Chapter 3

Hedging Strategies Using

Futures

Long & Short Hedges

A long futures hedge is appropriate when
you know you will purchase an asset in
the future and want to lock in the price
A short futures hedge is appropriate
when you know you will sell an asset in
the future and want to lock in the price

Arguments in Favor of Hedging

Companies should focus on the main
business they are in and take steps to
minimize risks arising from interest rates,
exchange rates, and other market variables

Arguments against Hedging

Shareholders are usually well diversified and
can make their own hedging decisions
It may increase risk to hedge when
competitors do not
Explaining a situation where there is a loss on
the hedge and a gain on the underlying can
be difficult

Short Hedge for Sale of an Asset

A short hedge is appropriate when the hedger
already owns an asset an expects to sell it at
some time in the future.
Eg: It is May 15. An oil producer has negotiated
a contract to sell 1 million barrels of crude oil in
August 15. Quotes:
Spot price : $60 per barrel
August oil futures price:$59 per barrel

1contract = 1000 barrels

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Illustration
The oil producer can hedge with the following
transactions:
May 15: Short 1000 August futures contracts
on crude oil
August 15: Close out futures position
Suppose spot price on August 15 proves to be $55.
- Gain in futures: $59-55 = $4 per barrel or $4million.
- Sales in spot market = $ 55m
- Net = $55+ $4 = $59million
-Effective price = $ 59 million/1 million barrels = $59/b
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What if price of oil on August 15 proves

to be $65 per barrel?
Calculate gain/loss in futures position;
What is the net outcomes?
What is the effective price?

Long Hedge for Purchase of an Asset

A long hedge is appropriate when a company
knows it will have to purchase a certain asset
in the future and wants to lock in a price now.
Eg: A copper fabricator knows it will need
100,000 pounds of copper on May 15. The
spot price of copper is 340 cents/pound and
the May futures price is 320 cents/pound.
Each contract is for the delivery of 25,000
pound of copper.
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Illustration
The copper fabricator can hedge with the following
transactions:
now: Take a long position in 4 May futures
contracts on copper
May 15: Close out the position.
Suppose that the price of copper on May 15 is 325
cents.
-Gain in futures: (3.25-3.20)*100,000= $5000
- Buying cost in spot: $ 325,000
- Net outcomes: ($325,000) + 5000= (320,000)
- Effective price: 320 cents per pound
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What if price of copper on May 15

proves to be 305 cents per pound?
Calculate gain/loss in futures position;
What is the net outcomes?
What is the effective price?

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Cross hedging
Occurs when 2 assets are different.
Hedge ratio is the ratio of the size of the
position taken in futures contracts to the size
of the exposure.
Hedge ratio=1 if underlying asset in futures
contract is the same as the asset being hedge
When cross hedging is used, setting the
hedge ratio equal to 1 is not always optimal.
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Optimal Hedge Ratio (page 57)

Proportion of the exposure that should optimally be
hedged is

h* S
where
F
S is the standard deviation of S, the change in the spot
price during the hedging period,
F is the standard deviation of F, the change in the
futures price during the hedging period
is the coefficient of correlation between S and F.

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Optimal Number of Contracts

QA

Size of position being hedged (units)

QF

Size of one futures contract (units)

VA

Value of position being hedged (=spot price time QA)

VF

Value of one futures contract (=futures price times QF)

Optimal number of contracts if

no tailing adjustment

h *Q A

QF

Optimal number of contracts

after tailing adjustment to allow
or daily settlement of futures

h *V A

VF
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Example (Pages 59-60)

Airline will purchase 2 million gallons of jet
fuel in one month and hedges using heating
oil futures
From historical data F =0.0313, S =0.0263,
and = 0.928
0.0263
h 0.928
0.7777
0.0313
*

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Example continued
The size of one heating oil contract is 42,000 gallons
The spot price is 1.94 and the futures price is 1.99
(both dollars per gallon) so that
V A 1.94 2,000,000 3,880,000
V F 1.99 42,000 83,580
Optimal number of contracts assuming no daily
settlement 0.7777 2,000,000 42,000 37.03
Optimal number of contracts after tailing
0.7777 3,880,000 83,580 36.10
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Hedging Using Index Futures

(Page 61)

To hedge the risk in a portfolio the

number of contracts that should be
shorted is V A

VF

where VA is the value of the portfolio, is

its beta, and VF is the value of one
futures contract
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Example
S&P 500 futures price 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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Why Hedge Equity Returns

May want to be out of the market for a while.
Hedging avoids the costs of selling and
repurchasing the portfolio
Suppose stocks in your portfolio have an
average beta of 1.0, but you feel they have
been chosen well and will outperform the
market in both good and bad times. Hedging
ensures that the return you earn is the riskfree return plus the excess return of your
portfolio over the market.
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