on her own account. If she is not, why should
the shareholders take the risk? Remember that here the risk involves a cost, namely the impact of
the risk on CaR. The bet the manager wants to take has to be good enough to justify this cost.
Lets go back to mispricing of the forward exchange rate by $0.04 when the cost of CaR is
$0.5 per unit of CaR. In this case, it does not pay for Export to hedge. Suppose that Export does not
hedge but rather takes on more foreign exchange risk by going long Swiss francs on the forward
market to take advantage of the mispricing on the forward market. Each Swiss franc it purchases on
the forward market has an expected profit of $0.04 and increases the CaR by $0.0717892. Each
dollar of CaR costs the firm $0.5. So, the net expected gain from purchasing a Swiss franc forward
is $0.04 - 0.5 x $0.0717892, or $0.0041054. In this case, Export can keep increasing its risk by
buying Swiss francs forward with no limits. In this example, therefore, the firm is almost riskneutral. When a risk has enough of a reward, there is no limit to how much the firm takes of this risk.
Chapter 7, page 20

It therefore does not make sense to assume that the cost of CaR is fixed per unit of CaR whatever
the amount of risk the firm has. Eventually, the cost of CaR has to increase, so that the firm does
not take more risks.
The optimal hedge is the one that maximizes the firms expected cash flow, taking into
account the cost of CaR. Let Export go short h Swiss francs on the forward market. Suppose further
that the cost associated with CaR is a constant, , times the square of CaR, (CaR)2, so that the total
cost of CaR is a quadratic function of CaR. Quadratic cost functions are commonly used in
economics. This cost formulation has the advantage that the cost of CaR per unit of CaR, the
marginal cost of CaR, increases with the level of CaR as shown in Figure 7.2. Figure 7.2. shows how
the total cost of CaR and the marginal cost of CaR increase with CaR.
With a quadratic cost function for CaR, the expected payoff net of the cost of CaR for Export
is:
Expected cash flow net of the cost of CaR
= Expected cash flow Cost of CaR per unit of CaR*(CaR)2
= Expected cash flow (CaR)2

(7.12.)

= 1M x E(S(June 1)) h x [E(S) F] [(1M - h)1.65Vol(S(June 1))]2

where h is the number of Swiss francs sold short forward. The unhedged position of Export is then
1M Swiss francs minus h. Figure 7.3. shows the expected cash flow net of the cost of CaR as a
function of h with our assumptions and shows that it is a concave function. Since the expected cash
flow net of the cost of CaR first increases and then falls as h increases, there is a hedge that
maximizes this expected cash flow. Assuming an expected spot exchange rate of $0.7102, a forward
Chapter 7, page 21

exchange rate of $0.6902, and a volatility of the spot exchange rate of 0.0435086, we find that the
optimal hedge is to go short 980,596 Swiss francs if the cost of CaR is $0.0001 per unit, and to go
short 805,964 Swiss francs if the cost of CaR is $0.00001 per unit. Since hedging has a positive cost
because the forward exchange rate is too low, the firm hedges less as the cost of CaR falls.
We can solve for the optimal hedge directly. At the margin, the cost of hedging has to be
equal to the benefit of hedging. Consequently, we can find it by setting the cost of hedging slightly
more (the marginal cost of hedging in the following) equal to the benefit from doing so (the marginal
benefit).
By hedging, one gives up the expected spot exchange rate to receive the forward exchange
rate for each Swiss franc one hedges. Consequently, by hedging  more units of the cash position,
our income changes by (F E(S(June 1)) where  represents a very slight increase in the size of
the hedge. The marginal cost of hedging is therefore:

Marginal cost of hedging = (F E(S(June 1)))

(7.13.)

For given , the marginal cost of hedging does not depend on h. Further, the marginal cost of
hedging depends only on the difference between the spot exchange rate the firm expects and the
forward exchange rate as long as neither transaction costs nor the forward exchange rate depend on
the size of the hedge.
The marginal benefit of hedging is the decrease in the cost of CaR resulting from hedging

Chapter 7, page 22

 more units of the cash position when  represents a very slight increase in the size of the hedge:2

Marginal benefit of hedging for firm with hedge h

= cost of CaR for hedge h - cost of CaR for hedge (h + )
= ((1M - h)1.65Vol[S(June 1)]) 2 - ((1M - h - )1.65Vol[S(June1)]2 (7.14.)
=2 (1M - h) (1.65Vol[S(June 1)]2 - 21.65Vol[S(June 1)]2
= 2 (1M-h) (CaR per unit of exposure) 2
To go to the last line, we use the fact that as long as  is small enough, the square of  is so small
that the second term in the third line can be ignored. Because the cost of risk for the firm is  times
CaR squared, the marginal benefit of hedging turns out to have a simple form. The marginal benefit
of hedging depends on , the unhedged exposure of SFR1M - h, and the square of CaR per unit of
exposure. The CaR per unit of exposure is fixed. Consequently, the marginal benefit of hedging falls
as the unhedged exposure falls. In other words, the more hedging takes place, the less valuable the
next unit of hedging. Since the firms CaR falls as the firm hedges more, it follows that the lower
the CaR, the lower the marginal benefit of hedging.
Figure 7.4. shows the marginal cost and the marginal benefit curves of hedging. The
intersection of the two curves gives us the optimal hedge. Increasing the marginal cost of hedging
moves the marginal cost of hedging curve up, and therefore reduces the extent to which the firm
hedges. Increasing the cost of CaR for a given hedge h moves the marginal benefit curve of hedging
up and leads to more hedging.

This marginal benefit is obtained by taking the derivative of the cost of CAR with
respect to the size of the hedge.
Chapter 7, page 23

We can solve for the optimal hedge by equating the marginal cost and the marginal benefit
of the hedge. When we do so,  drops out because it is on both sides of the equation. This gives us:

h = 1M -

E(S(June 1)) - F
2(CaR per unit of exposure) 2

(7.15.)

Suppose that the forward exchange rate is $0.6902, the expected spot exchange rate is 2 cents higher,

 is equal to 0.0001, and the CaR per SFR is $0.0717892. In this case, the optimal hedge applying
our formula is to sell forward 980, 596 Swiss francs. Not surprisingly, the optimal hedge is the same
as when we looked at Figure 7.3. Figure 7.5. shows the optimal hedge for different values of the
expected spot exchange rate at maturity of the exposure and different values of . The hedge ratio
becomes one as the cost of CaR becomes one. When the cost of CaR is not too large, the optimal
hedge ratio is below one if the forward exchange rate is below the expected spot exchange rate and
above one otherwise. As the expected spot exchange rate increases, the hedge falls and can become
negative. As the forward exchange rate increases, the optimal hedge increases because it is profitable
to sell the SFR short when the forward exchange rate is high relative to the expected spot exchange
rate.
This approach to hedging when CaR is costly gives a very general formula for the optimal
hedge:

Optimal hedge when CaR is costly

The optimal hedge (the size of a short position to hedge a long exposure) when the cost of CaR is
Chapter 7, page 24

 x CaR2 and when the cost of hedging does not depend on the size of the hedge, is given by the
expression:

Expected cash price per unit - Price for future delivery per unit
h = Exposure
(7.16.)
2x (CaR per unit of exposure) 2

To understand this expression for the optimal hedge, suppose first that the cost of CaR is very high.
In this case,  is very large, so the second term in the expression is trivial. This means that h is about
equal to the total exposure and hence close to the hedge that we would take in the absence of hedging
costs. (Remember from Chapter 6 that in the absence of basis risk, the minimum-volatility hedge is
to go short the exposure, so that h is equal to the exposure.) As  falls, so that CaR becomes less
expensive, it becomes possible for the firm to trade off the cost and benefit of hedging. The marginal
cost of hedging is the price for future delivery minus the expected spot price as the expected spot
price increases, Exports expected hedged cash flow falls compared to its expected unhedged cash
flow. As this marginal cost increases, the firm hedges less. The extent to which the firm hedges less
depends on the benefit of hedging. As the benefit from hedging increases, the expression in
parentheses becomes closer to zero in absolute value, so that the firm departs less from the
minimum-volatility hedge. (For those who want to see the details of the derivation of this result, they
are provided in Technical Box 7.2., Derivation of the optimal hedge when CaR is costly.)
Lets apply this analysis to Trading Inc. Trading Inc. has the same exposure as Export Inc.,
but this exposure comes from having a portfolio of Swiss francs T-bills with face value of 1M Swiss
francs maturing on June 1. Trading is concerned about its one-day VaR. We saw how to compute
Chapter 7, page 25

this one-day VaR for March 1, 1999, in Chapter 6. VaR is computed for portfolios of assets and
liabilities marked-to-market. In this case, the relevant exposure for VaR is the one arising from the
current value of the portfolio of Swiss francs T-bills. So far, we have computed the one-day VaR
assuming that the expected change in value of the portfolio over one day is zero. In this case, it is
optimal to reduce VaR to zero if VaR is costly because there is no offsetting gain from taking on
risk. If there is an offsetting gain that is economically important, then one must trade off the impact
of hedging on the expected change in portfolio value with the benefit from reducing the VaR through
hedging. This is the same tradeoff as the one we just analyzed with Export. Hence, to find the
optimal hedge when one is using VaR and when hedging is expensive, one has to equate the
marginal impact of the hedge on the expected return with the marginal benefit of the hedge on the
cost of VaR.

Section 7.3. Multiple exposures with same maturity.

Lets now see what happens when Export Inc. has two exposures that mature on June 1. One
cash flow is the cash flow of 1M Swiss francs. The other exposure is a cash flow of 1M yen. Lets
write Syen(June 1) for the spot exchange rate of the yen on June 1 and SSFR(June 1) for the spot
exchange rate of the Swiss franc at the same time. The variance of the unhedged cash flow is now:

Variance of unhedged cash flow = Var[1M x Syen(June 1) + 1M x SSFR(June 1)] =

Var[1M x Syen(June 1)] + 2Cov[1M x SSFR(June 1),1M x Syen(June 1)] + Var[1M x SSFR(June 1)]
(7.17.)
This formula is similar to the formula for the variance of the return of a portfolio with two stocks.
Chapter 7, page 26

Not surprisingly, the variance of the total cash flow depends on the covariance between the cash
flows. Consequently, the general formula for the variance of unhedged cash flow when there are m
cash flows accruing at date T is:

(7.18.)

where Ci(T) is the i-th cash flow accruing at time T. (Remember that the covariance of a random
variable with itself is its variance.) When a firm has several distinct cash flows accruing at the same
point, there is a diversification effect like that in investment portfolios. The diversification effect is
due to the fact that the covariance of two random variables is less than the product of the standard
deviations of the two random variables if the coefficient of correlation is less than one. The variance
of total unhedged cash flow falls as the correlation coefficient between the two cash flows falls. If
the correlation coefficient between the two cash flows is negative, the firm may have very little
aggregate risk. A firm can take advantage of this diversification effect to reduce the extent to which
it has to hedge through financial instruments to reach a target CaR.
Lets look at an extreme example. Suppose that the yen and the Swiss francs cash flows have
the same variance but are perfectly negatively correlated. In this case, the aggregate unhedged cash
flow of the firm has no risk, and no hedging is required. Yet, if the firm looked at these cash flows
one at a time, it would conclude that it has two cash flows that need to be hedged. It would hedge
each cash flow separately. If it used forward contracts for each, it could eliminate all risk. In fact, this
is risk that the firm does not need to eliminate because in the aggregate it cancels out.
Chapter 7, page 27

When hedging is costly, the diversification effect means a firm can reduce hedging costs by
reducing the number and size of the hedges it puts on. To take this diversification effect into account,
the firm should compute optimal hedges based on its aggregate cash flow, not its individual cash
flows. Using our example, the aggregate unhedged cash flow is:

Unhedged cash flow = 1M x Syen(June 1) + 1M x SSFR(June 1)

(7.19.)

Suppose we can use both a Swiss franc futures contract and a yen futures contract that mature on
June 1 or later. In this case, the hedged cash flow is:

Hedged cash flow = Unhedged cash flow - hSFR[GSFR(June 1) -GSFR(March 1)] - hyen[Gyen(June 1) Gyen(March 1)]

(7.20.)

where hSFR is the number of units of the Swiss franc futures and hyen is the number of units of the yen
futures we short before tailing. The Swiss franc futures contract has price GSFR(June 1) on June 1,
and the yen futures contract has price Gyen(June 1). With tailing, GSFR(June 1) - GSFR(March 1) is the
gain from a long position in the Swiss franc futures contracts from March 1 to June 1 equal every
day to the present value of a discount bond the next day that pays one Swiss franc on June 1.
Since we now have exposures in two currencies, we want to find a portfolio of futures
positions so that changes in value of that portfolio offsets as closely as possible unexpected changes
in the value of the cash position. We can use a regression to find the futures portfolio that best
predicts changes in the value of the cash position.
Chapter 7, page 28

Lets assume that the exchange rate and futures price changes have the same joint distribution
over time and that they satisfy the multivariate normal changes model presented in chapter 6. This
means we can use ordinary least squares regression to obtain the volatility-minimizing hedges. We
know Export Inc.s exposures, so we can compute what the value of the cash position would have
been for past values of the exchange rates. Hence, we can regress changes in the value of the cash
position using historical exchange rates on a constant and changes in the futures prices.
The regression coefficients provide us with optimal volatility-minimizing hedges because
we assume that the distribution of past changes is the same as the distribution of future changes. The
optimal hedges are given by the regression coefficients. Here, the dependent variable is the change
in the value of the cash position. Consequently, the coefficient for the change in the Swiss franc
futures price is the number of Swiss franc units for future delivery that one goes short, and the
coefficient for the change in the yen futures price is the number of units of yen for future delivery
that one goes short. The regression is therefore:

SSFR(t) x 1M + Syen(t) x 1M = constant + hSFR x GSFR(t) + hyen x Gyen(t) + (t) (7.21.)

where SSFR(t) is the change in the Swiss franc spot exchange rate over a period starting at t the
period is a day if we use daily observations. (t) is the random error of the regression. To hedge the
cash flow, Export Inc. should go short hSFR Swiss francs and hyen yen for future delivery.
The number of Swiss francs for future delivery Export Inc. should go short differs from the
hedge when Export Inc. has only a Swiss franc exposure. The hedge differs because the Swiss franc
futures contract helps hedge the yen exposure and because the yen futures contract helps hedge the
Chapter 7, page 29

Swiss franc exposure. We discuss these two reasons for why the Swiss franc futures position differs
in this chapter from what it was in the previous chapter in turn:
1. The Swiss franc futures contract helps hedge the yen exposure. Suppose that the slope
in a regression of change in the dollar value of the yen cash flow on changes in the Swiss franc
futures price is not zero. In this case, Export could use the Swiss franc futures contract to reduce the
risk of the yen exposure. If the covariance between changes in the yen spot exchange rate and
changes in the Swiss franc futures price is positive, going short the Swiss franc futures contract helps
hedge the yen exposure so that Export thus goes short the Swiss franc futures contract to a greater
extent than if it had only the Swiss franc exposure. If the covariance is negative, Export has to buy
Swiss francs for future delivery to hedge the yen exposure. Since it is optimal to sell Swiss francs
for future delivery to hedge the Swiss franc exposure, this means that Export Inc. sells fewer Swiss
francs for future delivery than it would if it had only a Swiss franc exposure; it takes a smaller
futures position.
2. The yen futures contract helps hedge the Swiss franc and yen exposures. The Swiss
franc futures contract is at best an imperfect hedge for the yen exposure. Suppose that the yen futures
contract is a perfect hedge for the yen exposure and the Swiss franc futures price is positively
correlated with the yen spot exchange rate. If Export uses the yen contract also, it will be able to
hedge the yen exposure perfectly with that contract and it can also take a smaller short position in
the Swiss franc futures contract than it would if it used only the Swiss franc futures contract. It might
even turn out that the yen futures contract is useful to hedge the Swiss franc exposure in conjunction
with the Swiss franc futures contract this would be the case if the yen futures price is correlated
with the basis risk of the Swiss franc futures contract.
Chapter 7, page 30

We can use the same regression approach to find the optimal hedge whatever the number of
different futures contracts we use to hedge an aggregate cash flow. If Export Inc. has a cash flow at
date T corresponding to fixed payments in x currencies, and there are m futures contracts to hedge
the total cash flow, we could obtain positions in these m futures contracts by regressing the change
in the total cash flow on the changes of the m futures contracts. Since the total cash flow is the sum
of known payments in foreign currencies, the hedges can be obtained from a regression using
historical data on exchange rates and futures prices assuming constant joint distributions of futures
prices and exchange rates over time.
Firms have many different exposures to risk. Focusing on exposures of aggregate cash flows
makes it possible to take advantage of diversification across cash flows in a very important way.
There are not always good hedges for every exposure separately. Possible hedges may have too much
basis risk. When a firm considers its aggregate cash flow though, there may be some good hedges
if the basis risks get diversified in the portfolio.
Though our discussion focused on cash flow exposures, the same conclusions apply when
one hedges the value of a portfolio. Lets turn to an example to see this. We examine the optimal
hedge of a portfolio in Chapter 6. Mr. Big has a portfolio of $100 million invested in the world
market portfolio of the Datastream Global Index on September 1, 1999. He is pessimistic about the
return of his portfolio over the next month, but does not want to sell because of tax consequences.
To protect himself, he wants to hedge and has settled on a futures hedge. In Chapter 6, Mr. Big
reasons that, since the U.S. is the biggest component of the world market portfolio, it makes sense
for him to hedge with the S&P 500 futures contract traded at the Chicago Mercantile Exchange. This
hedge allows him to eliminate 80.96% of the volatility of his portfolio.
Chapter 7, page 31

By using a regression of the world market portfolio return on the S&P 500 futures return, Mr.
Big already applies the portfolio method of this chapter. Mr. Big could have decided to consider each
stock he owns separately. If he did this, he would find that his exposure estimates are very poor for
many stocks. This is because diversifiable risk accounts for most of the return volatility of individual
stocks. At the portfolio level, however, systematic risk accounts for most of the return volatility
because diversifiable risk is diversified away. If Mr. Big attempts to hedge individual stocks, he
would therefore conclude that hedging makes little sense for most of his stocks and would therefore
be able to reduce the volatility of his portfolio very little. He could go a step further and decide to
treat his U.S. stocks as a portfolio and attempt to hedge that portfolio. He would then be left with
the risk of his non-U.S. stocks. By hedging the world market portfolio against its U.S. exposure, Mr.
Big uses the S&P 500 futures contract to hedge the return of the securities from other countries. This
is useful because the return of these securities is correlated with the U.S. market return.
The world market portfolio has exposures to other markets besides the U.S. market. We can
therefore investigate whether Mr. Big could improve his hedge by using a second futures contract.
The second biggest component in the world market portfolio is Japan. Lets see how Mr. Big could
improve his hedge by using the futures contract on the Nikkei traded on the Chicago Mercantile
Exchange as well as the S&P 500 contract. The payoff of that contract is in dollars. Regressing the
monthly (continuously-compounded) return of the world market portfolio on a constant and the rates
of change of the futures prices from January 1, 1991 to September 1, 1999 gives us:

Log(World index) = c + Log(S&P 500) + Log(Nikkei) + 

0.0048

0.6905

Chapter 7, page 32

0.2161

(7.22.)

(0.26)

(12.79)

(7.72)

We provide the t-statistics below the coefficients. These coefficients show that the return of the
world index is positively related to the return of the S&P500 and of the Nikkei. The exposure of the
world market to the S&P 500 is greater than its exposure to the Nikkei. Both exposure coefficients
are estimated precisely. The standard error of the estimate of the S&P 500 futures coefficient is 0.054
and the standard error of the estimate of the  coefficient is 0.028.
Consider now the implementation of this hedge where the hedge is adjusted every month.
Effectively, we hedge over a month, so that tailing is trivial and can be ignored. The Nikkei contract
is for $5 times the Nikkei. Consequently, the contract is for a position in the Nikkei worth
$89,012.40 on September 1, 1995, since on that day the Nikkei stands at 17,802.48. The S&P
contract is for 500 times the S&P 500. The S&P 500 is at 1,331.06 on September 1, 1999, so that
the contract corresponds to an investment of 1,331.06 x 500 in the S&P 500, namely $665,530. The
regression coefficient for the S&P 500 is 0.69048. This means that one would like a position in the
S&P 500 futures of $69,048,000 (i.e., 0.69048 x $100M). A one percent increase in that position
is $690,480. The expected increase in the value of the portfolio if the S&P500 increases by one
percent is 0.69048*$100M = $690,480 as well. To obtain the number of S&P 500 futures contracts,
we divide 69,048,000 by 665,531.5. The result is 103.7, which we round out to 104 contracts. To
get the number of Nikkei contracts, we would like a Nikkei position worth $21,609,000. The best
we can do is 243 contracts since 21,609,000/89,012.4 = 242.8.
Using both the S&P 500 and the Nikkei futures contracts to hedge has two important
implications for Mr. Big. First, adding the Nikkei futures contract to the hedging strategy improves
Chapter 7, page 33

the R-square from 0.6554 to 0.7845. This R2 means that we can expect to eliminate 88.57% of the
volatility of the world market portfolio with the two futures contracts but 80.96% with only the S&P
500 contract.3 Second, adding the Nikkei futures contract reduces the position in the S&P 500
contract. If Mr. Big uses only the S&P 500 contract, the regression coefficient on the S&P 500 is
0.86057, but if he uses the Nikkei it is 0.6905. The short position in the S&P 500 falls from 129
contracts to 104 contracts. The reason for this is that, absent the use of the Nikkei contract, the S&P
500 helps hedge the Japanese exposure because the S&P 500 return is correlated with the Nikkei
return. When Mr. Big uses the Nikkei futures contract, the Nikkei futures is a better hedge for the
Japanese exposure than the S&P 500 futures, so that the short position of the S&P 500 futures falls
since the S&P 500 futures is no longer needed to hedge Japanese exposure.

Section 7.4. Cash flows occurring at different dates.

We have shown the benefit of using a total cash flow approach to obtaining the optimal
hedge ratios. Even though a firm has large cash flows in a number of different currencies, it might
need relatively little hedging. This is a simplified world, though. In the real world, payments
typically accrue at different dates, thereby creating exposures that have different maturities.
When payments occur at different dates, how does a firm decide which cash flow volatility
it should minimize? If it tries to minimize the cash flow volatility at each date, it ignores the
diversification that takes place across payments at different dates. For instance, suppose that Export
Inc. receives a payment of 1M Swiss francs on June 1 and must make a payment of 1M Swiss francs
3

Remember that R2 is the fraction of the variance of the dependent variable explained by
the independent variables. To obtain the fraction of the volatility, one has to take the square root
of R2.
Chapter 7, page 34

ten days later. Hedging each cash flow separately ignores the fact that the exchange rate exposure
of the payment Export will receive is already reduced to a great extent by the payment it will make.
The only way to take advantage of diversification across time is to bring all future payments
to a common date to make them comparable. One solution is to use borrowing and lending to bring
the cash flows to the end of the accounting period, and then consider the resulting cash flow at that
time. A second solution is to bring all future payments back to the present date. This solution
involves taking present values of future payments to be received and be made. In this case, we should
be concerned about the risk of the changes of the present value of the firm over the period.
One measure of such risk is VaR. If all cash flows to the firm are taken into account in this
case, and the multivariate normal changes model holds for the cash flows, VaR is directly
proportional to the volatility of firm value changes. Rather than minimize the volatility of cash flow
at one particular date, volatility minimization now requires that we minimize the volatility of the
changes in the present value of the firm for the next period of time. The optimal hedges will change
over time because payments are made and received, so that the present value of the payments
exposed to exchange rate fluctuations changes over time.
To understand this, assume now that Export Inc. receives a payment of 1M Swiss francs on
June 1 and must make a payment of 1m Swiss francs on a different date, date T. Suppose Export Inc.
wants to hedge with a futures contract that matures after date T. The present value of the payments
is:

Present value of the payments = (PSFR(June 1) - PSFR(T))*S(March 1)*1M

Chapter 7, page 35

(7.23.)

where PSFR(T) is the price on March 1 of a discount bond paying one Swiss franc at T. The exposure
is 1M(PSFR(June 1) - PSFR(T)) Swiss francs. Viewed from March 1, the firm has little exposure if T
is close to June 1. This is because the two discount bonds have similar values, so that until June 1
the positive gain from an appreciation of the Swiss franc on the dollar value of the payment to be
received offsets the loss from an appreciation of the Swiss franc on the dollar value of the payment
to be made.
One way to see how having to make a Swiss franc payment at date T limits Exports
exposure to the Swiss franc is to compute a one-day VaR. Suppose that T is September 1, so that it
is six months from March 1, and PSFR(March 1, September 1) = 0.92. Using the data for the Swiss
franc exchange rate, we have:

One-day VaR = 1.65Vol[S(March 1)] x 1M[PSFR(March 1, June 1) - PSFR(March 1, September 1)]
= 1.65 x 0.0054816 x 1M x 0.96 - 0.92

(7.24.)

= $361.8
where 0.96 0.92 denotes the absolute value of 0.96 0.92, and Vol[S(March 1)] denotes the
volatility of the one-day change of the Swiss franc spot exchange rate. The one-day VaR of $361.80
is dramatically less than if Export Inc. is to receive only the payment of 1M Swiss francs on June 1,
which is $8,683, or 1.65 x 0.0054816 x 1M x 0.96. If Export Inc. makes the payment a long time in
the future, its VaR becomes closer to what it would be absent that payment because the present value
of the payment to be made is smaller, so that its current exposure is greater.
To find the hedge that minimizes the volatility of hedged firm value, Export needs to find
a minimum-volatility hedge ratio for a one-day Swiss franc exposure and then multiply this hedge
Chapter 7, page 36

ratio by its exposure. We already know that the volatility-minimizing hedge ratio over one day can
be obtained by regressing the daily change in the Swiss franc on the daily change in the futures price.
Letting S(t) be the change in the spot exchange rate and G(t) be the change in the futures price
from date t to the next day, the regression coefficient is Cov(S(t), G(t))/Var(G(t)). This gives
us the hedge ratio per unit of exposure. The exposure is 1M(PSFR(June 1) - PSFR(T)) Swiss francs.
Consequently, multiplying the exposure with the hedge ratio, we have the optimal hedge h:

Cov[S(t), G(t)]
h = 1M(PSFR (March 1, June 1) PSFR (March 1, September 1))

Var[ G(t)]

(7.25.)
Using a regression coefficient of 0.94, a maturity for the payment to be made of September 1, and
PSFR(March 1, September 1) = 0.92, the optimal hedge consists in going short 37,600 Swiss francs
as opposed to going short 902,400 Swiss francs if there was no payment to be made. Over the next
day, the two Swiss franc exposures almost offset each other so that the VaR is small and only a small
hedge is required.
Exposures change over time. This is not an important issue when, as in our initial discussion
of Exports hedging in Chapter 6, there is only one exposure that matures and disappears. With cash
flows occurring at different dates, however, things are dramatically different. Here, as of June 1, the
offsetting effect of the two exposures disappears. Consequently, on June 2, the exposure of Export
Inc. is the exposure resulting from having to make a 1M Swiss franc payment at date T. Hence, the
exposure rises sharply on June 1, which makes the hedge change dramatically. Before the payment
is received on June 1, Export Inc. goes short Swiss francs for future delivery by a small amount.
After the payment is received, the only Swiss franc exposure of Export Inc. is the payment it has to
Chapter 7, page 37

make later. As of that time, an unhedged Export Inc. is therefore short Swiss francs without the offset
of receiving a Swiss franc payment. This means that after June 1, Export Inc. must change its hedge
from being short Swiss francs for future delivery to being long Swiss francs for future delivery.
Figure 7.6. shows how the hedge changes over time. The VaR also evolves over time, in that it is
very low until June 1, when it increases dramatically.
Sometimes, a firm cannot take advantage of diversification in cash flows across time.
Consider a firm that plans on using this years cash flow for next years investment. The firm cannot
go to the capital markets or to a bank to borrow. It has a payment that is to be made at the end of this
year and will have to make a payment at the end of the following year. The payment to be made
reduces its exposure. Yet, this diversification effect may not help the firm. Suppose the exchange
rate is unexpectedly low at the end of this, so that the firm has a lower cash flow than expected and
has to cut back investment. The fact that the lower exchange rate means that the present value of
what the firm owes is also lower is irrelevant if the firm cannot use this gain to raise cash to finance
investment. Hence, when a firm has limited or no access to external funds, it may have to ignore
some of the time diversification of its exposures. Such a firm cannot use VaR it is concerned about
this years cash flow risk, while VaR allows its exposures across years to partly offset each other.
This firm would therefore compute CaR for this year, bring all cash flows that occur during the year
to a common end-of-year date.

Section 7.5. Metallgesellschaft

In December 1993, Metallgesellschaft AG headquartered in Frankfurt, Germany, faced a
crisis. It had lost over $1 billion dollars on oil futures contracts. Its chief executive was fired. A
Chapter 7, page 38

package of loans and debt restructuring was put together, and eventually large amounts of its assets
were sold. The losses brought about a drastic reorganization of the firm.
Metallgesellschafts losses are among the highest reported by firms in conjunction with the
use of derivatives. Are derivatives to blame? The firms board of directors thought so and changed
the firms strategy after becoming aware of the losses. Some prominent scholars thought the directors
panicked when they had no reason, and gave up a sound business strategy.
Metallgesellschaft is a large German company with interests in metal, mining, and
engineering businesses. In 1993, it had sales in excess of $16 billion, assets of about $10 billion
dollars, and 15 major subsidiaries. MG Corp, a U.S. subsidiary and trading operation of
Metallgesellschaft had equity capital of $50M dollars. It had an oil business organized in a subsidiary
called MG Refining and Marketing (MGRM). MGRM had a 49% stake in a refiner, Castle Energy.
MGRM had contracted to buy from Castle its output of refined products, amounting to
approximately 46M barrels per year at guaranteed margins for up to ten years. MGRM then turned
around and offered retailers long-term contracts in refined products at fixed prices. It thought its
expertise would enable it to make this strategy profitable.
MGRM offered three types of contracts. The first type required the buyer to take delivery of
a fixed amount of refined product per month. These contracts, most of them with a maturity of ten
years, accounted for 102M barrels of future deliveries. The second type of contract had fixed prices
but gave considerable latitude to buyers concerning when they would take delivery. These contracts,
again mostly running ten years, accounted for 52M barrels of future deliveries. Essentially, at the end
of 1993, MGRM had guaranteed delivery at fixed prices of 154M barrels of oil. A third type of
contracts had flexible prices.
Chapter 7, page 39

To alleviate credit risk, MGRM allowed buyers to take fixed-price contracts for a fraction
of their purchases of oil not exceeding 20%. It further included cash-out options. With the first type
of contracts, buyers could cash out and receive half the difference between the near-term futures
price and the fixed price times the remaining deliveries. With the second type of contracts, buyers
would receive the full difference between the second-nearest futures contract price and the fixed
price times the amount not yet delivered.
These contracts exposed MGRM to fluctuations in oil prices. Since it would pay spot prices
to Castle and would receive fixed prices from retail customers, increases in oil prices could
potentially bankrupt the company. MGRM therefore decided to hedge. To analyze the issues
involved in MGRMs hedging, lets assume for simplicity that the fixed-price contracts have no
credit risk, no flexible delivery dates, and no cash-out options. The contracts have a maturity of 10
years and MGRM would keep paying spot prices to Castle over the next ten years. The simplest way
for MGRM to eliminate all risks would be to buy a strip of forward contracts where each forward
contract has the maturity of a delivery date and is for a quantity of oil corresponding to the quantity
that has to be delivered on that date. If MGRM had done this, it would have been perfectly hedged.
It would no longer have had an exposure to oil prices.
MGRM chose not to buy a strip of forward contracts for two reasons. First, buying a strip of
forward contracts would have been expensive. It would have required using over-the-counter
markets of limited liquidity. This made a strategy using short-term futures contracts more attractive.
However, with this strategy, there was basis risk that would not have existed with forward contracts.
This basis risk necessitated the computation of a minimum-volatility hedge using the approach we
presented in Chapter 6.
Chapter 7, page 40

Mello and Parsons (1995) later figured that the minimum-volatility hedge would have
involved buying 86M barrels in the short-maturity futures contract. Pirrong (1997) estimates the
minimum-volatility hedge differently, and under most of his assumptions the minimum-volatility
hedge is smaller than the one obtained by Mello and Parson. One can argue about some of the
assumptions of these studies, but it is certainly the case the minimum volatility hedge involved a
long position in the short maturity futures contract of much less than MGRMs 154M barrels
commitment.
This is the case for two important reasons. In Chapter 6, we talked about the necessity to tail
the hedge and pointed out that tailing can have a dramatic impact when we are hedging exposures
that mature a number of years in the future. Here, Metallgesellschaft is hedging some exposures that
mature in 10 years. When hedging exposures like this, the tailing factor should be the present value
of a discount bond that matures in ten years. This sharply reduces the size of the hedge. In addition,
remember from our analysis that basis risk recuces the size of the hedge relative to the cash position.
In this case, rolling over short-term contracts exposes MGRM to substantial rollover risk that should
reduce its position.
Despite these considerations, MGRM bought 154M barrels in short- maturity contracts. Some
of these contracts were futures contracts, but others were traded over the counter. Hence, in no sense
did MGRM use a minimum-volatility hedge.
This brings us to the second reason why MGRM did not buy a strip of forward contracts. The
minimum volatility hedge of 86M barrels is computed ignoring expected returns altogether it just
minimizes the volatility of the hedged position. MGRM, however, thought that while it did not have
good information about future spot prices, it had good information on the basis. Its view was that
Chapter 7, page 41

typically prices for future delivery are lower than spot prices and that, consequently, there is money
to be made by being long futures as the futures price must rise towards spot prices over the life of
a contract. Such a relationship between spot prices and futures prices is called backwardation. Many
have argued that it arises because hedgers are naturally short, so that the speculators must be long
and must be compensated for taking the risk of the contract by an expected profit. Such an argument
is inconsistent with the logic of the CAPM where only systematic risk is priced; it therefore only
makes sense if one believes that the logic of the CAPM does not apply to futures contracts.
Since MGRM had an exposure to the price of oil, the positive expected return on futures
increased its long position relative to the optimal hedge. MGRM ended up having a long position
of 154M barrels of oil. The argument that makes sense of such a position is that with this position
MGRM was exposed to the basis but not to oil prices eventually, it would take delivery on every
one of the contracts as it rolled them over.
From the perspective of optimal hedging theory as we have developed it, the long position
of 154 million barrels can be decomposed into a pure hedge position of 86 million barrels of oil and
a speculative position of 68 million barrels of oil. MGRM was net long in oil prices. As prices fell
dramatically in 1993, it lost on its futures positions. Each dollar fall in the price of oil required
margin payments of $154M. While the losses on the minimum-volatility position were exactly offset
by gains on the fixed-price contracts, the losses on the speculative positions had no offset; they were
losses in the market value of Metallgesellschaft. In other words, assuming that the computation of
the minimum-volatility hedge is correct, the margin payment of $154M for a dollar fall in the price
of oil was offset by an increase in the value of the long-term contracts of $86M. The net loss for
Metallgesellschaft of a one dollar fall in the price of oil was $68M.
Chapter 7, page 42

MGRMs speculative position was based on gains from backwardation. In 1993, the markets
were not in backwardation, but in contango. Contango describe a situation where futures prices are
above spot prices. Hence, the source of gains MGRM counted on turned out to be illusory that year.
Instead of making rollover gains from closing contracts at a higher price than the contracts being
opened, Metallgesellschaft made rollover losses on the order of $50M every month.
The massive losses on futures contracts grew to more than $1 billion dollars. Some of these
losses were offset by gains on the fixed-price contracts, but the net loss to the corporation was large
because of the speculative position. The losses on futures contracts were current cash drains on the
corporation because the gains on the fixed-price contracts would not be recovered until later. A
hedging program that generates a cash drain of about one billion dollars on a corporation with assets
of ten billion dollars creates serious problems, although Metallgesellschaft could have raised funds
to offset this liquidity loss.
If Metallgesellschaft thought that MGRMs speculative position was sound at the inception
of the hedge program, it should have still thought so after the losses, and hence should have kept
taking that position in order to maximize shareholder wealth. Losses, though, make people look at
their positions more critically. It became harder to believe that backwardation was a free lunch.
Was the MGRM debacle a hedge that failed, or did Metallgesellschaft shrink from its
speculation? After all, if it really believed that backwardation made money, the losses of 1993 were
irrelevant. The strategy had to be profitable in the long run, not necessarily on a month by month or
year by year basis. Losses could lead Metallgesellschaft to give up on the strategy only if it changed
its position as to the expected profits of the speculation or could not afford the liquidity costs of the
speculation.
Chapter 7, page 43

Since Metallgesellschaft had lines of credit that it did not use, the most likely explanation is
that the company gave up on the strategy. As it changed direction, the board wanted the new
management to start on a clean slate, and so it decided to take all its losses quickly. This practice of
taking a bath around management changes is not unusual, as discussed in Weisbach (1995).
What do we learn from the Metallgesellschaft experience? Mostly that large losing futures
positions create liquidity drains due to the requirement to maintain margins, and also that it pays to
compute the correct minimum-volatility hedges. When a company implements a hedging program
with futures contracts, it is crucial to plan ahead for meeting the liquidity needs resulting from losing
futures positions. The VaR of the futures contract provides an effective way to understand the
distribution of the liquidity needs. With VaR, we know that over the period for which the VaR is
computed, we have a 5% chance of losing that amount. A hedge that develops losing futures
positions is not a bad hedge. On the contrary if the hedge is properly designed, losing futures
positions accompany winning cash positions, so that on net the company receives or loses nothing
in terms of present values. It is true that gains and losses of positions might have implications for
a companys liquidity. For Metallgesellschaft, the gains from a fall in oil prices would have to be
paid over time by the holders of long-term contracts, while the losses from futures prices had to be
paid immediately.
A hedged position that has no economic risk can be risky from an accounting perspective.
This issue played a role in the case of Metallgesellschaft. In principle, a hedge can be treated from
an accounting perspective in two different ways. First, the cash position and the hedge can be treated
as one item. In this case, the losses on the hedge are offset by gains in the cash position, so that
losses on a hedge position that is a perfect hedge have no implications for the earnings of the firm.
Chapter 7, page 44

Alternatively, the hedge position and the cash position can be treated separately. If accounting rules
prevent the gains in the cash position that offset the losses in the hedge position from being
recognized simultaneously, a firm can make large accounting earnings losses on a hedged position
because gains on the cash position are not recognized at the same time as the losses on the hedge.
In this case, there could be no economic losses because cash position gains and losses on the hedge
would offset each other exactly, yet there could be large accounting losses followed by large
accounting gains as hedging losses would be recognized first and cash position gains would be
recognized later. In the case of Metallgesellschaft, such a situation arose because accounting
statements did not mark the cash position to market as oil prices changed, but the hedge losses were
accounting losses as they occurred.
An intriguing question with the Metallgesellschaft case is whether the firm would have done
better had it not hedged than with the hedge it used. From a risk management perspective, the only
way this question makes sense is to ask whether Metallgesellschaft had more risk with the wrong
hedge than with no hedge at all. The answer to that question depends on the assumptions one makes.
A least one study, the one by Pirrong (1997), reaches the conclusion that an unhedged
Metallgesellschaft would have been less risky than the Metallgesellschaft with the hedge it used.
Irrespective of how this question is decided, however, the risk of Metallgesellschaft would have been
substantially smaller had it used the appropriate volatility-minimizing hedge. However, if one
believes that backwardation is a source of profits, Metallgesellschaft with the volatility-minimizing
hedge would have been less profitable ex ante.

Chapter 7, page 45

Section 7.6. Summary

In this chapter, we examined some issues that arise because financial markets are not perfect.
Financial market imperfections create basis risk. In a world of perfect financial markets, it would be
costless to create new futures contracts, liquidity would not be an issue, and so there would be
contracts for any exposure a hedger might be concerned about. In the real world, there are few
futures contracts compared to the plethora of exposures firms and investors want to hedge and
liquidity is often a first-order determinant of the optimal hedge. We saw that basis risk reduces the
size of the hedge. Liquidity can often make it optimal to use short maturity contracts. Using contracts
that have a shorter maturity than the exposure exposes the hedger to rollover risk. Rollover risk is
the risk that the contract one must open has a price that differs from the price of the contract one is
getting out of.
Hedging can be expensive, but it need not be so. When one hedges with derivatives traded
in highly liquid markets, hedging generally has a low cost. Nevertheless, it is important to be able
to deal with situations where the costs of hedging are high. To do so, one has to have a clear
understanding of the costs of the risks that one is trying to hedge. We saw how this understanding
can be put in quantitative terms to derive an optimal hedge. We showed that firms with lower costs
of hedging or greater costs of risks hedge more. We then showed that treating exposures as portfolios
of exposures reduces the costs of hedging because doing so takes into account the diversification
across risks. In general, when a firm has exposures maturing at different dates, one has to focus on
their present value or their value at a terminal date.
We concluded the chapter with the Metallgesellschaft story. At the very least, this story
shows that the practical issues that have to be resolved in implementing a hedging program matter
Chapter 7, page 46

a great deal. Metallgesellshaft used short maturity contracts to hedge a long maturity exposure. It had
the wrong hedge ratio. It lost hundreds of millions of dollars because of risk it thought it did not
have.

Chapter 7, page 47

Key concepts
Hedging costs, cost of CaR, lognormal distribution, i.i.d. returns model, log change model, crosshedge, market impact, open interest, ex ante.

Chapter 7, page 48

Review questions
1. Why could hedging be costly?
2. Why hedge at all if hedging is costly?
3. What is the marginal cost of CaR?
4. What is the optimal hedge if hedging is costly?
5. Why does diversification across exposures reduce hedging costs?
6. How does diversification across exposure maturities reduce hedging costs?
7. When is the i.i.d. changes model inappropriate for financial assets?
8. What is a better model than the i.i.d. changes model for financial assets?
9. How can we find the optimal hedge if returns are i.i.d.?
10. How does the optimal hedge change through time if returns are i.i.d.?
10. What model for returns does Riskmetrics use?
11. What were the weaknesses of the hedge put on by Metallgesellschaft?

Chapter 7, page 49

Questions and exercises

1. Consider a firm that has a long exposure in the SFR for which risk, measured by CaR, is costly.
Management believes that the forward price of the SFR is low relative to the expected spot exchange
rate at maturity of the forward contract. Suppose that management is right. Does that necessarily
mean that the firms value will be higher if management hedges less than it would if it believed that
the forward price of the SFR is exactly equal to the expected spot exchange rate?

2. How would you decide whether the i.i.d. return model or the i.i.d. change model is more
appropriate for the hedging problem you face?

3. Suppose that Metallgesellshaft had ten-year exposures and that the minimum-volatility hedge ratio
before tailing is 0.7. Assume that the 10-year interest rate is 10%. What is the effective long position
in oil of Metallgesellschaft per barrel if it uses a hedge ratio of 1 per barrel? Does Metallgesellshaft
have a greater or lower exposure to oil prices in absolute value if it uses a hedge ratio of 1 or a hedge
ratio of 0?

4. A firm will receive a payment in one year of 10,000 shares of company XYZ. A share of company
XYZ costs $100. The beta of that company is 1.5 and the yearly volatility of the return of a share is
30%. The one-year interest rate is 10%. The firm has no other exposure. What is the one-year CaR
of this company?

Chapter 7, page 50

5. Using the data of question 4 and a market risk premium of 6%, what is the expected cash flow of
the company in one year without adjusting for risk? What is the expected risk-adjusted cash flow?

6. Suppose the volatility of the market return is 15% and XYZ hedges out the market risk. What is
the CaR of XYZ after it hedges the market risk?

7. Suppose that the marginal cost of CaR is 0.001*CaR for XYZ and it costs 0.2 cents for each dollar
of the market portfolio XYZ sells short. Assuming that XYZ hedges up to the point where the market
cost of CaR equals the marginal cost of hedging, how much does XYZ sell short?

8. Suppose that in our example of hedging the world market portfolio, we had found that the tstatistic of the Nikkei is 1.1 instead. What would be your concerns in using the Nikkei contract in
your hedging strategy? Would you still use the contract to hedge the world market portfolio?

9. Suppose that you use the i.i.d. change model when you should be using the return i.i.d. model.
Does your mistake imply that the VaR you estimate is always too low? If not, why not?

10. You hire a consultant who tells you that if your hedge ratio is wrong, your are better off if it is
too low rather than too high. Is this correct?

Chapter 7, page 51

Figure 7.1. Variance of hedged payoff as a function of hedge ratio and variance of basis risk.
In this figure, basis risk is assumed to be uncorrelated with the futures price.

Chapter 7, page 52

Figure 7.2. Total and marginal cost of CaR when CaR = CaR2.
Panel A. Total cost of CaR.
Total cost of CaR

CaR

Alpha
Panel B. Marginal cost of CaR.
Marginal cost of CaR

CaR

Alpha

Chapter 7, page 53

Figure 7.3. Expected cash flow net of CaR cost as a function of hedge.
We use an expected Swiss franc spot exchange rate of $0.7102, a forward exchange rate of $0.6902,
and a cost of CaR of 0.0001 and 0.00001. With this example, hedging involves going short the
Swiss franc, which reduces the expected cash flow because the spot exchange rate exceeds the
forward exchange rate. Consequently, if  = 0, no hedging would take place and the firm would go
long on the forward market. The fact that risk is costly makes the expected cash flow net of CaR
a concave function of the hedge, so that there is an optimal hedge. As  falls, the optimal hedge
falls also.

Chapter 7, page 54

Figure 7.4. Marginal cost and marginal gain from hedging.

We use an expected spot exchange rate of $0.7102, a forward exchange rate of $0.6902, and a cost
of CaR of 0.0001 and 0.00001. With this example, hedging reduces the expected cash flow because
the spot exchange rate exceeds the forward exchange rate. Consequently, if  = 0, no hedging
would take place and the firm would go long on the forward market. The fact that risk is costly
makes the expected cash flow net of CaR a concave function of the hedge, so that there is an
optimal hedge. As  falls, the optimal hedge falls also.

Chapter 7, page 55

Figure 7.5. Optimal hedge ratio as a function of the spot exchange rate and  when the cost
of CaR is *CaR2. We use a forward exchange rate of $0.6902.

Chapter 7, page 56

Figure 7.6. Short position to hedge Export Inc.s exposure.

The hedging period starts on March 1. Export Inc. receives a payment of 1M Swiss franc on June
1 and must make a payment of 1M on November 1. The price on March 1 of a discount bond
maturing on June 1 is $0.96 and the price on June 1 of a discount bond maturing on September 1
is $0.92. The optimal hedge ratio for an exposure of one Swiss franc is 0.94. March 1 is time 0 and
September 1 is time 0.5.

Chapter 7, page 57

Technical Box 7.1. The costs of hedging and Daimler-Benzs FX losses.

In the first half of 1995, Daimler-Benz had net losses of DM 1.56 billion. These losses, the
largest in the groups 109-year history, were due to the fall of the dollar relative to the DM.
Daimler-Benz Aerospace (DASA) has an order book of DM 20 billion, 80% of it denominated in
dollars. Consequently, a fall in the dollar reduces the DM value of the payments Daimler-Benz will
receive from fulfilling the contracts it has agreed to.
The company uses both options and forwards to hedge. On December 31, 1994, DaimlerBenz group had DM23 billion in outstanding currency instruments on its books and DM15.7 billion
of interest rate instruments. Despite these large outstanding positions, it had not hedged large
portions of its order book. German accounting rules require the company to book all expected losses
on outstanding orders, so that Daimler-Benz had to book losses due to the fall of the dollar. Had
Daimler-Benz been hedged, it would have shown no losses.
Why did Daimler-Benz not hedge? According to Risk Magazine, Daimler-Benz claimed
its banks forecasts for the dollar/Deutschmark rate for 1995 were so diverse that it held off
hedging large portions of its foreign exchange exposure. It claims 16 banks gave exchange rate
forecasts ranging from DM 1.20 to DM 1.70 per dollar. Some analysts explained the lack of
hedging by their understanding that Daimler-Benz had a view that the dollar would not fall below
DM 1.55. With this view, hedging would have been expensive it would have had to sell dollars
at a cheaper price than it expected to get without hedging. Daimler-Benzs view turned out to be
wrong since the dollar fell to DM 1.38. However, the company blamed its losses on its bankers.
If a company simply minimizes the volatility of its hedged cash flow, it should be
completely indifferent to forecasts of the exchange rate. If it has a forecast of the exchange rate that
Chapter 7, page 58

differs from the forward exchange rate, however, it bears a cost for hedging if it sells the foreign
currency forward at a price below what it expects the spot exchange rate to be. One would think that
if forecasts differ too much across forecasters, this reveals by itself that there is a great deal of
uncertainty about the future spot exchange rate. Therefore, the benefits of hedging should be
greater. This was obviously not the reasoning of Daimler-Benz. It is unclear whether the company
thought that it could hedge a forecasted depreciation or whether it was unable to pin down the costs
of hedging and therefore did not want to hedge.

Source: Andrew Priest, Daimler blames banks forex forecasts for losses, Risk Magazine 8, No.
10 (October 1995), p. 11.

Chapter 7, page 59

Technical Box 7.2. Derivation of the optimal hedge when CaR is costly.
To obtain equation (7.3.), assume that the firms cash flow consists of receiving n units of spot at
some future date and selling h units of spot at the forward price of F per unit for delivery at the same
date. (The analysis is the same for a futures price G for a tailed hedge assuming fixed interest rates.)
With this notation, the expected cash flow net of the cost of CaR (computed for that expected cash
flow) for an exposure of n and a hedge of h is:

Expected cash flow net of cost of CaR = Expected income minus cost of CaR
= (n - h)E(S) + hF - CaR2

(Box 7.2.A)

This equation follows because we sell n - h units on the spot market and h units on the forward
market. Remember now that the CaR with a hedge h assuming that changes are normally distributed
is 1.65Vol((n - h)S) where S denotes the spot price at the delivery date. Substituting the definition
of CaR in equation (7.2.A.), we have:

Expected cash flow net of cost of CaR = (n - h)E(S) + hF - (1.65Vol((n - h)S))2 (Box 7.2.B)

To maximize the expected cash flow net of the cost of CaR, we take the derivative with respect to
h and set it equal to zero (remembering that Vol((n - h)S) is equal to (n - h)Vol(S)):

-E(S) + F + 21.65(n - h)Vol(S)*1.65Vol(S) = 0

Chapter 7, page 60

(Box 7.2.C)

Solving for h and rearranging, we get the formula:

h = n -

F - E(S)
21.652 Var(S)

(Box 7.2.D)

Remember now that 1.65Vol(S) is the CaR of one unit of unhedged exposure. Using the definition
of CaR therefore yields equation (7.3.) in the text.

Chapter 7, page 61

Literature note
Portfolio approaches to hedging take into account the expected gain associated with futures
contracts as well as the risk reduction resulting from hedging. A number of papers discuss such
approaches, including Rutledge (1972), Peck (1975), Anderson and Danthine (1981, 1983), Makin
(1978) and Benninga, Eldo, and Zilcha (1984). Stulz (1983) develops optimal hedges in the
presence of transaction costs. The analysis of this chapter which uses CaR and Var is new, but given
our assumptions it is directly related to the analysis of Stulz (1983). Witt, Schroeder, and Hayenga
(1987) compare different regression approaches to obtaining hedge ratios. Bailey, Ng, and Stulz
(1992) study how hedges depend on the estimation period when hedging an investment in the
Nikkei 225 against exchange rate risk. Extending optimal hedging models to take into account the
liquidity of the hedging firms turns out to be difficult as demonstrated by Mello and Parsons (1997).
However, their work shows that firms with limited liquidity may not be able to hedge as much and
that careful attention has to be paid to liquidity.
Culp and Miller (1994) present the view that the hedging strategy of Metallgesellschaft was
sensible. Edwards and Canter (1995), Mello and Parsons (1995) and Pirrong (1997) provide
estimates of the minimum-volatility hedge for Metallgesellschaft.

Chapter 7, page 62