Lecture 3.

Hedging Strategies Using Futures II

& Interest Rates
EF4420. Derivative Analysis and Advanced Investment Strategies

Dr. Yongjin Kim

3 February, 2017

1 / 32
Lecture Outline

Hedging Using Futures

Cross Hedge
Hedge Using Stock Index Futures

Interest Rates
Type of interest rates
Measurement of interest rates
Zero (spot) rates
Forward rates

2 / 32
Cross Hedging

Cross hedging is to hedge a risk of price of an asset using futures

contract on a dierent underlying asset.

Ex. An airline that is concerned about the future price of jet fuel uses
futures contract on heating oil.

Hedge ratio = size of position in futures contract

size of exposure

1 In perfect hedge, hedge ratio = 1

2 In cross hedge, hedge ratio is not equal to one usually.

In cross hedging, the hedge ratio is chosen to minimize the variance

of the value of the hedged position.

3 / 32
Cross Hedging - Minimum Variance Hedge Ratio

Assume that we have one unit of an asset and shorts futures on h

units of underlying asset.

Let S denote the price change in the asset and F denote the
change in futures price in the hedge period.

Then, the change in the portfolio value is

S h F
short position in future contract

The variance of the value change is

Var ( S) 2h Cov ( S, F ) + h2 Var ( F )

4 / 32
Cross Hedging - Minimum Variance Hedge Ratio

We want to find h such that minimizes the variance.

To do so, we calculate the derivative of the variance with respect to h

and set it equal to 0:
changing price of asset price and future price
Cov ( S, F ) S1 F1
h = S2 F2 SI-S0 F1-F0
Var ( F )
St F3 S2-S1 F2-F1

The hedge ratio can be rewritten as

S
h =
F

where is the correlation coefficient between S and F, F is the standard deviation of

F , and S is the standard deviation of S.

5 / 32
Cross Hedging - Minimum Variance Hedge Ratio

Given the optimal hedge ratio, we want to know the optimal number
of futures contract.

Let QA denote units of assets to be hedged, and QF denote units of

underlying assets of one futures contract.

Then, the number of contracts N should satisfy

N QF
h =
QA

Thus,
h QA
N =
QF

6 / 32
Cross Hedging - Example

An airline expect to purchase two million gallons of jet fuel in one

month and decides to use heating oil futures for hedging. The
standard deviation of futures price is F = 0.0313, the standard
deviation of jut fuel price is S = 0.0263, and the correlation
coefficient is = 0.928.

Q1. What is the minimum variance hedge ratio?

0.928* 0.0263/ 0.0313

Q2. Each of the futures contract is for 42,000 gallons of heating oil. How
many contracts does the airline need?
h* = N * 42,000/ 2,000,000 = the first question ans
N* = 37

7 / 32
Stock Index Futures

A stock index tracks changes in the value of a hypothetical portfolio

of stocks (e.g. Dow Jones Industrial Averages, S&P 500)

In the exchange, we have futures contract on these indices available.

Suppose we invest in a portfolio of stocks (not same as the index

portfolio). Futures on this specific portfolio is not available.
There may be some coefficient in futures and we nay
hedge some risk
How can we hedge the risk of the portfolio value?
) we use futures on a stock index.

8 / 32
Stock Index Futures
Suppose we invest $1 in the portfolio and short futures on $h amount
of index. dont have a specific portfolio so hedge the index

Let rS denote the return on the portfolio and rF denote the the return
on futures over the hedging period.

Then, the change in the portfolio value is

rS hrF
1*rs -(short position) h* rF
To minimize the variance of the value change, we choose
rF = rM because the rate of future is close to systematic risk
the marketCov (rS , rF ) Cov (rS , rM )

h = =
Var (rF ) Var (rM )
r1 (rate of return of the stock)- rf (rate of return of risk free rate)
where rM is the return on the market portfolio.

9 / 32
Stock Index Futures

We want to know the optimal number of contracts on the index.

Let VA be the current value of the portfolio, VF be the current value

of one futures contract.

Then, the number of contracts N should satisfy

N VF
=
VA

Thus,
VA
N =
VF

10 / 32
Stock Index Futures - Example

Suppose we want to hedge the value of a stock portfolio over the next
three months. We use a futures contract with four months to
maturity. The situation is ...
S&P 500 index = 1,000
S&P 500 futures price = 1,010
Value of portfolio = $5,050,000
Risk-free interest rate = 4% per annum
Beta of portfolio = 1.5 T= 0; Index = 1000; Future price= 1010;
One futures contract is for dollar
delivery $250amount=
times250the
*index
index.

The optimal number of contract to be shorted:

5, 050, 000
N = (1.5) = 30
250 1, 010
h* = N* 1010 * 250/ 5050000 = 1.5

11 / 32
Stock Index Futures - Example

What if S&P 500 index and futures prices are as follows three months
later?

S&P 500 index 900 1,100

in three months
Futures price 902 1,103
in three months
Gain on futures position 810,000
Expected return on portfolio -15.5%
5050000*
Expected portfolio value (1-0.155)
Total value of position
in three months

12 / 32
Stock Index Futures - Example

If S&P 500 index is 900 and futures price is 902, then...

the dollar amount in previous two pages * N*
Gain on futures = (1, 010 902) 250 30 = 810, 000
present
Return on the market portfolio is (900 1000)/1000 = 10%

Using CAPM, the expected return on the portfolio is

E (r ) = rf + (E (rm ) rf ) = 1 + (1.5)( 10 1) = 15.5%

Then, the expected portfolio value is

5, 050, 000 (1 0.155) = 4, 267, 250.

Total value of position is 810,000 + 4,267,250 = 5,077,250

13 / 32
Stock Index Futures - Example

If S&P 500 index is 1,100 and futures price is 1,103, then...

Gain on futures = (1, 010 1, 103) 250 30 = 697, 500

Return on the market portfolio is (1, 100 1000)/1000 = 10%

Using CAPM, the expected return on the portfolio is

E (r ) = rf + (E (rm ) rf ) = 1 + (1.5)(10 1) = 14.5%

Then, the expected portfolio value is

5, 050, 000 (1 + 0.145) = 5, 782, 250.

Total value of position is -697,500 + 5,782,250 = 5,084,750

14 / 32
Stock Index Futures - Example

What if S&P 500 index and futures prices are as follows three months
later?

S&P 500 index 900 1,100

in three months
Futures price 902 1,103
in three months
Gain on futures position 810,000 -697,500
Expected return on portfolio -15.5% 14.5%
Expected portfolio value 4,267,250 5,782,250
Total value of position 5,077,250 5,084,750
the numbers are not the same because its not the pure perfect hedge
in three months

With hedging, the total value of position is almost independent of the

value of the index.

15 / 32
Interest Rates

16 / 32
Interest Rates

For valuation of derivatives, we need interest rates.

We need to be clear on how to deal with interest rates, in particular

types and measurement of the rates.

In general, interest rates are higher for riskier investments (think of

CAPM).
Risk-free interest rate is the rate for investment having no risk.

17 / 32
Types of Interest Rates
1 Treasury Rates
the rates investors earn when they invest in government (treasury)
bonds.
because they have right to print money
Government can always pay back the principal and interest, so
investing in the government bonds is risk-free () risk-free rate).
local government may default

2 LIBOR (London Interbank Oered Rate) is supposed to be higher than Treasury

rate
the rate at which banks can obtain loan from other banks
A bank should be creditworthy (e.g. with the credit rating of AA or
higher) to be able to borrow at LIBOR.
This is an unsecured loan, so the borrowing bank may default in theory.
However, the chance of default is very small, because banks
participating in the LIBOR market have high credit ratings
() (almost) risk-free rate ).

18 / 32
Types of Interest Rates

Treasury Rates v.s. LIBOR

19 / 32
Measuring Interest Rates
Usually, interest rates are quoted as annual rate.

However, the actual frequency at which interests are earned may not
be annual
semiannual compounding: interests are earned in every six year.
quarterly compounding: interests are earned in every quarter.
monthly compounding: interests are earned in every month.
.
..

ATR
Let R denote the annual rate and m denote the number of
compounding periods in a year. If you invest $1 for one year, then
future value is
R m
$1 1 +
m

20 / 32
Measuring Interest Rates

Continuous compounding is a liming case where interests are

earned at every instant.

With the annual rate R, the future value of $1 after one year with
continuous compounding is
lim $1* (1+R/m)m = E power of r
R
$1 e

The future value after T years is

$1 e RT

21 / 32
Conversion of Interest Rates

In some cases, we need to convert the interest rate with continuous

compounding to the rate with dierent compounding frequency (or
vice versa).

Let Rc denote the rate with continuous compounding. Also, let Rm

denote the rate with compounding m times per year. Then,
m
R m
e Rc = 1 +
m

Ex. An interest rate is quoted as 10% per annum with semiannual

compounding. What is the equivalent rate with continuous
compounding? ln ((1+ 10%/2) square

22 / 32
Zero Rates

The n-year zero-coupon interest rate is the rate of interests investors

earn on n-year investment (they invest now and all principal and
interests are paid at the end of n years).

In short, we also call n-year zero rate or n-year spot rate.

Ex. 5-year zero-coupon bond with the principal of $1,000 is priced at

$890. What is the 5-year zero rate with continuous compounding?
) Solving for r such that 890 e r 5 = 1000, r =2.33%.

23 / 32
Zero Rates - Facts I
In the market, the zero rates are dierent depending on investment
horizon (maturity).

US-treasury yield on 25 November, 2016

[source: https://www.treasury.gov/resource-center/data-chart-center/interest-rates/Pages/default.aspx]

The relation between the interest rates and maturities is called term
structure of interest rates.upward sloping relationship
24 / 32
Zero Rates - Facts II

The interest rate for a certain maturity is time-varying.

US-treasury yield for 2-year maturity from 2000 to 2016

even if its risk free asset, we still dont know the interest rate when you see the asset which isnt
in starting point. The interest rate is the random volume. its time varying.
[source: https://www.treasury.gov/resource-center/data-chart-center/interest-rates/Pages/default.aspx]
policy , supply and demand of money, inflation rate
will affect the interest rate

25 / 32
Interest Rates - Notation

Given dierent interest rates depending on the maturity, we use the

following notation:
r (t1 , t2 )
is the interest rate from t1 to t2 (with continuous compounding).

T =0 1 2 3 year

/
r (0,1)
/
r (0,2)
/
r (0,3)

26 / 32
Forward Rates

Ex. Consider the following term-structure of interest rates:

Maturity (years) Interest rate (%)

1 3.0
2 4.0

We can find the implicit rate that can be earned from year 1 to year
3% ?(r0 (1,2))
2. Let r denote the rate. Then,
0 1 2
e 0.042 = e 0.03 e r
4%
r = 5.00%.

We call r the (implied) forward rate.

27 / 32
Forward Rates - Notation

In the forward rate, the time of measuring interest rate is dierent

from the starting time of investment.

Thus, we generalize the notation for interest rate:

rt (t1 , t2 )

is the interest rate from time t1 to t2 , measured on date t.

28 / 32
Forward Rates

Ex. Consider the following term-structure of interest rates:

Maturity (years) Interest rate (%)
1 3.0
2 4.0
3 4.6

What is r0 (2, 3)?

)
e 0.0463 = e 0.042 e r0 (2,3)1
r0 (2, 3) = 5.8%.
0 1 2 3

29 / 32
Forward Rates

Once we know the term structure of spot rates, we can find the
forward rates between T1 and T2 as follows:
r0 (0, T2 )T2 r0 (0, T1 )T1
r0 (T1 , T2 ) =
T2 T1
e power of ro(0, T2)T2= e r0(0,T1)T1* e r0(T1, T2)(T2,T1)
What if we cannot find an asset that directly provides the forward
rate? We use two compounding coupon bond to create the specific forward rate

We can combine the zero coupon bonds to construct such an asset.

there is an example in next two pages

30 / 32
Forward Rates

Ex. Go back to the previous example. How can we construct an asset that
provides r0 (2, 3)?
) We can use 2-year and 3-year zero coupon bonds. Consider the
following portfolio: cash flow

Action Year 0 Year 2 Year 3

sell 2-year bond e 0.042 -1
bond issuer- sell: get positive money now but pay back later

buy 3-year bond e 0.042 e 0.042 e 0.0463

0 -1 e (0.046)(3) (0.04)(2)

asset with forward rate -1 e power of 0.058

31 / 32
Things To Do

57-67 79-84, 88-95 except 90-92

Read the textbook chapters 3.4 - 3.5, 4.1 - 4.3, 4.6

Assignment 2 (due on Friday, 10 February at 11 pm)

32 / 32