Lecture-Ch.3 - Hedging Strategies Using Futures Chapter 3 1...

Hedging Strategies Using
Futures
Chapter 3
1

Long 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
•
Example : It is May 15. A copper
fabricator will need 100,000 pounds of
copper on July 15. The spot price of
copper is 340 cents per pound and the
July futures price is 320 cents per pound.
Copper fabricator can hedge by:
May 15: Long 4 July futures (each
2

Short Hedges
•
A short futures hedge is appropriate
when you know you will sell an asset
in the future & want to lock in the price
•
Example : It is May 15. An oil producer
has negotiated a contract to sell 1 million
barrels of crude oil. The price in the sales
contract is the spot price on August 15.
Oil producer can hedge by:
•
May 15: Short 1,000 August futures
(each contract is for 1000 barrels)
3

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
4

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
–
Example: jewelery producer’s hedging of gold
prices will make profits volatile
•
Explaining a situation where there is a loss
on the hedge and a gain on the underlying
can be difficult
–
Hedging may reduce potential profits
5

Convergence of Futures to Spot
(Hedge initiated at time t 1 and closed out at time t 2)
6
Time
Spot
Price
Futures
Price
t 1 t 2

Short Hedge
•
Suppose that
F 1 : Initial Futures Price
F 2 : Final Futures Price
S 2 : Final Asset Price
•
You hedge the future sale of an asset by
entering into a short futures contract
•
Price Realized= S 2+ ( F 1 – F 2) = F 1+ ( S 2 –
F 2) = F 1 + b 2
7

Long Hedge
•
Suppose that
F 1 : Initial Futures Price
F 2 : Final Futures Price
S 2 : Final Asset Price
•
You hedge the future purchase of an
asset by entering into a long futures
contract
•
Cost of Asset= S 2 – ( F 2 – F 1) = F 1 + ( S 2
– F 2) F 1+ b 1
8