4.

Hedging Strategies Using Futures

Chapter 4

4.2

Hedging with Futures

Short Hedge: The end-user plans to sell the asset or hold the asset and faces the risk that the asset price may fall. Short position in futures contracts Long Hedge: The end-user plans to buy the asset or has sold the asset short and faces the risk that the asset price may rise. Long position in futures contracts

4.3

End-User of Natural Gas Exposure

1500 1000

Change in Profits

500 0 -500 -1000 -1500 Change in Prices -1 -0.8 -0.6 -0.4 -0.2 0 0.2 0.4 0.6 0.8 1

4.4

End-user Exposure plus Long Futures Contract

1500
Changes in Profits

1000 500 0 -500 -1000 -1500 -1

Original Exposure Net position

-0.8 -0.6 -0.4 -0.2 0 0.2 0.4

Long Futures
0.6 0.8 1

Change in Prices

4.5

Mechanics of a Futures Trade

Futures contracts are traded through Future Commission Merchants (FCMs) or commodity brokers.
Both are licensed by the Commodity Futures Trading Commission

Make initial margin (good faith deposit) Futures position will be marked-to-market at the close of every trading day.
Profits (losses) are credited (debited) against your account Any profits over margin requirement may be withdrawn If balance falls below maintenance level, deposit funds so that balance returns to initial margin amount

4.6

Mechanics of a Futures Trade

Futures contracts are traded in the trading pits
NYMEX and Kansas City Board of Trade

Price of futures are determined through competitive bids and offers, a process which is referred to as open outcry. The majority of purchasers of futures contracts offset the obligations to take delivery of the actual commodity by later selling a contract for delivery in the same month. Major risks:
Large margin call that cannot be met If underlying commodity price is very volatile, end-user can face a margin call
demands capital

Basis risk

4.7

Hedging with Futures: Some Considerations

The Basis = Spot price of asset to be hedged - Futures price of contract used. If the asset to be hedged and the asset underlying the futures contract are the same, the basis should be zero at the expiration of the futures. Main factors affect the basis
The choice of asset underlying the futures contract The choice of the delivery month Closing out the contract before settlement

Basis Risk
risk due to changes in the basis

4.8

Long Hedge
Suppose that F1 : Initial Futures Price F2 : Final Futures Price S2 : Final Asset Price You hedge the future purchase of an asset by entering into a long futures contract Cost of Asset=S2 -F2+F1 = F1 + Basis

4.9

Short Hedge
Suppose that F1 : Initial Futures Price F2 : Final Futures Price S2 : Final Asset Price You hedge the future sale of an asset by entering into a short futures contract Price Realized=S2 -F2+F1 = F1 + Basis

10

Spot Price

Futures Price

/3 0/ 12 199 5 /3 0/ 19 9 2/ 29 5 /1 4/ 996 30 /1 6/ 996 30 /1 8/ 996 30 / 10 199 6 /3 0/ 12 199 6 /3 0/ 1 2/ 996 28 /1 4/ 997 30 /1 6/ 997 30 /1 8/ 997 30 / 10 199 7 /3 0/ 19 97

Natural Gas Spot and Futures Prices

4.10

Basis: Spot Price - Futures Price Natural Gas

3 2.5 2 1.5 1 0.5 0 10/30/1995 -0.5 -1 -1.5

4.11

Basis

4/30/1996

10/30/1996

4/30/1997

10/30/1997

Date

4.12

Product Basis: Choice of asset underlying the futures contract

Mismatch in the quality, consistency, or other specification of the asset to be hedged and the asset underlying the futures contract
Find futures contract whose price is most correlated with the price of the asset being hedged.

End-user contracts to buy gas at Overthrust Pipeline and hedges price risk by buying a Henry Hub natural gas futures contract Basis = Spot Overthrust price - NYMEX Henry Hub futures price

4.13

Types of Basis
Time Basis:
An electric utility needing gas in the winter hedges its position by purchasing January natural gas future contracts. If a severe cold wave occurs in December, then the price of December natural gas may surge more than the January prices.
The price risk will last as long as the cold wave or as long as it takes for gas pipeline to bring sufficient new supplies.

Location Basis:
Prices of the same product may vary significantly from one location to another Natural gas prices will almost always be higher in northeastern cities of the US than they are at Henry Hub which is near producing gas fields

4.14

Hedging Profitability & the Basis

Type of Hedge Short Hedge Benefits from Strengthening of the basis Which occurs if Spot price rises more than futures price or Spot price falls less than futures price or Spot price rises and futures price falls

Long Hedge

W eakening basis

Spot price rises less than futures price or Spot price falls more than futures price or Spot price falls and futures price rises

Basis Risk: Unrolling the position and not taking delivery

Date Spot Price 2.20 Futures Basis Price 2.00 0.20

4.15

Futures Effective G/L Price

Initiate Hedge Unrolling/reversing the futures position Case 1: Case 2: Case 3: 2.20 2.20 2.20 2.00 2.10 1.95 0.20 0.10 0.25 0.00 0.10 -0.05 2.20 2.10 2.25

4.16

Number of Futures Contracts and the Optimal Hedge Ratio

Hedge ratio is the ratio of the size of the futures position to the size of the exposure Have assumed this to be one. If the objective of a hedger is to minimize risk, the optimal hedge ratio can be found by regressing the change in the spot price against the change in the futures price. Number of contracts
No. of futures contracts = (opt. hedge ratio) * (size of position being hedged) (size of one futures contract)

4.17

Hedging Using Index Futures

To hedge the risk in a portfolio the number of contracts that should be shorted is P

where P is the value of the portfolio, b is its beta, and A is the value of the assets underlying one futures contract Reasons for Hedging an Equity Portfolio Desire to be out of the market for a short period of time. (Hedging may be cheaper than selling the portfolio and buying it back.) Desire to hedge systematic risk (Appropriate when you feel that you have picked stocks that will outperform the market.)

4.18

Changing the Beta of a Portfolio

An investor can use futures contracts to change the beta of its portfolio. To change the beta of a portfolio from b to b*, where b > b*, a short position in (b - b*) x(S/F) contracts is required
To change the beta of a portfolio from b to b*, where b < b*, a long position in (b* - b) x(S/F) contracts is required
where S = total value of shares being hedged F = total price of one futures contract

where S = total value of shares being hedged F = total price of one futures contract

4.19

Rolling The Hedge Forward

We can use a series of futures contracts to increase the life of a hedge Each time we switch from 1 futures contract to another we incur a type of basis risk