04. Hedging Strategies Using Futures

8/16/2019 04. Hedging Strategies Using Futures

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Hedging Strategies

Using Futures


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Introduction – Hedging using

Futures

• Many of the participants in futuresmarkets are hedgers.

• Their aim is to use futures markets toreduce a particular risk that theyface. This risk might relate touctuations in the price of oil, a

foreign echange rate, the le!el ofthe stock market, or some other!aria"le.


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• # perfect hedge is one thatcompletely eliminates the risk.$erfect hedges are rare. For the most

part, therefore, a study of hedgingusing futures contracts is a study ofthe %ays in %hich hedges can "e

constructed so that they perform asclose to perfect as possi"le.


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SI' $(I)'I$*+S

• hen an indi!idual or company choosesto use futures markets to hedge a risk, theo"-ecti!e is usually to take a position that

neutralies the risk as far as possi"le.• 'onsider a company that kno%s it %ill

gain /01,111 for each 0 cent increase inthe price of a commodity o!er the net 2months and lose /01,111 for each 0 centdecrease in the price during the sameperiod.


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Hedging Strategy

• To hedge, the company3s treasurer should take a shortfutures position that is designed to o4set this risk.

• The futures position should lead to a loss of $10,000for each 1 cent increase in the price of the commodity

over the 3 months and a gain of $10,000 for each 1cent decrease in the price during this period.

• If the price of the commodity goes do%n, the gain onthe futures position o4sets the loss on the rest of thecompany3s "usiness.

• If the price of the commodity goes up, the loss on thefutures position is oset by the gain on the rest of thecompany’s business.


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Short Hedges

• # short hedge is a hedge, that in!ol!es a shortposition in futures contracts.

• # short hedge is appropriate %hen the hedgeralready o%ns an asset and epects to sell it at some

time in the future.

• For eample, a short hedge could "e used "y afarmer %ho o%ns some hogs and kno%s that they%ill "e ready for sale at the local market in t%o

months.• # short hedge can also "e used %hen an asset is not

o%ned right no% "ut %ill "e o%ned at some time inthe future.


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Illustration eample – Futures

$osition

• 'onsider, for eample, a US eporter %hokno%s that he or she %ill recei!e euros in 2months. The eporter %ill realie a gain if

the euro increases in !alue relati!e to theUS dollar and %ill sustain a loss if the eurodecreases in !alue relati!e to the US dollar.

• # short futures position leads to a loss if

the euro increases in !alue and a gain if itdecreases in !alue. It has the e4ect ofo4setting the eporter3s risk.


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Short Hedge eample

To pro!ide a more detailed illustration of the operationof a short hedge in a speci5c situation,

%e assume that it is May 06 today and that an oilproducer has -ust negotiated a contract to sell 0

million "arrels of crude oil.

It has "een agreed that the price that %ill apply in thecontract is the market price on #ugust 06.

The oil producer is therefore in the position %here it

%ill gain /01,111 for each 0 cent increase in the priceof oil o!er the net 2 months and lose /01,111 foreach 0 cent decrease in the price during this period.


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Short Hedge eample

Suppose that on May 06 the spot price is /71per "arrel and the crude oil futures price for#ugust deli!ery is /89 per "arrel.

&ecause each futures contract is for thedeli!ery of 0,111 "arrels, the company canhedge its eposure "y shorting :i.e., selling;0,111 futures contracts.

If the oil producer closes out its position on#ugust 06, the e4ect of the strategy should"e to lock in a price close to /89 per "arrel.


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To illustrate %hat might happen, suppose that the spotprice on #ugust 06 pro!es to "e /86 per "arrel. Thecompany realies /86 million for the oil under its salescontract.

&ecause #ugust is the deli!ery month for the futurescontract, the futures price on #ugust 06 should "e !eryclose to the spot price of /86 on that date.

The company therefore gains approimately $!" # $! %$& per barrel, or $& million in total from the short futures

position. The total amount realied from "oth the futures positionand the sales contract is therefore approimately /89 per"arrel, or /89 million in total. :/86mn < /=mn;


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For an alternati!e outcome, suppose that theprice of oil on #ugust 06 pro!es to "e /76 per"arrel.

The company realies /76 per "arrel for theoil and loses approimately /76 > /89 ? /@per "arrel on the short futures position.

#gain, the total amount realied is

approimately /89 million.

It is easy to see that in all cases the companyends up %ith approimately /89 million.


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*ong Hedges

• Hedges that in!ol!e taking a longposition in a futures contract arekno%n as long hedges.

• # long hedge is appropriate 'hen acompany (no's it 'ill have to

purchase a certain asset in the future

and 'ants to loc( in a price no'.


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• Suppose that it is no% Aanuary 06. # copper fa"ricatorkno%s it %ill reBuire 011,111 pounds of copper on May06 to meet a certain contract.

• The spot price of copper is 2=1 cents per pound, and the

futures price for May deli!ery is 2C1 cents per pound. The fa"ricator can hedge its position "y taking a longposition in four futures contracts o4ered "y the 'DM+Edi!ision of the 'M+ roup and closing its position onMay 06.

• +ach contract is for the deli!ery of C6,111 pounds ofcopper. The strategy has the e4ect of locking in theprice of the reBuired copper at close to 2C1 cents perpound.


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• Suppose that the spot price of copper on May06 pro!es to "e 2C6 cents per pound.

• &ecause May is the deli!ery month for the

futures contract, this should "e !ery close to• the futures price. The fa"ricator therefore gains

approimately /6111 on the futures contracts.

• 011,111 G :/2C6 > /2C1; ? /6,111

• It pays 011,111 G /2C6 ? /2C6,111 for thecopper, making the net cost approimately/2C6,111 > /6,111 ? /2C1,111.


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• For an alternati!e outcome, suppose thatthe spot price is 216 cents per pound onMay 06. The fa"ricator then loses

approimately 011,111 G:/2C1> /216;? /06,111

• Dn the futures contract and pays 011,111/216 ? /216,111 for the copper.

• #gain, the net cost is approimately/2C1,111, or 2C1 cents per pound.


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• )ote that, in this case, it is clearly "etter for the company to usefutures contracts than to "uy the copper on Aanuary 06 in the spotmarket.

• If it does the latter, it %ill pay 2=1 cents per pound instead of 2C1cents per pound and %ill incur "oth interest costs and storage costs.

• For a company using copper on a regular "asis, this disad!antage%ould "e o4set "y the con!enience of ha!ing the copper on hand.Ho%e!er, for a company that kno%s it %ill not reBuire the copperuntil May 06, the futures contract alternati!e is likely to "e preferred.

• )ote hedgers %ith long positions usually a!oid any possi"ility ofha!ing to take deli!ery "y closing out their positions "efore the

• deli!ery period.

• e ha!e also assumed in the t%o eamples that there is no dailysettlement


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SIS (IS

• The hedges in the eamples considered so farha!e "een almost too good to "e true.

• The hedger %as a"le to identify the precise

date in the future %hen an asset %ould "e"ought or sold.

• The hedger %as then a"le to use futurescontracts to remo!e almost all the risk arising

from the price of the asset on that date.• In practice, hedging is often not Buite as

straightfor%ard as this.


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• Some of the reasons are as follo%s

0. The asset %hose price is to "e hedged may

not "e eactly the same as the asset

underlying the futures contract.C. The hedger may "e uncertain as to the eact

date %hen the asset %ill "e "ought or sold.

2. The hedge may reBuire the futures contract

to "e closed out "efore its deli!ery month. These pro"lems gi!e rise to %hat is termed

"asis risk.


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The &asis

• The "asis in a hedging situation is asfollo%s

• &asis ?

• :Spot price of asset to "e hedged > Futures priceof contract used;

• If the asset to "e hedged and the assetunderlying the futures contract are the same, the

"asis should "e ero at the epiration of thefutures contract.

• $rior to epiration, the "asis may "e positi!e ornegati!e.


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• #s time passes, the spot price andthe futures price for a particularmonth do not necessarily change "y

the same amount.

• #s a result, the "asis changes. #nincrease in the "asis is referred to as

a strengthening of the "asisJ adecrease in the "asis is referred to asa %eakening of the "asis.


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Spot !s Futures > &asis

•

The a"o!e illustrates ho% a "asis mightchange o!er time in a situation %here the"asis is positi!e prior to epiration of thefutures contract.


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To eamine the nature of "asis risk, %e%ill use the follo%ing notation

• S0 Spot price at time t0

• SC Spot price at time tC

• F0 Futures price at time t0

•

FC Futures price at time tC• "0 &asis at time t0

• "C &asis at time tC.


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• e %ill assume that a hedge is put in place at time t0and closed out at time tC.

• #s an eample, %e %ill consider the case %here thespot and futures prices at the time the hedge is

initiated are /C.61 and /C.C1, respecti!ely, and that atthe time the hedge is closed out they are /C.11 and/0.91, respecti!ely.

• This means that

• S0 ? C61, F0 ? CC1, SC ? C11, and FC ? 091.

• From the de5nition of the "asis,

• %e ha!e "0 ? S0 > F0 and "C ? SC > FC

• so that, in our eample, "0 ? 121 and "C ? 101.


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'hoice of 'ontract

• Dne key factor a4ecting "asis risk isthe choice of the futures contract to"e used for

• hedging.

This choice has t%o components

• 0. The choice of the asset underlyingthe futures contract

• C. The choice of the deli!ery month.

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04. Hedging Strategies Using Futures

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