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.

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