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ISSUES 3.1 Basic Principles: Short Hedge

1. When is a short futures position appropriates？ A hedge involves a short position in futures.

2. When is a long futures position appropriate？

Hedging Strategies Using Forward A short hedge is appropriate when the hedger already
owns an assets and expects to sell it at some time in the
and Futures 3. Which futures contract should be used？ future.

4. What is the optimal size of the futures position for reducing risk？
A short hedge can also be used when an assets is not owned
right but will be owned at some time in the future.

ASSUME 3.1 Basic Principles-Long Hedge

 ISSUES

 ASSUME 1 Hedges that involve taking a long position in a futures contract

Hedge and forget are known as long hedges.
3.1 Basic Principle

3.2 Arguments For and Against Hedging A long hedge is appropriate when a company knows it will have
to purchase a certain assets in the future and wants to lock a
2 Futures contracts as forward contracts price now.
3.3 Basis Risk

3.4 Cross Hedging

Long hedge can be used to manage an existing short position.

3.5 Stock Index Futures

3.6 Rolling the Hedging Forward

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3.2 Arguments For and Against Hedging 3.3 Basis Risk 3.3 Basis Risk
Suppose that

• Hedging and Shareholders F1 : Initial Futures Price

1 The asset whose price is to be hedged may not be exactly Spot price F2 : Final Futures Price
the same as the asset underlying the futures contract. S1 S2 : Final Asset Price
1 Shareholders can do the hedging themselves. b1 = S1 –F1
b1

2 The hedger may be uncertain as to the exact when the b2 =S2– F2

F1
asset will be bought or sold. Long Hedge :
It assumes that shareholders have as much Futures price S2
b2 You hedge the future purchase of an asset by entering into a
2 information about the risks faced by a company long futures contract
The hedge may require the futures contract to be closed F2
as does the company’s management. 3 The effective price that is paid with hedge is
out before its delivery month.
S2 + F1 – F2 = F1 + b2
basis risk
Shareholders can do far more easily than Short Hedge :
3 You hedge the future sold of an asset by entering into a short
a corporation to diversify risk. t1 t2 futures contract
These problem gives rise to what is termed basic risk. Figure 3.1 Variation of basis over time The effective price that is obtained for the asset with hedge
is S2 + F1 – F2 = F1 + b2

3.2 Arguments For and Against Hedging 3.3 Basis Risk 3.3 Basis Risk

Choice of Contract
• Hedging and Competitors The basis in a hedging situation is as follows:
One key factor affecting basis risk is the choice of the futures contract
Basis = Spot price of asset to be hedged – Futures price of contract used to be used for hedging. This choice has two components:
=S–F 1. The choice of the assets underlying the futures contracts

If hedging is not the norm in a certain industry, it 2. The choice of the delivery month
may not make sense for one particular company to
choose to be different from all other. An increase in the basis is referred to a strengthening of the basis
. A contract with a later delivery month is
usually chosen in these circumstances.

A decrease in the basis is referred to as a weakening of the basis

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3.4 Cross Hedging 3.5 Stock Index Future 3.5 Stock Index Future

Value of index in
Calculating the Minimum Variance Hedge Ratio Hedging Using Stock Index Futures 900 950 1 ,000 1,050 1,100
three months：
Time to maturity
Futures price of
1,010 1,010 1,010 1,010 1,010

index today：
1
( 0 . 04  0 .01 ) 
h*   S P
Futures price of index
in three months：
902  900952 e 1,003
12
1,053 1,103

F N*  
A Gain on futures 810,000
The gain from the short futures position
= 435,000
30* ( 1,010 – 902 –
) *250 = $ 810,000
52,500 – 697,500
position： 322,500
h* : Hedge ratio that minimizes the variance of the hedger’s position. N*: Optimal number of futures contracts for hedging •The loss on the index = 10 %
Return on market： – 4.750% 0.250% 5.250% 10.250%
 : Coefficient of correlation between ΔS and ΔF P : Current value of the portfolio – 9.750% ••The
The risk-free interest rate =of10.25%per
% per 3 months
index pays a dividend 3 months
ΔS : Change in spot price, S, during a period of time equal to the life of the hedge. A : Current value of one futures contract Expected return – ••An
Expected return
investor in onindex
the portfolio
would earn = –14.875%
9.75 %
– 7.625% – 0.125% 7.375%
on portfolio： 15.125% ==$15,000,000*(1
+ 1.5*( – 9.75– –0.15125)
1 ) = – 15.125 %
ΔF : Change in future price, F, during a period of time equal to the life of the hedge. β : From the capital asset pricing model to determined = $4,243,750
Expected portfolio
σS : Standard deviation of ΔS the appropriate hedge ratio 5,368,75
value in three months 4,618,750 4,993,750 5,743,750
4,243,750 =$ 4,243,750 + $810,000 0
σF : Standard deviation of ΔF (including dividends)：
Total expected value
5,046,25
of position in three 5,053,750 5,053,750 5,046,250 5,046,250
0
months：

3.4 Cross Hedging 3.5 Stock Index Future 3.5 Stock Index Future

Optimal Number of Contracts Example

Reasons for Hedging an Equity Portfolio
Value of S&P 500 index =1000
S&P 500 futures price =1010
h*NA Value of portfolio = $5,000,000 A hedge using index futures removes the risk arising from market
N*  The futures contracts used should Risk-free interest rate = 4% per annum
and leaves the hedger exposed only to the performance of the
QF have a face value of h* NA Dividend yield on index = 1% per annum
portfolio relative to the market.
One future contract is for
Beta of portfolio = 1.5 delivery of $250 times the index
NA : Size of position being hedged (unit) The hedger is planning to hold a portfolio for a long period of time
Current value of one futures contract = 250*1000 = 250,000 and requires short-term protection.
Q F : Size of one futures contract (unit)
N* : Optimal number of futures contracts for hedging
Optimal number of futures contracts for hedging
P  5,000 ,000 
N*    1 .5     30
A  250 ,000 

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3.5 Stock Index Future 3.6 Rolling The Hedge Forward

Changing the Beta of a Portfolio

 This involves entering into a sequence of futures

 To reduce the beta of the portfolio to 0.75 contracts to increase the life of a hedge

P 5,000,000
(    *)  (1.5  0.75)  15(short)
A 250,000
 To increase the beta of the portfolio to 2.0  Rollover basis risk

P 5,000,000
(  *  )  (2  1.5)  10(long)
A 250,000

3.5 Stock Index Future

Exposure to the Price of an Individual Stock

 Similar to hedging a well-diversified stock portfolio

 The performance of the hedge is considerably worse,

only against the risk arising from market movements