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Futures
Lecture IV
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• When the oil producer can expect a gain from this transaction?
• What should the oil producer be worried about?
• Which position he should take in the futures to offset his worries?
Example
• On May 15 the spot price is Rs.60 per barrel and the crude oil futures price for
August delivery is Rs.59 per barrel.
• Suppose that spot price on August 15 proves to be Rs.55 per barrel and that futures
price settled on the same day is also close to this price or assume it to be Rs.55.
Example
• For an alternative outcome, suppose that the price of oil on August 15 proves to be
Rs.65 per barrel.
• Hedging, therefore, reduces risk from either position, i.e. if one side weakens, the
other offsets.
Long Hedges
• Hedges that involve taking a long position in a futures contract are known as long
hedges.
• A long hedge is appropriate when a company knows it will have to purchase a
certain asset in the future and wants to lock in a price now.
• A long hedge can also be used when an asset is sold short today and is expected to
be bought in future at a low price.
Example
• Consider a Pakistani exporter Mr. Umer who knows that he will receive pounds
(£’s) in 3 months. Mr. Umer will realize a gain if the pound increases in value
relative to Pakistani rupee.
• When the copper fabricator can expect a gain from this transaction?
• What should the copper fabricator be worried about?
• Which position he should take in the futures to offset his worries?
Example
• Suppose that the spot price of copper on May 15 proves to be $3.25 per pound and
futures price also to be $3.25.
• Suppose that the spot price of copper on May 15 proves to be $3.05 per pound and
futures price also to be $3.05.
Summary of Hedging Situations
σS
h=ρ
σF
Minimum Variance Hedge Ratio
• The optimal hedge ratio, h, is the slope of the best-fit line when ΔS is regressed
against ΔF, i.e.
ΔS = α + β ΔF + ε
• Then β = ΔS / ΔF, is an estimate of the hedge ratio or,
h = ΔS / ΔF
Example
• An airline expects to purchase 1000 gallons of jet fuel in 1 month and decides to
use heating oil futures for hedging. The standard deviation of change in futures
price and spot price are 0.0313 and 0.0263, respectively. The correlation between
the change in prices of two assets is 0.928. Calculate the hedge ratio.
Example
• An airline expects to purchase 1000 gallons of jet fuel in 1 month and decides to
use heating oil futures for hedging. The standard deviation of change in futures
price and spot price are 0.0313 and 0.0263, respectively. The correlation between
the change in prices of two assets is 0.928. Calculate the hedge ratio.
σS
h=ρ
σF
0.0263
h = 0.928 ˟
0.0313
h = 0.78
Optimal Number of Contracts
• QA: Size of position being hedged (units)
• QF: Size of one futures contract (units)
• N: Optimal number of futures contracts for hedging
• The futures contracts should be hQA units of the asset. The number of futures
contracts required is therefore given by:
𝑄𝐴
N=h
𝑄𝐹
Example
• Keeping in view the previous example, suppose that each heating oil contract
traded on exchange is on 100 gallons of heating oil, calculate the optimal number
of contracts for this hedge.
Example
• Keeping in view the previous example, suppose that each heating oil contract
traded on exchange is on 100 gallons of heating oil, calculate the optimal number
of contracts for this hedge.
𝑄𝐴
N=h
𝑄𝐹
1000
N = 0.78 ˟
100
N = 7.8 contracts
Question
• Suppose you are long 1000 oz. of gold (in the cash market). There are 100 oz. of
gold per futures contract. For every $1.00 change in the futures price, the cash
market changes by $0.90. You want to engage in a risk minimizing hedge.