Chapter 3

Hedging Strategies Using Futures

Joel R. Barber

Department of Finance Florida International University Miami, FL 33199

1 Long and 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. A short futures hedge is also appropriate when you currently own the spot asset and want to be protected against price decline.

2 Arguments in Favor of Hedging 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.

3 Arguments against Hedging Shareholders are usually well diversied and can make their own hedging decisions It may increase risk to hedge when competitors do not Explaining a situation where there is a loss on the hedge and a gain on the underlying can be dicult

4 Basis Risk Basis is the dierence between spot and futures Basis risk arises because of the uncertainty about the basis when the hedge is closed out

5 Convergence of Futures to Spot

Futures Price Spot Price

Spot Price Futures Price

Time

Time

(a)

(b)

6 The basis converges to zero in both plots. If the basis does not go to zero, an arbitrage opportunity is available at the delivery date. The basis is negative in plot (a) and positive in plot (b) Plot (a) is typical of a cost of carry market. Plot (b) is typical of normal backwardation in the commodity futures market.

7 Notation F1 futures price at time 1 (today) F2 futures price at time 2 S2 Uncertain spot price at time 2 8 Long Hedge You hedge the future purchase of an asset by entering into a long futures contract Exposed to basis risk if hedging period does not match maturity date of futures

9 Eective Cost of Purchasing Asset using a Long Hedge Eective Cost of Asset = Future Spot Price Gain on Futures

 Gain on Futures: F2 F1 Future Spot Price: S2 Eective Cost of Asset: S2 (F2 F1) Eective Cost of Asset: F1 + BASIS2 Basis at time 2: S2 F2 Future basis is uncertain Therefore, eective cost of asset hedged is uncertain

10 Short Hedge You hedge the future sale of an asset by entering into a short futures contract Exposed to basis risk if hedging period does not match maturity date of futures

11 Eective Price Realized using a Short Hedge Eective Price = Future Spot Price + Gain on Futures Gain on Futures: F1 F2 Future Spot Price: S2 Eective Price: S2 + (F1 F2)

 Eective Cost of Asset: F1 + BASIS2 Future basis is uncertain Therefore, eective price of an asset short hedged is uncertain

12 Example Hedging period 3 months Futures contract expires in 4 months Were exposed to basis risk Suppose F1 = $105 and S1 = 100 Current BASIS : 100 105 = 5

 Basis in 3 months is uncertain What is basis in 4 months?

13 Suppose: F2 = 110 and S2 = $102 Long Hedge Gain: 110 105 = $5 Eective cost: 102 + (5) = $97 Short Hedge Gain: 105 110 = $ 5 Realized (eective) price: = 102 + (5) = $97

 BASIS2: 102 110 = 8 Formula: F1 + BASIS2 = 105 8 = 97 15 Choice of Contract Choose a delivery month that is as close as possible to, but later than, the end of the life of the hedge When there is no futures contract on the asset being hedged, choose the contract whose futures price is most highly correlated with the asset price.

16 Imperfect hedge Basis Risk Cross-Hedge Risk

17 Naive Hedge Dene hedge ratio h as the ratio of total futures to spot position: QF QS where QF is total number of units controlled by futures contract and QS is total exposure to spot asset. Naive Hedge: h=1

 Example: Beef producer plans on buying 200,000 lbs of live cattle in six months Each contract is for delivery of 40,000 lbs of live cattle Naive hedge: Buy 5 futures contracts maturing in six months.

18 Review of Correlation Analysis Remember correlation (rho) measures the extent to which there is a linear relationship between two random variables Correlation is bounded: 1 1

 If the correlation between X and Y equals one, then we have perfect linear relationship: Y = a + bX where a and b are constants and b > 0. The relationship is deterministic. Standard deviation (sigma) measures the volatility of a random variable. Example: the correlation between the temperature at MIA in Fahrenheit and Centigrade equals one: 5 C = (F 32) 9 Note the standard deviation in Fahrenheit is greater than the in Centigrade. Correlation does not depend upon the standard deviation of X or Y . If > 0, we have a positive linear relationship.

 if < 0, we have a negative linear relationship if = 0, the relationship is not linear. Example. Suppose Y = X 2 for 1 < X < 1. The relationship is deterministic but = 0.

0.8

0.6

0.4

0.2

Y = X2

-1

-0.8

-0.6

-0.4

-0.2

0.2

0.4 X 0.6

0.8

Example: X = sin(2 t), Y = 3 sin(2 t) + .2 X = sin(2 t), Y = 3 sin(2 t) + .2

3 2 1

0 -1 -2

0.2

0.4

0.6

0.8

19 Minimum Variance (or standard deviation) Hedge Because of basis and cross hedge risk, futures price changes and spot price changes over hedging period are not perfectly correlated. Therefore, any hedge will contain an error. Our objective is to choose a hedge ratio that minimizes the standard deviation of the hedging error. Dene S and F as change in spot and future price over hedging period.

 Dene as the correlation between S and F . If = 1, a perfect hedge is possible. Dene S as the standard deviation of the change in spot price. Dene F as the standard deviation of the change in futures price The minimum variance hedge ratio is given by h= S F 20 Justication for formula (optional) Error = S h F Perfect hedge: Error = 0 at all times

(3.1)

 S = h F + Error Choose h to minimize var(Error) Therefore, h = slope of regression Or h = cov( F )/ var( F ) Same as equation (3.1) In Figure 3.3 the slope of the is the optimal hedge ratio. regression line

21 Intuition Behind Formula Suppose = 1, then perfect hedge is feasible: h= S F Further, suppose the volatility of S is three times as great as F , as shown below:

3 2 1 0 -1 -2

0.2

0.4

0.6

0.8

Then to oset the higher spot volatility we need to sell (or buy) three times as much of the futures to hedge. The regression line is a perfect t: S = .2 + 3 F with no error term. Now, suppose = 0. Then hedging is impossible.

22 Portfolio Analysis Remember total risk can divided up into systematic and unsystematic risk Systematic risk is measured by the portfolio beta: Hedging with futures allows us to change the systematic risk But not the unsystematic risk 23 Hedging Using Index Futures Notation P Current value of portfolio A Current value of stocks underlying one futures contract N Number of contracts

 F Futures price of index A = F multiplier multiplier is like contract size For S&P 500 futures, multiplier = $250 If F = 1000, A = 250, 000 Naive Hedge N = P/A Match dollar value of futures to dollar value of portfolio Suppose you wish to hedge $1M portfolio with S&P 500 hundred futures Sell 1,000,000/250,000 = 4 contracts Minimum Systematic Risk Hedge

 To hedge the (systematic) risk in a portfolio the number of contracts that should be shorted is P N= (3.4) A In words, naive hedge times the beta where P is the value of the portfolio, is its beta, and A is the value of the assets underlying one futures contract Changing the Beta Let = desired beta Let = portfolio beta Then N = ( ) N < 0 sell P A

(page 67)

 N > 0 buy If we adopt the above convention, this formula generalizes (3.4) Example: Hedging Systematic Risk Value of S&P 500 is 1,000 Value of Portfolio is $5 million Beta of portfolio is 1.5 What position in futures contracts on the S&P 500 is necessary to hedge the portfolio? A = 1000 250 = $.25M N = (0 - 1.5)(5/.25) Example: Changing Beta What position is necessary to reduce the beta of the portfolio to 0.75? = 30 contracts (sell)

 N = (.75 - 1 .5)(5/. 25) = 15 contracts (sell) What position is necessary to increase the beta of the portfolio to 2.0? N = (2 - 1.5)(5/.25) = 10 contracts (buy)