Hedging with futures contract

Basis risk, optimal hedge ratio and hedging

multi-period purchases

COVERAGE
Many

of the participants use futures markets to

reduce a particular risk that they face (hedgers).
We discuss general issues associated with the way
hedges are set up using futures contracts

Which position in futures is appropriate to set the hedge

Which tenure to be used ? (basis risk)
What is the optimal size for reducing risk (Hedge ratio)
Tailing the hedge
How to roll a hedge forward
Use of stock index futures

Arguments

for and against hedging

Basis risk, liquidity risk and tailing the hedge are the major factors
2

Futures contracts
Agreement between 2 parties to buy or sell an asset at a
certain time in the future for a certain price(similar to forward)

Nature
Contract
terms
Any credit
risks

Forward contract
OTC (contract b/w 2
private parties)

Futures contract
Traded on an exchange

Tailor-made

Highly standardized

Some at the time of

settlement

Virtually none as
contracts are settled daily

Delivery dates Usually one specific

delivery date

Range of delivery dates

Delivery
Delivery or final cash
arrangements settlement usually
happens

Contract is usually closed

out prior to maturity

Examples of Futures Contracts

On 25-Jun-15, Agreement to:
Buy 100 shares of Infosys Limited at Rs.1,006.70 in 27-Aug-15
(NSE)
Buy 10 grams of Gold at Rs.26,533 in 05-Aug-2015 (MCX)
Buy 1 barrel of Crude oil at Rs.3,830 in 20-Jul-2015 (MCX)
Buy 1,000 @ Rs. 100.9125 in 27-Aug-2015 (MCX-SX)

Buy 100 oz. of gold @ US$1,280/oz. in Oct (NYMEX)

Sell 62,500 @ 1.6500 US$/ in June (CME)
Sell 1,000 bbl. of oil @ US$114/bbl. in April (NYMEX)

Futures Contracts
Futures

price are determined in the same way as

other prices (i.e., by the laws of supply and demand).
If more traders want to go long than short, the price goes up;
If the reverse is true, then the price goes down.

To make

trading possible, the exchange specifies

certain standardized features and Futures prices are
regularly reported live and in the financial press.
Tick size
Delivery date
Contract size

Specific issues in Futures

The

two parties do not necessarily know each other

Margining mechanism (daily settlement
procedures) is devised to assure both parties a
guarantee that the contract will be honoured.

Other

specific issues with futures are

delivery procedures,
bid-offer spreads, and the
role of the exchange clearing house

Why we cant lock into Spot price?

A perfect

hedge is one that eliminates hedger's risk.

It can just lead to a more certain outcome.

Does not always lead to better outcome than imperfect
hedge

NO,

we can not lock into Spot price as

forward prices, in general, are different from
the spot prices.

Perfect hedge may not lead to better

outcome!
Suppose

the asset's price movements prove to be

favourable to a hedger.
A perfect hedge totally neutralizes the company's gain from
these favourable price movements.
An imperfect hedge, which only partially neutralizes the gains,
might well give a better outcome.

3 reasons for not hedging

If

the competitors are not hedging, the treasurer

might feel that the company will experience less risk
if it does not hedge

The

treasurer might feel that the company's

shareholders have diversified their risk away.

If

there is a loss on hedge and gain from company's

exposure to the UA, the treasurer might find it
difficult in justifying the hedging to other executives
within the organization.

Hedging is too demanding!

The

hedger shall be able to identify the precise date

in future when an asset would be bought / sold.
Then he/she shall decide b/w Futures and option to
remove almost all the risk arising from the price of
the asset on that date.
In practice, hedging is often not straightforward.
The asset whose price is to be hedged (ATH) may not be
exactly the same as the asset underlying (UA) the futures.
Hedger may be uncertain as to the exact date when the
asset will be bought or sold.
Hedge termination date is not the same as the contract
maturity in such cases (closing out the futures).

Convergence of Futures to Spot

(Hedge initiated at time t1 and closed out at time t2)
Basis = Spot price of asset to be hedged
Futures price of contract used
Basis is negative

Basis is positive

Spot
Price

Futures
Price

Spot
Price

Futures
Price

Time
t1

t2

t1

t2

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Basis Risk
Basis

= 0 when both ATH and UA are same and the hedge

is lifted on contract expiration day.
Prior to expiration, the basis may be +ve or -ve.
As time passes, spot prices and futures price does not
change by same amount!
Basis risk arises from hedgers uncertainty as to the basis
at the hedge termination date (closed out)
The hedge termination date is not the same as the contract maturity in
such cases.
Basis

risk can lead to an improvement or a worsening of a

hedger's position.
Basis strengthening increase in basis
Basis weakening decrease in basis

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Long Hedge and Short hedge

We

define

S1 : Initial Asset Price

F1 : Initial Futures Price

S2 : Final Asset Price

F2 : Final Futures Price

If

you hedge the future purchase by entering into

a long futures contract then
Cost of Asset = S2 (F2 F1) = F1 + Basis2

If

you hedge the future sale of an asset by

entering into a short futures contract then
Price Realized = S2+ (F1 F2) = F1 + Basis2

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Short Hedge
Basis strengthens
Basis weakens
(increases)
(decreases) unexpectedly
unexpectedly / suddenly
/ Suddenly
Long
hedge

hedger's position worsens

hedger's position improves

Short
hedge

Hedgers position improves hedgers position worsens

Basis is the amount by which the spot price exceeds the forward price.
A short hedger is long the asset and short futures contracts.
The value of his position hence improves as the basis increases.
Similarly it worsens as the basis decreases.
To minimize basis risk, S and F must be highly correlated

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2 issues in choosing a contract

One

key factor affecting basis risk is the

choice of the futures contract to be used.
This contract choice has two components:
The choice of the asset underlying the contract
The choice of the delivery month
1.

If ATH UA, carry out a careful analysis to

determine which of the available futures contracts

has futures prices that are most closely correlated
with the price of ATH

2 issues in choosing a contract

2.

A contract with a later delivery month is usually

chosen for asset to be purchased in this month

The futures prices are in some instances quite erratic

during the delivery month.
Moreover, a long hedger runs the risk of having to
take delivery of the physical asset if the contract is
held during the delivery month.
Taking delivery can be expensive &inconvenient.

Determining the no. of contracts

Hedge ratio = size of the position in futures / size of

ATH.
If UA = ATH, it is natural to use a hedge ratio of 1.0.
If UA = ATH, the hedger should choose a value for the
hedge ratio that minimizes the variance of the value of the
hedged position.

Approaches to estimate the risk-minimizing hedge ratio

Portfolio approach to a risk-minimizing hedge (MVHR)
Dollar equivalency approach

MVHR - Portfolio approach

Assume that hedger is long one unit of cash asset and is interested in
risk minimization.
Gain/loss on 1 unit is 1(S1 S0) = 1S
Risk of unhedged position = Var(1S) = 12 Var(S)

Suppose hedger sells h futures contracts

Gain/loss on portfolio = 1(S1 S0) h (F1 F0)
Portfolio risk = Var [1(S1 S0) h (F1 F0)
= 12 Var(S)+ h2 Var(F) 2(1)(h)Cov(S, F)
= Var(S)+ h2 Var(F) 2h (S)(F) Corr(S, F)
To minimize risk, take first derivative d/dx [risk(h)] = 0
2h F2 2h S F FS = 0
h* = corr(S, F) (S) / (F)

If you ran the regression model S = a + b F using historical

price data, then b = h*

If you believe that past is not accurate portrayal of future, dont use
regression approach; use dollar equivalency approach.

Tailing the Hedge

A futures

contract, when used for hedging, can

give rise to cash flow problems due to M2M.
Two way of determining the number of contracts
to use for hedging are
Compare the exposure to be hedged with the value of
the assets underlying one futures contract
Compare the exposure to be hedged with the value of
one futures contract (=futures price time size of futures
contract
The

second approach incorporates an adjustment

for the daily settlement of futures

Choosing the delivery month

(A strip hedge vs. a stacked hedge)

Selecting the delivery month requires proper analysis. You are

expecting CF on 20-ug-15. June and Sep Contracts are
traded in market.
Use June futures alone, ________ risk is left during __________.
Use June futures today, offset it just before the delivery date, and
then (in June) use Sep futures to hedge. (Stacking hedge)
Use Sep futures today and bear the ________ risk that exist when
you offset the Sep futures on June 20. (Strip hedge)

A firm faces series of dates (or periods) on which it faces price

risk.
Use a strip of futures contracts, each with a different delivery date.
Use a stack hedge, in which the most nearby and liquid contract is
used, and it is rolled over to the next-to-nearest contract as time
passes viz. Rolling the hedge forward using a series of futures
contracts to increase the life of a hedge

Factors to be considered
The

liquidity of nearby contracts relative to the

liquidity of contracts with distant delivery dates
Near-by contracts has far more liquidity and have a narrower
bid-ask spreads
When liquidity is a factor, rolling hedge is good

Transaction

costs will usually be lower when one is

employing a strip hedge
Rolling hedge may require double the contracts

Is

the contract with distant delivery more or less

overpriced than nearby contract? Relative mispricing
Basis risk for a rolling hedge is usually greater than
that the basis risk existing in a strip hedge.

Summary

Most concepts about using forwards will apply when

hedging with futures
Transaction costs, liquidity, accounting rules and basis risk
will determine which contact is preferred
Liquidity risk and basis risk are important considerations
when one is comparing forwards with futures for RM

Using futures to manage price risk introduces

Basis risk futures are standardized. The UA, delivery
location, quantity and delivery date may differ from ATH
If the UA is sufficiently different from the asset being hedged,
it is important to determine the degree to which price
changes of the two assets are correlated.
If date of the hedging horizon lies beyond the date of most
nearby futures contract, the hedge must be rolled forward
Because futures are M2M daily, futures hedges must be
tailed.

Summary
Hedging

is a way of reducing risk. As such, it

should be welcomed by most executives.
On a theoretical level, we can argue that
shareholders, by holding well-diversified portfolios,
can eliminate many of the risks faced by a
company.
In reality, there are a number of theoretical and
practical reasons why companies do not hedge.
They do not require the company to hedge these risks.
On a practical level, a company may find that it is
increasing rather than decreasing risk by hedging if
none of its competitors does so.
Also, a treasurer may fear criticism from other
executives if the company makes a gain from
movements in the price of the underlying asset and a
loss on the hedge.

Summary
The

hedger should first identify the net

exposure to risk this determines whether
futures should be bought or sold
Futures price changes should be highly
correlated with price changes of the asset
being hedged, and the futures contract should
be as liquid as possible
An important concept in hedging is basis risk.
The basis is the difference between the spot
price of an asset and its futures price.
Basis risk arises from uncertainty as to what the
basis will be at maturity of the hedge.

Summary

The hedge ratio is the ratio of the size of the position

taken in futures contracts to the size of the exposure.
Hedge ratio determines the number of futures contracts
that will lead to a risk-minimizing hedge, and some
hedgers may not wish to have such a position.
It is not always optimal to use a hedge ratio of 1.0. If the
hedger wishes to minimize the variance of a position, a
hedge ratio different from 1.0 may be appropriate.
The hedge ratio can be estimated using either the
regression (portfolio) approach or the dollar equivalency
approach
The optimal hedge ratio is the slope of the best-fit line
obtained when changes in the spot price are regressed
against changes in futures price.
Hedges should be tailed when interest rates are high
and/or hedging horizons are long.

Summary
Stack

and roll is appropriate When there is no

liquid futures contract that matures later than
the expiration of the hedge.
This involves entering into a sequence of futures
contracts. When the first futures contract is near
expiration, it is closed out and the hedger enters
into a second contract with a later delivery month.
When the second contract is close to expiration, it
is closed out and the hedger enters into a third
contract with a later delivery month; and so on.
The result of all this is the creation of a long-dated
futures contract by trading a series of short-dated
contracts.

Finally,

hedges should be actively monitored

and evaluated.