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Hedging Strategies Using Futures

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Spot & Futures Prices

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Convergence of Futures to Spot

Futures
Price Spot Price

Spot Price Futures

Price

Time Time
(a) (b)

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

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Example 1: Futures Price > Spot Price in Delivery Period

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

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Example 2: Futures Price < Spot Price in Delivery Period

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

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Introduction to Hedging

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Definition

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

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

http://www.investopedia.com/terms/h/hedge.asp
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Long & Short Hedges
A long futures hedge is appropriate when you know you will
purchase an asset in the future and want to lock in the price
A short futures hedge is appropriate when you know you will
sell an asset in the future and want to lock in the price

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Example 3
Asset: Oil Delivery Month: August, Target Date T: Aug 15, S0 = $60, F0 = $59
Compute the payoffs for each of the following strategies and each of the following traders
when ST = $55 / $65.
Producer: S1: Signs a contract to sell at ST OR S2: Sells a Futures Contract
Consumer: S1: Signs a contract to buy at ST OR S2: Buys a Futures Contract
Payoff:
ST Producer Consumer
Strategy S1: $55 -5 +5
Strategy S1: $65 +5 -5
Strategy S2: $55 +4 -4
Locked in Price: 59
Strategy S2: $65 -6 +6
Strategy S2 $ST 59 – ST ST – 59
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Arguments For & Against Hedging
FOR
Companies should focus on the main business they are in and take steps to
minimize risks arising from interest rates, exchange rates, and other market
variables

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

What do the competitors do?

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Example 4

Two views on this

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

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Basis Risk

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 Basis Risk
Hedging is often not quite straightforward
1. The asset whose price is to be hedged may not be exactly the same as the asset
underlying the futures contract.
2. The hedge may require the futures contract to be closed out before its delivery month.
These problems give rise to what is termed basis risk.

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

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Long Hedge for Purchase of an Asset
Asset mismatch or Date mismatch
Define
F1: Futures price at time hedge is set up
F2: Futures price at time asset is purchased
S2: Asset price at time of purchase
b2: Basis at time of purchase

Cost of asset S2
Gain on Futures F2 −F1
Net amount paid S2 − (F2 −F1) =F1 + b2

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Short Hedge for Sale of an Asset
Asset mismatch or Date mismatch
Define
F1: Futures price at time hedge is set up
F2: Futures price at time asset is sold
S2: Asset price at time of sale
b2: Basis at time of sale
Price of asset S2
Gain on Futures F1 −F2
Net amount received S2 + (F1 −F2) =F1 + b2

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Hedge Ratio

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

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

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

The futures market in the required asset is illiquid

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

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Choice of Contracts: Date Mismatch

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

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

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

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

We can roll futures contracts forward to hedge future exposures

Initially we enter into futures contracts to hedge exposures up to a time horizon
Just before maturity we close them out an replace them with new contracts
& so on

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

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A Digression on Regression

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

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

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

Suppose we have QY2 of Y

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

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

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

QY1 = (Slope of Line)* QY2 / 1

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

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

= Slope of Regression Line

𝐓𝐡𝐞 𝐜𝐡𝐚𝐧𝐠𝐞 𝐢𝐧 𝐬𝐩𝐨𝐭 𝐩𝐫𝐢𝐜𝐞
=
𝐓𝐡𝐞 𝐜𝐡𝐚𝐧𝐠𝐞 𝐢𝐧 𝐟𝐮𝐭𝐮𝐫𝐞𝐬 𝐩𝐫𝐢𝐜𝐞

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

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Optimal Number of Contracts
Proportion of the exposure that should optimally be hedged is
𝛔𝐒 𝐂𝐡𝐚𝐧𝐠𝐞 𝐢𝐧 𝐬𝐩𝐨𝐭 𝐩𝐫𝐢𝐜𝐞
𝐡∗ = 𝛒 =
𝛔𝐅 𝐂𝐡𝐚𝐧𝐠𝐞 𝐢𝐧 𝐟𝐮𝐭𝐮𝐫𝐞𝐬 𝐩𝐫𝐢𝐜𝐞

Optimal Number of Contracts

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

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Example 9: Cross Hedging
Air Jet will purchase 2 million gallons of jet fuel in one month and hedges using
heating oil futures
From historical data sF =0.0313, sS =0.0263, and r= 0.928
Explain how Air Jet will hedge if the size of one heating oil contract is 42,000 gallons
0.0263
ℎ∗ = 0.928 ∗ = 0.7798
0.0313
The size of one heating oil contract is 42,000 gallons
Optimal number of contracts is = 0.78 * 2,000,000 / 42,000 = 37.1333 ~ 37
Air Jet will go long on 37 heating oil futures contracts

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

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

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

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

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Tailing The hedge

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

Hence we need to tail the hedge

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

V
Optimal number of contracts is h෠ A
VF

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

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

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

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

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