Hedging Strategies Using

Futures
Chapter 3

Copyright © John C. Hull 2013 1

Recap – Commodities (Ex. Crude
Oil)
 Underlying – Crude Oil
 Name – Crude oil futures (or forward)

 Lot size – # barrels

 Spot price – Current market price of crude oil

 Futures price – Current crude futures price (F0)

 Expiry – expiry month (pre-specified date)

 Total value of futures contract (notional) bought or shorted

= Current futures price*Lot size*Number of contracts

 Gain (loss) from long futures = FT – F0

 Gain (loss) from short futures = F0 – FT

Recap – Financial Assets (Ex.
Stock and Stock Index)
 Underlying – Individual stock (e.g. HUL / Nifty / Bank
Nifty)
 Name – Stock / Index futures

 Lot size – # of shares

 Spot price – Current market price of stock or stock index

 Futures price – Current futures price (F0)

 Expiry – expiry month (pre-specified date)

 Total value of futures contract (notional)

= Current futures price*Lot size*Number of contracts

 Gain (loss) from long futures = FT - F0
 Long & Short Hedges

 A long hedge is appropriate when you know you will purchase

an asset in the future and want to lock in the price today.
 A short hedge is appropriate when you know you will sell an
asset in the future & want to lock in the price today.
(Hedge and Forget)
 Example: Wheat farmer (takes a short hedge) and the Baker
(takes a long hedge) on wheat.
 Example: Oil company (currently holding stock of oil and fears
price decline therefore will short oil futures) and Airline
company (will be needing oil for continuation of operations in
future and therefore will go long on oil at prevailing futures
prices).
Copyright © John C. Hull 2013 4
Hedging Short Stock with Index
Futures
 Futures market quote (remember daily
MTM settlement)

NIFTY Futures Quote – NIFTY 50

 Hedgers at times use index futures for

hedging risk of the individual stock.
 In such cases the hedgers concern is to
reduce the market risk component. 5
 Arguments in Favor of Hedging

How as CFO you justify use of derivatives

for hedging risk?

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
Copyright © John C. Hull 2013 6
 Arguments against Hedging

 Shareholders are usually well diversified

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 difficult (windfall opportunity lost!)

Copyright © John C. Hull 2013 7

Performance of key market
variables in the past months

Nifty

Crude oil

INR versus USD

3-month T-bill
8
 Convergence of Futures to Spot
(Hedge initiated at time t1 and closed out at time t2)

Spot
Price

Futures
Price

Time

t1 t2

Copyright © John C. Hull 2013 9

Short Hedge for Sale of an Asset

• Aim is to neutralize the risk exposure.

• Oil company is concerned what if the price of oil falls?

• Therefore, short futures.

• After the hedge is set up:

• As the price of oil goes up company gains on price
increases but loses on the hedge, vice versa

• Net result is ZERO. Hence, perfectly hedged

10
Short Hedge for Sale of an Asset
Example
• Firm will sell 1 million barrel of oil on Dec 15 at the prevailing
spot price on Dec 15. Spot price today = $80
• Futures price on Oct 15 (i.e. today) is $79. ••• Short at $79.

• On expiry (Dec, 15) the spot price is $75

• Gain on futures = $(79-75) = $4

• Therefore, the effective lock-in price = $(75+4) = $79

• What if, the spot price goes up to $85 on expiry

• Effective lock-in price = $85+$(79-85)=$79 (t=0 futures price)

• Risks and rewards both are neutralized!
11
 Basis Risk

 Hedge and forget approach may not

always work?
 Asset used for hedging may not be same as the
underlying
 Uncertainty with respect to when the asset will
be bought or sold (i.e. exact date in future)
 Hedger may require the futures contract to be
closed out before its delivery. Usually hedgers
do not want futures contract to expire before
the date they are expecting the delivery of the
contract.

Copyright © John C. Hull 2013 12

 Basis Risk contd..

 Basis is the difference between spot &

futures prices
 Basis risk arises because of the uncertainty
about the basis when the hedge is closed
out
 Basis = Spot Price – Futures Price (and
reverse for Financial assets)
 Basis risk arises because of the factors
discussed in the previous slide
 Hence, basis risk is zero on expiration
Copyright © John C. Hull 2013 13
Long Hedge for Purchase of an Asset
 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

Copyright © John C. Hull 2013 14

 Short Hedge for Sale of an Asset

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 (ex. refer to notes)

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

Copyright © John C. Hull 2013 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. There are
then 2 components to basis
Copyright © John C. Hull 2013 16
 Cross Hedging
 Cross hedging occurs with the two assets
are different
 Approach is used to manage the risk by
using two positively correlated securities
that have similar price movement (Source:
Investopedia)
 E.g. Gold mining company and Gold ETF
 E.g. Jet fuel and Heating oil
Copyright © John C. Hull 2013 17
 Optimal Hedge Ratio
Proportion of the exposure that should optimally be
hedged is
sS
hr
sF
where
sS is the standard deviation of DS, the change in the
spot price during the hedging period,
sF is the standard deviation of DF, the change in the
futures price during the hedging period
r is the coefficient of correlation between DS and DF.
(Example refer to Jet Fuel and Oil Futures.xlsx)

Copyright © John C. Hull 2013 18

 Optimal Number of Contracts (once the
optimal hedge ratio is estimated)

QA Size of position being hedged (units)

QF Size of one futures contract (units)
Note: If hedge ratio is ONE then its simply the ratio of total size of
the position hedged and the lot size of one futures contract.

Optimal number of contracts

Optimal number of contracts if after tailing adjustment to allow
no tailing adjustment or daily settlement of futures

h *Q A h *V A
 
QF VF

Copyright © John C. Hull 2013 19

 Example
 Airline 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
0.0263
h  0.928 
*
 0.7777
0.0313

Copyright © John C. Hull 2013 20

Example continued
 The size of one heating oil contract is 42,000 gallons
 The spot price is 1.94 and the futures price is 1.99
(both dollars per gallon) so that

V A  1.94  2,000,000  3,880,000

VF  1.99  42,000  83,580

 Optimal number of contracts assuming no daily

settlement ?
 Optimal number of contracts after tailing = 36.10

Copyright © John C. Hull 2013 21

Question 1
 The standard deviation of monthly changes in the
spot price of live cattle is (in cents per pound) 1.2.
The standard deviation of monthly changes in the
futures price of live cattle for the closest contract is
1.4. The correlation between the futures price
changes and the spot price changes is 0.7. It is now
October 15. A beef producer is committed to
purchasing 200,000 pounds of live cattle on
November 15. The producer wants to use the
December live cattle futures contract to hedge its risk.
Each contract is for the delivery of 40,000 pounds of
cattle. What strategy should the beef producer follow?
Copyright © John C. Hull 2013 22
Question 2
A trader owns 55,000 units of a particular asset and
decides to hedge the value of her position with futures
contracts on another related asset. Each futures
contract is on 5,000 units. The spot price of the asset
that is owned is $28 and the standard deviation of the
change in this price over the life of the hedge is
estimated to be $0.43. The futures price of the related
asset is $27 and the standard deviation of the change in
this over the life of the hedge is $0.40. The coefficient of
correlation between the spot price change and futures
price change is 0.95.

Copyright © John C. Hull 2013 23

Question 2 contd..
(a) What is the minimum variance hedge ratio?

(b) Should the hedger take a long or short futures

position?

(c) What is the optimal number of futures contracts

with no tailing of the hedge?

(d) What is the optimal number of futures contracts

with tailing of the hedge?
Copyright © John C. Hull 2013 24
 Hedging Using Index Futures
To hedge the risk in a portfolio the
number of contracts that should be
shorted is
VA
b
VF
where VA is the current value of the
portfolio, b is its beta, and VF is the
current value of one futures (=futures
price times contract size)
Copyright © John C. Hull 2013 25
 Example – Portfolio hedging with
a stock Index
 Value of S&P 500 index = 1,000
 S&P 500 futures price = Rs 1,010
 Value of portfolio = $5,050,000
 Risk-free interest rate = 4% per annum
 Dividend yield on the index = 1% per
annum
 Beta of the portfolio = 1.5

Ch3, Copyright © John C. Hull 2013 26

 Link to spreadsheet

Ch3, Copyright © John C. Hull 2013 27

 Example
Futures price of S&P 500 is 1,000
Size of portfolio is $5 million
Beta of portfolio is 1.5
One contract is on $250 times the index

What position in futures contracts on the

S&P 500 is necessary to hedge the
portfolio?
Copyright © John C. Hull 2013 28
 Changing Beta

 What position is necessary to reduce the

beta of the portfolio to 0.75?
 What position is necessary to increase the
beta of the portfolio to 2.0?

Copyright © John C. Hull 2013 29

 Why Hedge Equity Returns
 May want to be out of the market for a while.
Hedging avoids the costs of selling and
repurchasing the portfolio
 Suppose stocks in your portfolio have an
average beta of 1.0, but you feel they have been
chosen well and will outperform the market in
both good and bad times. Hedging ensures that
the return you earn is the risk-free return plus
the excess return of your portfolio over the
market.

Copyright © John C. Hull 2013 30

 Stock Picking
 If you think you can pick stocks that will
outperform the market, futures contract
can be used to hedge the market risk
 If you are right, you will make money
whether the market goes up or down

Copyright © John C. Hull 2013 31