Topic 3 Hedging Strategies using Futures

Topic 3 Hedging Strategies using Futures

1. Margin Deposits

   • Initial margin: a specified amount of cash and/or marketable securities which must be DEPOSITED deposited with the futures broker for each traded contract
   • Margin requirement helps to ensure that traders don’t default on their obligation.
   • Margin requirements are set by the futures exchange (approx 5 - 7% of underlying contract value
   • That is, futures trading is highly leveraged!!!
   • The balance in a trader’s margin account is adjusted to reflect daily settlement prices. That is, accounts are “MARKET-to- MARKET” on a DAILY basis.

2. Maintenance Margin

   • If a trader's cumulative losses on a futures contract cause the “INITIAL MARGIN ” to fall below the predetermined “MAINTENANCE MARGIN ” then additional margin will have to be deposited in order to restore the account to the “INITIAL MARGIN” level.

3. Hedging Concepts: The Basis

   • In practice, hedging is not as straight forward as it may appear. Reasons include;
     • 1. The asset to be hedged may not be exactly the same as that underlying the futures contract (e.g an airline company might use the crude oil futures contract to hedge its jet fuel exposures)
     • 2. The hedger may not be sure of the exact date the asset will be bought or sold
     • 3. The hedger usually buys (or sells) the underlying asset and closes out its futures contracts before the contract expiry date.
   • These problems give rise to “BASIC RISK"
     • BASIS = Spot price - Futures price.
     • The basis should be zero at the expiration of a futures contract (due to “convergence” - next 2 slides) if the asset to be hedged and the underlying asset of the futures contract are identical
     • However, prior to the expiration date the basis may be either POSITIVE or NEGATIVE
     • When spot price increases by more than the futures price (strengthening basis) the basis increases;
     • When futures price increases by more than spot price (weakening basis) the basis declines.

4. Convergence of Futures to Spot

   • As the delivery month of a futures contract approaches, the futures price converges to the spot price of the underlying asset.
   • If convergence did not happen then ARBITRAGE activities would eventually give rise to convergence
   • For example, if the futures price is above the spot price during delivery period then arbitrageurs could:
     • short the futures contract (i.e. sell high), and
     • buy the asset at spot price, (i.e. buy low), and
     • make delivery against the futures contract!!,
     • This would give rise to a risk free profit – the possibility of this drives the market to equilibrium

5. Hedging and the Basis

6. Valuing Forward Contracts

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