{[ promptMessage ]}

Bookmark it

{[ promptMessage ]}

FINS3635 Week 3-4 - Hedging with futures

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

Info icon This preview shows pages 1–3. Sign up to view the full content.

View Full Document Right Arrow Icon
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 basis risk 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)? t t ll h d d (h d ti 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 Risk: spot price fluctuation on Dec 15 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 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 + Basis 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 + Basis 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 and current spot price is $5.75. What should the farmer do today? Each futures contract is for delivery of 5,000 bu soybean.
Image of page 1

Info icon This preview has intentionally blurred sections. Sign up to view the full version.

View Full Document Right Arrow Icon