FINS3635 Week 3-4 - Hedging with futures

FINS3635 Week 3-4 - Hedging with futures - Hedging with...

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1 Hedging with futures – Ch.3 Lecture outline • Introduction to hedging strategies using futures • Long/short hedging • Hedging outcomes Week 3 - Hedging with futures FINS 3635 Options, Futures, and Risk Management Techniques 1 •ba s i s r i sk • hedge ratios Hedging with Futures • Use a futures position to reduce or eliminate the risk of the underlying asset price fluctuations. • What position (Long or Short)? • How many contracts (hedge ratio)? ttl l hd d(hd t i 1 ) Week 3 - Hedging with futures FINS 3635 Options, Futures, and Risk Management Techniques 2 • totally hedged (hedge ratio =1); • partially hedged (hedge ratio<1); • overly hedged (hedge ratio >1) • The size of a futures contract and the relationship between spot and futures prices during the hedging period have impact on the hedge ratio. Example of Long Hedge • A long hedge is a hedge involves a long position in futures contract to offset the short position in underlying asset. • Assume that it is now Mar 15. An investor needs to buy 100 shares of IBM stock on Dec 15. • Risk: spot price fluctuation on Dec 15 Week 3 - Hedging with futures FINS 3635 Options, Futures, and Risk Management Techniques 3 • Strategy to reduce risk: buy IBM stock futures with Dec. delivery (note that size of the futures contract is 100 and suppose that futures price is $98 per share now) Hedging in practice • Examples assume that futures position is closed out in the delivery month. If the hedging position has to be closed out before maturity due to hedging requirement, what would happen? • Most likely, futures price is not the same as spot price when the futures Week 3 - Hedging with futures FINS 3635 Options, Futures, and Risk Management Techniques 4 position is closed out before maturity. • Basis = Spot price – futures price • Basis would change over time which has impact on hedging outcomes • Daily settlement has impact on hedging performance. Consequences of Long & Short Hedge Suppose that F 1 : Initial Futures Price 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= 2 (F 2 1 )= 1 + Basis You hedge the future sale of an asset by entering into a short futures contract Price Realized= 2 +( 1 2 1 +Bas is Week 3 - Hedging with futures FINS 3635 Options, Futures, and Risk Management Techniques 5 Hedging Illustrations – Basis and Basis Risk ¾ Assume that a soybean farmer expects to sell 30,000 bushels of soybean three months from now. The current futures price which matures in four months is $6.20/bu and current spot price is $5.75. What should the farmer Week 3 - Hedging with futures FINS 3635 Options, Futures, and Risk Management Techniques 6 do today? Each futures contract is for delivery of 5,000 bu soybean.
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2 Hedging Strategies Farmer: • position: selling (short) • number of contracts: six soybean futures contracts • delivery time: in four months Week 3 - Hedging with futures FINS 3635 Options, Futures, and Risk Management Techniques 7
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FINS3635 Week 3-4 - Hedging with futures - Hedging with...

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