Hedging Strategies Using Futures

Chapter 3 Hedging Strategies Using Futures Options, Futures, and Other Derivatives, 8th Edition Copyright O John C Hull 2012

Chapter 3 Hedging Strategies Using Futures Options, Futures, and Other Derivatives, 8th Edition, Copyright © John C. Hull 2012 1

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 o a short futures hedge is appropriate when you know you will sell an asset in the future and want to lock in the price Options, Futures, and Other Derivatives, 8th Edition Copyright@ John C Hull 2012

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 Options, Futures, and Other Derivatives, 8th Edition, Copyright © John C. Hull 2012 2

Arguments in Favor ofhedging e 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 Options, Futures, and Other Derivatives, 8th Edition Copyright@ John C Hull 2012 3

Arguments in Favor of Hedging Options, Futures, and Other Derivatives, 8th Edition, Copyright © John C. Hull 2012 3 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 o Shareholders are usually well diversified and can make their own hedging decisions e It may increase risk to hedge when competitors do not e Explaining a situation where there is a loss on the hedge and a gain on the underlying can be difficult Options Futures, and other Derivatives, 8th edition Copyright o John C Hull 2012

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 Options, Futures, and Other Derivatives, 8th Edition, Copyright © John C. Hull 2012 4

Basis risk o Basis is usually defined as the spot price minus the futures price e Basis risk arises because of the uncertainty about the basis when the hedge is closed out Options, Futures, and Other Derivatives, 8th Edition Copyright@ John C Hull 2012 5

Basis Risk Basis is usually defined as the spot price minus the futures price Basis risk arises because of the uncertainty about the basis when the hedge is closed out Options, Futures, and Other Derivatives, 8th Edition, Copyright © John C. Hull 2012 5

Long Hedge for Purchase of an Asset e Define F1: Futures price at time hedge is set up F2: Futures price at time asset is purchased S2: Asset price at time of purchase b2: Basis at time of purchase Cost of asset Gain on Futures F2-F1 Net amount paid S2-(F2-F1)=F1+b2 Options Futures, and other Derivatives, 8th edition Copyright@ John C Hull 2012

Long Hedge for Purchase of an Asset Define F1 : Futures price at time hedge is set up F2 : Futures price at time asset is purchased S2 : Asset price at time of purchase b2 : Basis at time of purchase Options, Futures, and Other Derivatives, 8th Edition, Copyright © John C. Hull 2012 6 Cost of asset S2 Gain on Futures F2 −F1 Net amount paid S2 − (F2 −F1 ) =F1 + b2

Short Hedge for sale of an asset e Define F1: Futures price at time hedge is set up 2: Futures price at time asset is sold S2: Asset price at time of sale b,. Basis at time of sale Price of asset Gain on futures F1-F2 Net amount received S2+(F1-F2)=F1+b2 Options, Futures, and Other Derivatives, 8th Edition Copyright C John C Hull 2012 7

Short Hedge for Sale of an Asset Options, Futures, and Other Derivatives, 8th Edition, Copyright © John C. Hull 2012 7 Define F1 : Futures price at time hedge is set up F2 : Futures price at time asset is sold S2 : Asset price at time of sale b2 : Basis at time of sale Price of asset S2 Gain on Futures F1 −F2 Net amount received S2 + (F1 −F2 ) =F1 + b2

Choice of contract Choose a delivery month that is as close as possible to, but later than, the end of the life of the hedge e When there is no futures contract on the asset being hedged, choose the contract whose futures price is most highly correlated with the asset price. This is known as cross hedging Options Futures, and other Derivatives, 8th edition Copyright@ John C Hull 2012

Choice of Contract Choose a delivery month that is as close as possible to, but later than, the end of the life of the hedge When there is no futures contract on the asset being hedged, choose the contract whose futures price is most highly correlated with the asset price. This is known as cross hedging. Options, Futures, and Other Derivatives, 8th Edition, Copyright © John C. Hull 2012 8

Optimal Hedge ratio (page 57) Proportion of the exposure that should optimally be hedged is S Where s is the standard deviation of as, the change in the spot price during the hedging period or is the standard deviation of af, the change in the futures price during the hedging period p is the coefficient of correlation between AS and AF Options, Futures, and Other Derivatives, 8th Edition Copyright@ John C Hull 2012 9

Optimal Hedge Ratio (page 57) Proportion of the exposure that should optimally be hedged is where sS is the standard deviation of DS, the change in the spot price during the hedging period, sF is the standard deviation of DF, the change in the futures price during the hedging period r is the coefficient of correlation between DS and DF. Options, Futures, and Other Derivatives, 8th Edition, Copyright © John C. Hull 2012 9 F S h s s = r *

Optimal Number of contracts Size of position being hedged(units Q Size of one futures contract(units) Value of position being hedged (spot price time ON) Value of one futures contract futures price times O) Optimal number of contracts Optimal number of contracts if after tailing adjustment to allow no tailing adjustment or daily settlement of futures h o h v Q F Options, Futures, and Other Derivatives, 8th Edition Copyright@ John C Hull 2012 10

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 ) Options, Futures, and Other Derivatives, 8th Edition, Copyright © John C. Hull 2012 10 Optimal number of contracts if no tailing adjustment F A Q h Q * = Optimal number of contracts after tailing adjustment to allow or daily settlement of futures F A V h V * =