Derivatives Hedging with Futures

Identifying the exposure

Exposure: position to be hedged Cash flow(s) Future income Ex: oil/gold producer Future expense Ex: user of commodity Value Asset Ex: asset manager Liability Ex: financial intermediary General formulation: Exposure = M S with: M = quantity, size (M > 0 asset, income M < 0 liability, expense) S = market price

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Setting up the hedge

Futures position: Number of contracts n (n>0 long hedge n<0 short hedge) Size of one contract N Futures price F Hedge = n N F Perfect hedge: choose n so that value of hedged position does not change if S changes

V M S n N F 0

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Hedge ratio

V M S n N F 0
To achieve V = 0

M S N F

If M >0 : n <0 short hedge If M<0 : n>0 long hedge

n N # contracts size of one futures contract Hedge ratio: n M Size of position being hedged (units)
To achieve V = 0

S F

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Perfect hedge
Assume F and S are perfectly correlated:

S F
then: h = - and

M N

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Basis risk
Basis = Spot price of asset Futures prices
t1

(S-F)
t2

Spot price Futures price Basis Cash flow at time t2: Long hedge: Short hedge:

S1 F1 b1= S1 F1

S2 F2 b2 = S2 F2

-S2 + (F2 F1) = F1 b2 +S2 + (F1 F2) = + F1 + b2

known at time t1
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Minimum variance hedge

Real life more complex: 1. asset to be hedged might differ from underlying the futures contract 2. basis (S F) might vary randomly More general specification:

S F
Choose n to minimize the variance of V

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Some math

Var (V ) M 2Var (S ) n N Var (F ) 2MnN cov(S , F )

Take derivative and set it equal to 0:

2nN Var (F ) 2MN cov(S , F ) 0

Solve for n:

M cov(S , F ) n N Var (F )

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Hedging Using Index Futures

Stock index futures: futures on hypothetical portfolio tracked by index. Size = Index Value of 1 index point Example: S&P 500 (CME) - $250 index To hedge the risk in a portfolio the number of contracts that should be shorted is

P A
where P is the value of the portfolio, is its beta, and A is the value of the assets underlying one futures contract

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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.)

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Example
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?

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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?

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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

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