Hedging Using Futures

Hedging Using Futures

1. Why hedge?

   • For
     • Perfect hedge?
     • Eliminate/offset price risk!
       • Permits companies to focus on their main activities
       • Avoid unpleasant surprises
   • Against (in practice, many risks are left unhedged!)
     • Are shareholder hedges meaningful or cheap?
     • Makes little sense if hedging isn't the industry norm
       • Here, hedging might actually increase profit volatility
     • Eliminates potential gains!!

2. Any prior assumptions to analysis?

3. Long and short hedges

   • Self-explanatory - involve taking out a long/short position in futures contracts
   • When is a long hedge appropriate?
     • Expecting to buy an asset in the future
     • Example = food manufacturer using wheat as an input
       • Wheat price and profits - correlated (short position in wheat)
   • When is a short hedge appropriate?
     • Expecting to sell an asset in the future
     • Example = oil producer
       • Oil price and profits + correlated (long position in oil)
   • Spot prices and futures prices tend to be + correlated
     • Creates chances to profit from buying/selling (depending on position) futures

4. Choosing a futures contract

   • One of key factors affecting basis risk
   • Two components...
     • Asset underlying the contract?
       • Cross hedging?
     • Delivery month?

5. Basis risk

   • Basis = spot price - price of futures contract
     • Basis can be + or - prior to maturity
       • Should move to 0 at maturity
         • But what if asset underlying contract isn't the same as the one being hedged?
     • Basis changes over time
       • Basis up = "strengthening"
       • Basis down = "weakening"
   • Well illustrated via an example! (Basis trading)
     • Relationship between basis risk and an investor's position?
       • Don't confuse this with the effect of offsetting price risk

6. Optimal hedge ratio

   • Optimal no. of contracts

7. Hedging an equity portfolio

   • Why?
   • How?
   • Optimal no. of contracts to short?
     • Changing the beta
     • Example

8. Rolling the hedge forward