L4 Hedging Strategies Using Futures

# L4 Hedging Strategies Using Futures - Hedging Strategies...

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Unformatted text preview: Hedging Strategies Using Futures Chapter 3 AGENDA : Hedging Strategies Using Futures Long and Short Hedge; Basis risk; Cross Hedging and Hedge ratio; Hedging using index futures; Rolling The Hedge Forward. 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 & want to lock in the price; Example: short hedge In May 15, an oil producer has negotiated a contract to sell 1 mill barrels of crude oil . Spot price = \$19 per barrel; August oil future price = \$18.75 per barrel; Case 1: the price of oil in August is \$17.5 • Gain on futures: 18.75 – 17.5 = 1.25 \$ per barrel; • Sell at spot for \$17.5 mill. • The total amount realized is \$18.75 mill Case 2: the price of oil in August is \$19.5 • Loss on futures: 19.5 – 18.75 = 0.75\$ per barrel • Sell at spot for \$19.5 mill. • The total amount realized is \$18.75 mill. In both cases the end-up cash flow is \$18.75 mill Arguments in Favor of Hedging Most of companies do not have skills in predicting variables such as interest rates, exchange rates, commodity prices and other market variables. So, it makes sense for them to hedge the risk. In practice, many risks are left unhedged. Arguments against Hedging Shareholders are usually well diversified and can make their own hedging decisions; If hedging is not a norm in the certain industry, the company may choose not to hedge; Hedging can reduces risk as well as return of the company - explaining a situation where there is a loss on the hedge and a gain on the underlying can be difficult. Basis Risk It is not possible to achieve the perfect hedge because of the basis risk. Some reasons of basis risk: • The asset whose price is to be hedged may not be the same as the asset underlying the future contract; • The hedger may not be certain of the exact date the asset will be bought or sold; • The hedge may require the futures contract to be closed out before the expiration date. Convergence of Futures to Spot (Hedge initiated at time t 1 and closed out at time t 2 ) Time Spot Price Futures Price t 1 t 2 Basis = S – F Basis = 0 if the asset to be hedged and the asset underlying the future contract are the same; When the spot price increases by more than the future price, the basis increases or we say it is a strengthening of the basis ; When the future price increases by more than the spot price, the basis decreases or we say it is a weakening of the basis ; If the asset to be hedged and the asset underlying the future contract are different The basis on investments assets is usually less than on consumptions assets; The basis is greater when assets being hedged and assets used for hedging are different and their prices are not highly correlated. Choice of contract to reduce the basis...
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## This note was uploaded on 02/18/2012 for the course FIN 101 taught by Professor Write during the Spring '12 term at PWSZ w Gorzowie Wielkopolskim.

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L4 Hedging Strategies Using Futures - Hedging Strategies...

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