Topic 4: Futures Mechanics and Hedging

Strategies

Willem J. van Vliet

FINA4110 Options and Futures

Chinese University of Hong Kong

2024 Term 1

1
Futures

Today is all about understanding how futures work.

As a reminder, a forward contract is a contract to buy an underlying

asset at a specied time (delivery date) at a specied price (forward
price).

Futures are meant to be standardized forwards that sell on an

exchange, but this is not how they actually work.

2
Futures Contract

A typical contract species:

1 The asset
2 The contract size
3 The delivery date
4 Delivery arrangements
5 How prices are quoted
6 Termination of trading
7 Price and position limits

3
1. The Asset

Futures can be written on many assets

Commodities: goods that are fungible, meaning individual units are

completely interchangeable
▶ Agricultural products: corn, soybeans, cattle, hogs, cocoa, sugar, etc.
▶ Raw materials: oil, iron ore, gold, etc.

Financial instruments
▶ Stock indices, exchange rates, Treasurys, gold, real estate, etc.

A futures contract species exactly which asset it is on

4
Asset Grades

For many assets, there are dierent qualities/types/grades available.

For some futures, the contract species exactly which grade the
contract is on:
▶ Example: CL (NYMEX WTI Crude Oil) species the exact chemical

properties of the crude oil that can be delivered

For other futures, the contract species a range of dierent grades

that are accepted:
▶ Example: ZC (Corn) species the #2 grade Yellow corn, with #1

Yellow and #3 Yellow also accepted

▶ Example: ZN (10-year Treasury Note) species any US Treasury note

with a remaining time to maturity of 6.5 to 10 years

5
2. Contract Size

Futures contracts specify the size: the amount of the asset that has
to be delivered per contract

The size is set by the exchange in order to balance:

▶ being small enough so that investors can aord to enter contracts, and
▶ being large enough to keep trading costs low

For some futures, exchanges oer an additional mini version that has
a substantially smaller size. That is a separate contract.

6
3. Delivery Date

The delivery date is when the asset has to be delivered. Usually

specied to be within a particular month, called the delivery month.

Often, for physically delivered goods (like commodities) the delivery

date is a whole month

For some contracts featuring only nancial settlement, the delivery

date can be a much smaller window

A contract is typically referred to by its month of delivery

▶ Example: March corn future means the corn futures contract with a

March delivery date

7
4. Delivery Arrangements

In addition to when (the delivery date), contracts specify how and

where delivery should be made

For commodities, this usually species physically where the asset has
to be delivered (usually something like a warehouse receipt at a
particular location)
▶ For some assets, there may be a range of acceptable delivery locations

For nancial assets, usually species how asset needs to be transferred

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5. Price Quotes

The contract species how prices are quoted

▶ Example: ZC (Corn) futures are quoted in US cents per bushel, with

1/4 cent price increments

▶ Example: ZN (10-year Treasury Note) future are quoted in 1/64

increments of a basis point per $100 of face value

For futures that allow for multiple grades or allow for multiple delivery
methods, the contract also species how the quoted price gets
adjusted based on the grade/delivery location
▶ Example: ZC (Corn) futures price is for #2 Yellow corn. #1 Yellow

receives a 1.5 cent per bushel premium, while #3 receives a 24 cent
per bushel discount.
▶ Example: ZC (Corn) futures price is for delivery at the Chicago and

Burns Harbor. Five other locations are accepted, with price

adjustments of an additional 4.75 to 16.25 cents per bushel.

9
6. Trading Times and Termination

The contracts specify when they start and stop trading

For physically delivered goods, this is typically some time before the
delivery month
▶ Example: ZC (Corn) futures stop trading on the business day prior to

the 15th day of the contract month

Contracts also typically specify when the contracts start trading on the
exchange

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7. Price Limits, Circuit Breakers, Position Limits

Many contracts contain features to combat excessive eects from

speculators

Price limits: maximum amount a price can move up or down during a

trading session

Circuit breakers: trading temporarily stops if a price limit is reached

Position limits: maximum number of contracts a speculator may hold

11
Example: CL Futures
NYMEX WTI (West Texas Intermediate) Crude Oil future

Asset: West Texas Intermediate, a light sweet crude oil blend

Contract size: 1000 barrels

Delivery date: during the contract month

Delivery arrangements: at any pipeline or storage facility in Cushing,

Oklahoma, USA

Price quotes: US dollars and cents per barrel

Trading termination: 3 business days prior to the 25th calendar day of

the month prior to the contract month

Price and position limits: look them up if you really want to know!

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Example: CL Futures

Source: CME group

13
Futures Mechanics

For now, completely forget about the underlying asset, delivery, and
any parallels to forward contracts.

Treat a futures contract as just a piece of paper that has some quoted
forward price.

Each trade has two sides, a buyer and a seller. Neither party actually
pays anything when entering into the contract. They have just agreed
to enter into the contract a the forward price.

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Positions

For each investor, we only keep track of how many contracts that
investor has bought minus how many contracts that investor has sold
▶ An investor has a long position if they have bought more than they
have sold
▶ An investor has a short position if they have sold more than they have
bought

An investor is said to be opening a position if they increase their net

position
▶ From net zero, this means either buying (to open a long position) or
selling (to open a short position)
▶ For an investor with an existing long position, they open a position by

buying more contracts

▶ For an investor with an existing short position, they open a position by

selling more contracts

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Closing Positions

An investor is said to be closing a position if they decrease their net

position
▶ For an investor with an existing long position, they close by selling

contracts
▶ For an investor with an existing short position, they close by buying

contracts

We'll typically say an investor closes out if they close their entire
position

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Margin

Investors are required to hold margin accounts with their brokers

▶ This is just a cash or cash-like account

Upon opening a position, investors are required to post initial margin

to their margin account
▶ A minimum amount is set by the exchange/clearinghouse, but brokers

are free to increase that minimum

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Settlement Price

Every day, the exchange announces a settlement price, as specied

by the contract

Usually it is based on trading data within a particular time window,

with a fallback in case there are no trades
▶ Example: ZC (Corn) futures use the volume-weighted average price of

all trades between [Link] and [Link] central time, with other rules
if there are no trades or if the contracts are far from their delivery date

The settlement price is used daily to adjust the balance in the margin
account through a process known as marking to market

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Marking to Market: First Day

On the rst day, we look at the dierence between the trade price and
the settlement price

If the trader opened a long position, for each contract we add

(settlement price − trade price) × contract size

to the trader's margin account. (If this value is negative, that means
money is taken out of the account.)

If the trader opened a short position, the amount is instead subtracted

from their margin account

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Marking to Market: Subsequent Days

After the rst day, we look at the dierence between today's

settlement price and the previous day's settlement price

If the trader has a long position, for each contract we add

(today's settlement price − previous settlement price) × contract size

to the trader's margin account. (If this value is negative, that means
money is taken out of the account.)

If the trader has a short position, the amount is instead subtracted

from their margin account

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Maintenance Margin

Investors need to main a maintenance margin in their account

▶ Like the initial margin, it is determined by the exchange/clearinghouse

and possibly increased by the broker

▶ The value is usually lower than initial margin

If the value of the margin account falls below the maintenance margin,
the broker issues a margin call to the investor. The investor must
deposit funds to raise the margin account back to initial margin. The
funds deposited are called the variation margin.

If the investor fails to provide the variation margin, the broker closes
out the position

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Closing a Position

If an investor closes their position (either by trading in the opposite

direction or because their broker forces them to close out after failing
to post margin), we do a nal adjustment to the margin account

If the investor closes a long position, then for each contract closed we
add

(trade price − previous settlement price) × contract size

to their margin account. (If this value is negative, that means money
is taken out of the account.)

If the trader closes a short position, the amount is instead subtracted

from their margin account

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Day Trading

If the position was opened after the last settlement time, then the
price dierence is calculated from the price the investor opened at, not
the previous settlement price.

Example: an investor who opens and closes a long position before any
settlement would earn

(sell price − purchase price) × contract size

in their margin account

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Example
CL futures: prices in $/bbl, contract size is 1,000bbl, initial margin
$10,000, maintenance margin $8,000

Day Price Gain Margin Margin Call Margin After Call

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Example
CL futures: prices in $/bbl, contract size is 1,000bbl, initial margin
$10,000, maintenance margin $8,000

Buy 3 contracts at $80.

Day Price Gain Margin Margin Call Margin After Call

Open 80.00 30,000

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Example
CL futures: prices in $/bbl, contract size is 1,000bbl, initial margin
$10,000, maintenance margin $8,000

First day's settlement price: $85.

Day Price Gain Margin Margin Call Margin After Call

Open 80.00 30,000

1 85.00 15,000 45,000 - 45,000

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Example
CL futures: prices in $/bbl, contract size is 1,000bbl, initial margin
$10,000, maintenance margin $8,000

Second day's settlement price: $75.

Day Price Gain Margin Margin Call Margin After Call

Open 80.00 30,000

1 85.00 15,000 45,000 - 45,000
2 75.00 −30,000 15,000

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Example
CL futures: prices in $/bbl, contract size is 1,000bbl, initial margin
$10,000, maintenance margin $8,000

Second day's settlement price: $75. Margin call.

Day Price Gain Margin Margin Call Margin After Call

Open 80.00 30,000

1 85.00 15,000 45,000 - 45,000
2 75.00 −30,000 15,000 15,000 30,000

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Example
CL futures: prices in $/bbl, contract size is 1,000bbl, initial margin
$10,000, maintenance margin $8,000

Third day's settlement price: $73.

Day Price Gain Margin Margin Call Margin After Call

Open 80.00 30,000

1 85.00 15,000 45,000 - 45,000
2 75.00 −30,000 15,000 15,000 30,000
3 73.00 −6,000 24,000

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Example
CL futures: prices in $/bbl, contract size is 1,000bbl, initial margin
$10,000, maintenance margin $8,000

Third day's settlement price: $73. No margin call.

Day Price Gain Margin Margin Call Margin After Call

Open 80.00 30,000

1 85.00 15,000 45,000 - 45,000
2 75.00 −30,000 15,000 15,000 30,000
3 73.00 −6,000 24,000 - 24,000

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Example
CL futures: prices in $/bbl, contract size is 1,000bbl, initial margin
$10,000, maintenance margin $8,000

Close position at $74. Take the $27,000.

Day Price Gain Margin Margin Call Margin After Call

Open 80.00 30,000

1 85.00 15,000 45,000 - 45,000
2 75.00 −30,000 15,000 15,000 30,000
3 73.00 −6,000 24,000 - 24,000
Close 74.00 3,000 27,000 - 27,000

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Total Cash Earned/Lost
In the example above: put in $30,000 in initial margin, $15,000 in
variation, and took out $27,000. In total, earned

$27, 000 − ($30, 000 + $15, 000) = −$18, 000

(i.e., lost $18,000)

Now look at the trades: opened 3 contracts at $80, and closed at $74.
If we do:

($74 − $80) × 1000

|{z} × 3
|{z} = −$18, 000
| {z }
price increase size of contract number of contracts

we get the same number

That is not a coincidence! This is exactly how it is designed.

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Total Cash Earned/Lost

This works because of a telescoping sum

For example, for being long a contract:

total earned

= (settlement day 1 − open price)×contract size

+ (settlement day 2 − settlement day 1)×contract size

+ ···
+ ((settlement day n − 1) − (settlement day n − 2)) × contract size

+ (close price − (settlement day n − 1)) × contract size

= (close price − open price) × contract size

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Total Cash Earned/Lost

If we open a long position at price Fo and close it at price Fc , we gain

(Fc − Fo ) × contract size × number of contracts

If we open a short position at price Fo and close it at price Fc , we lose

(Fc − Fo ) × contract size × number of contracts

So even though we never actually pay the forward price, we do get any
price increase (if we are long) or any price decreases (if we are short)

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Where Does All This Cash Go?

We analyzed it from the perspective of one investor. Cash magically

appeared in the margin account, and cash was taken out.

In the background, the brokers and the exchange's clearinghouse are

passing around these payments

Futures are in net zero supply: for every long position, there is a short
position

Money is moved (through the clearinghouse) from investors who lose

money to investors who gain money
▶ This is not quite accurate: brokers will typically net among their own

clients, and then the rest is moved through the clearinghouse

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Delivery

So far, we analyzed what happened if we open and subsequently close

a position.

We could also continue to hold on to the position to the last trading

date. What happens then?

That depends on the futures contract. They come in two forms:

▶ Contracts with delivery (ones where the underlying asset is actually

delivered)
▶ Financially settled contracts (ones where a cash payment is made

instead)

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Delivery Mechanics

If a seller does not close out their position, they have to deliver the
asset at the delivery date.

The short seller, through their broker, issues a notice of intention to

deliver when they are ready to do so.

The clearinghouse matches the seller to someone who is still long and
issues then the notice.
▶ Usually the oldest long position still outstanding is given the notice,

but sometimes it is random.

▶ Sometimes, notices can be transferable, in which case the long
position holder may have a short time window to nd another long
position holder who is willing to take the notice.

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Delivery Mechanics

Once a short party is matched to a long party, the following exchange

is made:
▶ The buyer/long party pays the last settlement price (the settlement

right before trading halted) and takes possession of the asset

▶ The seller/short party receives the last settlement price and delivers the

asset

In case of a physical asset/commodity, transfer of the asset is usually

done by signing over a warehouse receipt

In case of a nancial asset, transfer of the asset is usually done

electronically (wire)

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Financial Settlement

Some futures (such as interest rate and index futures) are nancially
settled.

For these, the exchange sets the last settlement price to be equal to
the market price, and then closes out all positions at this price.
Investors take whatever is in their margin account.

Example: stock index futures, which are quoted in terms of the level
of the stock. The nal settlement price of the futures is simply the
index at that time.

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Futures Like Forwards?

Now that you know the mechanics of a futures contract, let's think
about how this possibly resembles a forward contract.

Remember that a forward contract is a contract to exchange an asset

at the delivery date for the forward price. No cash exchanges hands
when the contract is signed, and nothing is done to the delivery date.

Futures: we gain and lose daily in our margin account based on how
the forward price rises and falls. If we hold past the last trading date,
we exchange the asset for the last settlement price of the futures
contract.

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Long Position Eective Payment
Suppose you take a long position in the futures contract at price F0
and hold on to the contract to the last trading date, when the nal
settlement price is FT . In your margin account, you will have gained

(FT − F0 ) × size of contract

in cash.

You take delivery of the asset, for which you pay FT × size of contract.

Combined, you have:

▶ Lost in cash

FT ×size of contract−(FT −F0 )×size of contract = F0 ×size of contract

▶ Gained the asset

Eectively, you have paid F0 per unit of asset! Remember F0 is the

price you initially opened the futures position at. So, eectively you
have locked in the futures price for the asset.
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Short Position Eective Payment

For somebody opening a short position, everything is reversed. They

will gain
(F0 − FT ) × size of contract

in cash, and deliver the asset for FT × size of contract payment,

resulting in:
▶ Gain in cash:

FT ×size of contract+(F0 −FT )×size of contract = F0 ×size of contract

▶ Loss of the asset

Eectively, like receive F0 per unit of asset. Again, eectively locked

in the futures price for the sale of the asset.

35
Futures Recap

The mechanics behind futures is totally dierent from forwards. Daily

gains/losses through marking to market vs. one single payment at the
end.

This enables the exchange-traded nature of futures. You don't need to

know who you traded with: marking to market nets everything out,
and only if anybody is left long/short at the last trading date do we
start matching investors for delivery.

Also mimics the total payo of a forward contract.

▶ Buying a futures contract and holding to delivery eectively means you

pay the initial futures price for the asset.

▶ Selling a futures contract and choosing to delivery eectively means

you receive the initial futures price for the asset.

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Margin: Details

As an investor, you are allowed to take any money out of your margin
account that is in excess of initial margin

Brokers typically oer interest on margin, and may also mark to

market at a higher frequency than daily

Margin requirements typically vary with the purpose of the trade

▶ Hedgers typically have lower requirements than speculators
▶ Day traders typically have lower requirements
▶ Spread traders (long one delivery date, short a dierent one) typically

have lower requirements

37
Mechanics: Details

In the background, we have a clearinghouse. It's a corporation of a

futures exchanged that acts as the intermediary for all trades

Eectively, when you go long and someone else goes short, this is two
trades: you go long with the clearinghouse, and the other party goes
short with the clearinghouse.

Brokers come in two types:

▶ Brokers that are members of the clearinghouse. These post their own

kind of margin with the clearinghouse, called a clearing margin,

typically based on the net contracts outstanding from the broker's
clients
▶ Brokers that are not members. They cannot trade with the

clearinghouse, so they need to be clients of a member broker, and need

to post margin with that member broker.

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Default Risk
Margin acts as collateral for any payments that will be owed. Margin
requirements are set to cover almost all daily losses.

Of course, if there is an extreme price movement, the losses may

exceed the amount in the margin account. If the investor/broker is
unable to make up this shortfall, they default.
▶ Remember: the investor has a relationship with the clearinghouse, not

another investor. They default on their payment to the clearinghouse,

but the clearinghouse still has to make payments to those with
opposite positions.

To deal with these, the clearinghouse has a default fund, consisting

of contributions from the clearinghouse itself and all the member
brokers. Defaults are covered by this fund.

In the extremely unlikely event of mass defaults, the clearinghouse has

procedures in place. Usually, this is in the form of:
▶ Extra contributions to default fund by members
▶ Forced closing of positions, and distributing losses across all investors
39
Futures and Delivery

In practice, delivery (for non-nancially settled futures) is quite rare.

For speculators, this is obvious. Why deal with physical possession of

the asset if all you want is a nancial exposure? (Think about a retail
investor taking delivery of 1000 barrels of oil!)

Even true for hedgers. Why? The futures contract has very specic
delivery arrangements. It is unlikely that those are convenient.
▶ Think about the CL (WTI Crude Oil) contract. It species that

delivery takes place at any storage facility or pipeline in Cushing,

Oklahoma, USA. Even if you are producing/consuming oil, it is unlikely
you will want to do it there.

Also, typically want to us your own clients/suppliers, not some random

counterparty from the futures contract.

40
Futures Price Near Delivery

The futures price close to the delivery date should be close to the
spot price of the underlying asset (the market price for simply buying

or selling the asset directly)

Why? Near the delivery date there is not much dierence between
simply buying the asset or buying a futures contract.
▶ If you buy the asset, you pay the spot price now and get the asset now
▶ If you buy the futures contract, you pay the futures price soon and get

the asset soon

41
Futures and Delivery

As a result, even if you want to buy or sell the underlying asset, often
this is done by closing out the position some time before trading stops.

The futures price and spot prices near the delivery date are very close

So, whether you go through with delivery at the last settlement price
or close out and trade in the spot market, those prices are very close

You might as well have the convenience of buying/selling the asset in

your preferred market

42
Using Futures

Now that we know how futures work, let's turn to using futures

Futures can be used to speculate. That is up to the individual investor.

Futures can also be used to hedge. That is what we will look at now.

43
Hedging

Recall that hedging means to reduce one's (nancial) exposure,

usually to another investment

A perfect hedge means a hedge where the exposure is fully eliminated

A long hedge is a hedge involving a long position in a futures contract

A short hedge is a hedge involving a short position in a futures

contract

44
Long Hedge

Recall that if you are long, you are eectively locking in a buying price

A long hedge is appropriate if you have to buy the underlying asset in

the future (or somehow you have an exposure where you will need
more money when prices are high)

Example: you are an iron ore renery, and you know you need to buy
20,000 tons of iron ore in 3 months. You can hedge the uncertainty
from price movements by buying 40 contracts of iron ore futures.

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Short Hedge

Recall that if you are short, you are eectively locking in a selling price

A short hedge is appropriate if you have to sell the underlying asset in

the future (or somehow you have an exposure where you will need
more money when prices are low)

Example: you are an iron mine, and you know you will produce 20,000
tons of iron ore in 3 months. You can hedge the uncertainty from
price movements by selling 40 contracts of iron ore futures.

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Imperfect Hedging

The two examples above were perfect hedges: there was a contract
with the same underlying asset and the same delivery date as the
exposure.

In practice, you can rarely perfectly hedge

▶ You may not know the exact quantity of the asset you will have
▶ You may not know the exact timing of the risk

▶ There may not be a futures contract on the correct asset

▶ It may not be feasible or practical to use a futures contract that has

the delivery date at the same time as your source of your risk

In these cases, you can still do an imperfect hedge that reduces, but
does not eliminate, the risk

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Basis

To analyze imperfect hedging, we introduce the concept of a basis.

This is quite confusing!

The basis is dened to be

basis = spot price of asset(s) that needs to be hedged

− futures price of the contract(s) used

Why do we care? It turns out the basis at the delivery date is the
relevant quantity.

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Notation
Symbol Meaning

0 Now
T Time of the payout of the asset we want to hedge
S0 , ST Spot prices of the asset we want to hedge (now and at T)
F 0 , FT Futures prices of the contract used (now and at T)
ST∗ Spot price of the asset underlying the futures contract (at T)
bT Basis at T (bT = ST − FT )
Note: S0 and F0 are known today. ST , FT , ST∗ , and bT are all
unknown today.

Suppose you need to sell the asset, and so you use a short hedge:
▶ Earn F 0 − FT from your short hedge
▶ Earn ST from selling the asset

Total payout is

ST + (F0 − FT ) = F0 + (ST − FT ) = F0 + bT
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Basis Risk

If you need to sell the asset (and are using a short hedge), your payo
is
F 0 + bT

If you need to buy the asset (and are using a long hedge), your payo
is the opposite
−(F0 + bT )

Either way, your payo is proportional to F0 + bT

▶ F0 is known today
▶ bT is unknown, only revealed at date T

All the risk in this hedging strategy comes from bT . This is known as
the basis risk, which is the risk in the basis at T.

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Decomposing Basis Risk

Recall: ST is the spot price of the asset we are trying to hedge, ST∗ is
the spot price of the underlying asset of the futures contract

We can write the basis as

bT = ST − FT
= ST − FT + (ST∗ − ST∗ )
= (ST − ST∗ ) + (ST∗ − FT )

51
Decomposing Basis Risk

Recall: ST is the spot price of the asset we are trying to hedge, ST∗ is
the spot price of the underlying asset of the futures contract

We can write the basis as

bT = ST − FT
= ST − FT + (ST∗ − ST∗ )
= (ST − ST∗ ) + (ST∗ − FT )

▶ ST − ST∗ : part of the basis coming from any asset mismatch

▶ ST∗ − FT : a timing mismatch (I'll explain this shortly!)

51
Asset Mismatch

This portion is easiest to understand: if we are hedging using futures

written on a dierent asset, the futures are designed to hedge that
other asset.

The use of a futures contract written on a dierent asset is known as

cross hedging

We'll analyze cross hedging soon

52
Timing Mismatch
I called ST∗ − FT a timing mismatch

Why? Remember that close to the delivery date of the futures

contract, the spot price of its underlying asset and the futures price
are very close

If your futures position has delivery date close to T (which, remember,

is the timing of the payo you are trying to hedge, not necessarily the
delivery date of the futures!), ST∗ ≈ FT and therefore ST∗ − FT is close
to zero.

The only way to get ST∗ signicantly dierent from FT is if T is before

the delivery date of the futures contract.

This term ST∗ − FT therefore captures the part of the basis risk that
comes from using a futures contract with delivery date dierent from
T, which we call a timing mismatch

53
Timing Mismatch

Why would there ever be a timing mismatch? After all, you are in
control.

Three reasons:
1 The timing of the risk T is not known. Maybe you know that at some
point in the future you need to buy the asset, but you do not know
exactly when.
2 A futures contract with a long enough time to delivery may not be
available, or may not be liquid.
3 You may deliberately want to take a contract that has a delivery date
slightly longer than T.

54
Why a Longer Delivery Date?

Remember that delivery is often inconvenient. It's usually better to

close out before the nal trading date. This requires taking a futures
contract with a delivery date beyond the timing of the exposure you
want to hedge (T ).

Furthermore, futures prices can behave erratically in the period before

trading halts. If you want to avoid this, you need to close out even
earlier, which means taking an even longer contract.

55
Erratic Futures Pricing
An amazing/extreme example: on April 20, 2020 the WTI Crude Oil
May contract had a settlement price of negative $37.63
April 21 was the last trading day of the May contract

Perfect storm of factors:

▶ Reduced demand for oil due to the Covid-19 pandemic

▶ Supply had not yet been cut as much as demand (OPEC was struggling

to agree)
▶ Cushing, Oklahoma, USA storage facilities (where delivery takes place)

were at 75% capacity and expected to be full by mid-May

Long investors realized they would not be able to take delivery as

there would be no storage space. They panicked, and tried to close
out all long positions to make sure they would not risk taking delivery.
This pushed prices negative.

In this case, prices bounced back to normal the next day

56
Example of Timing Mismatch

You are an oil company, and you will extract 10,000 barrels of light
sweet crude oil next March

You want to use CL (WTI Light Sweet Crude Oil) futures to hedge
your price risk, but it is inconvenient to have to deliver oil in Cushing,
Oklahoma

Instead of shorting 10 contracts of March CL futures with the

intention to deliver, you short 10 contracts of April CL futures with
the intention to close out in March

57
Example of Timing Mismatch
Let's illustrate the risk with some numbers. Suppose you shorted the
April CL futures at $80.00/bbl.

In March, suppose the spot price is $75.00/bbl, and the April futures
price is $76.00/bbl.
▶ You earn $75 × 10, 000 = $750, 000 from the sale of your oil
▶ You earn ($80 − $76) × 1000 × 10 = $40, 000 from shorting 10
contracts
▶ In total, you earn $790,000

Suppose instead in March the spot price was $75.00/bbl and the April
futures price is $74.00/bbl
▶ You earn $75 × 10, 000 = $750, 000 from the sale of your oil
▶ You earn ($80 − $74) × 1000 × 10 = $60, 000 from shorting 10
contracts
▶ In total you earn $810,000

You are exposed to the mismatch between the March spot price and
the price in March for the April futures contract
58
Cross Hedging: How Much?

When you are not cross hedging, it is typically obvious how many units
worth of futures contracts to buy/sell

For example: if you have to buy 10,000 barrels of oil, then you would
probably buy 10,000 barrels of oil worth (usually 10 contracts of 1000
barrels each) of contracts

But, when you are cross hedging, how much do you use?

59
Hedge Ratios
The hedge ratio is the size of the futures position taken divided by
the size of the exposure you are hedging

It is measured in the actual units of the underlying assets used, not

contracts

For example: if you use 10,000 barrels of oil worth of futures contracts
(10 contracts of 1,000 barrels) to hedge against 13,000 tons of coal,
your hedge ratio is

10, 000 bbls oil bbls oil

h= = 0.769
13, 000 tons coal tons coal

Again, when not cross hedging, the obvious hedge ratio is 1 (example:
1 barrel of oil for 1 barrel of oil)

When cross hedging, how do we pick?

60
Picking a Hedge Ratio

Let's work from the perspective of someone who has to buy an asset
(or, more generally, has a long exposure and is concerned about price
increases of the asset)

Unhedged, they are facing the risk in the spot price of the asset
changing:
ST − S0

A long position in the futures contract over the same time period
generates
FT − F0
in cash

61
Picking a Hedge Ratio

If an investor uses a hedge ratio of h, that means that for every 1 unit
of exposure to the spot price change ST − S0 they have h units of
exposure to the futures price change FT − F0 .

That means that they are covering the risk in ST − S0 with

h(FT − F0 ) from their futures position.

The optimal hedge ratio h∗ is the hedge ratio h such that

h(FT − F0 ) tracks ST − S0 as closely as possible.

62
Using Data

One way of doing this is to assume that the future closely resembles
the past

We start by collecting historical data of:

▶ Changes in the forward price of the futures contract that is going to be

used (historical FT − F 0 )
▶ Changes in the spot price of the asset that needs to be hedged

(historical ST − S0 )

Both changes are measured at the same time horizon T as the hedge
we are trying to do

We plot the data and it looks something like...

63
Using Data
6 ●

4 ●●
●

●● ●
● ● ● ●
2 ● ●
Delta S

●
● ● ●
● ●
●
● ●
●
0
● ●
● ●●
●
● ●
●
● ●
−2
●
● ●
●
●
−4 ●

−5 0 5 10
Delta F

64
Using Data

Remember, we are trying to nd the value h such that h(FT − F0 )

best matches ST − S0 , at least historically

What is that? That's the slope of the line of best t (linear regression)

65
Using Data
6 ●

4 ●●
●

●● ●
● ● ● ●
2 ● ●
Delta S

●
● ● ●
● ●
●
● ●
●
0
● ●
●●
● ●
● ● Slope: 0.357
●
● ●
−2
●
● ●
●
●
−4 ●

−5 0 5 10
Delta F

66
Using Data

The slope of this line is known as the minimum variance hedge ratio

Mathematically, you can calculate it from historical data as

σ∆S
h∗ = ρ
σ∆F
where
▶ σ∆S is the standard deviation of ∆S = ST − S0
▶ σ∆F is the standard deviation of ∆F = Ft − F0
▶ ρ is the correlation between ∆S and ∆F

In case you are unfamiliar, check the note on Blackboard

67
Number of Contracts

The hedge ratio h is measured as the number of units of exposure to

FT − F0 we want per unit of exposure to ST − S0 . This is not what
the contracts are measured in as well.
▶ Example: you are trying to cross-hedge hay prices using corn futures.

Maybe you measured ST − S0 in cents per bale of hay, and F T − F0 is

given in cents per bushel. That then means that h is measured in
bushels of corn per bale of hay.

To get the number of contracts, we have to scale by the appropriate

quantities:
QA
N ∗ = h∗
QF
where QA is the quantity of the asset being hedged, and QF is the
quantity of of the underlying asset in a single forward contract.

68
Example

Continue with the hay/corn example. Suppose you nd h∗ to be 0.85.

A ZC corn contract is on 5,000 bushels of corn, and suppose you will
need to buy 25,000 bales of hay in the future.

The optimal number of contracts is

25, 000
N ∗ = 0.85 = 4.25
5, 000

Can you actually trade a quarter contract? No, so we need to round.

This suggests that hedging can be achieved by buying 4 contracts.

69
Cross-Hedging

Our analysis was from the perspective of someone trying to to

purchase the asset. Cross-hedging is achieved by buying N∗ contracts
(rounded).

What about if you are trying to sell the asset? (Or more generally, you
have an exposure where you lose money if the spot price falls?)

In that case, do the opposite: sell N∗ contracts, where N∗ is

computed exactly the same way.

70
Negative h?

If forward prices for the futures contract and spot prices of the asset
to hedge are negatively correlated (ρ < 0), your calculation for h∗ will
be negative.

This is not wrong! It just means your hedge needs to be the other way
around. That is, instead of going long, you go short, and vice versa.

For example, suppose that somehow corn futures and hay bales are
negatively correlated, and you get h∗ = −0.85. In the earlier example,
that means someone who needs to buy 25,000 bales of hay would
optimally buy N ∗ = −4.25 contracts, which rounded means to buy −4
contracts.

This means that they would short 4 contracts.

71
Quick Way to Remember Regression

It's very easy to forget which way the regression for the optimal hedge
ratio goes: futures on spot prices, or spot prices on futures

Easy way to remember:

▶ Left-hand side variable in a regression is the one we are trying to match

as closely as possible by the right-hand side variable(s)

▶ In our case: we want to match changes in spot prices by using futures

contracts, so spot price should bet the left-hand side variable, and the
futures prices should be on the right

72
Some Loose Ends

Stack and roll strategies

Should you actually hedge?

73
Rolling a Hedge

In our analysis, we have always assumed that a long enough futures

contract was available. This is not always true: your exposure might
be longer than longest contract available, or there may not be enough
liquidity in long-term contracts.

Common solution is known as rolling a hedge:

▶ You buy/sell short-dated futures at a delivery date that is

available/liquid
▶ Before expiration, you close out, and then buy/sell new short-dated

futures
▶ Repeat

This does carry risk! As you will see in the homework, you are exposed
to the risk in the dierence between the forward price of the contract
you are closing out vs the forward contract you are entering into.

74
Stack and Roll

A common extension of rolling a hedge is known as stack and roll.

Typically, a rm trying to hedge will want to hedge prices at multiple

times
▶ Example: an oil producer doesn't just produce oil once. They produce

every month, and may want to hedge oil production from many
dierent months

Stack and roll is a method where you try to hedge all of the

exposures through rolling. You transact in shorter-dated futures for all

of your exposures, and then roll over like before, except this time we
reduce the number of contracts according to how much exposure is
left. That is, we reduce our futures position according to how much
exposure we still have left.

75
Stack and Roll

For example, suppose you have 10,000 bbl of oil to sell in 1, 2, 3, 4,

and 5 years.

Traditional hedging: sell 10 contracts expiring in 1 year, 10 in 2 years,

10 in 3 years, 10 in 4 years, and 10 in 5 years. You close them out as
the expire.

Stack and roll:

▶ Sell 50 contracts expiring in 1 year now
▶ In 1 year, close out, sell 40 contracts expiring in the next year
▶ In 2 years, close out, sell 30 contracts expiring in the next year
▶ In 3 years, close out, sell 20 contracts expiring in the next year

▶ In 4 years, close out, sell 10 contracts expiring in the next year

▶ In 5 years, close out

76
Example of Stack and Roll Going Badly

Stack and roll went poorly for Metallgesellschaft AG in 1993

They had entered into contracts to supply xed amounts of gasoline,

diesel, and heating oil at xed prices for 10 years (at attractive prices:
3 to 5 dollars per barrel above initial spot prices)

They didn't produce this, and were therefore exposed to the purchase
price of fuels. They hedged this through a long hedge (buy futures),
and did it using a stack and roll strategy with one- to three-month
futures contracts

77
Example of Stack and Roll Going Badly
Two things happened:
▶ Oil prices fell substantially ($19/bbl to $15/bbl), so forward prices with

close delivery dates also fell

▶ Longer oil futures went into contango (much higher forward prices

than spot prices)

Drop in forward prices of existing futures meant margin large margin

calls

In addition, with the need to roll over, Metallgesellschaft was closing

out at low prices and then rolling over to new contracts with high
prices

Even though this was (partly) oset by the large earnings on the
xed-price contracts, management (perhaps incorrectly) closed out the
hedge position and its canceled its supply contracts

Loss of $1.33 billion, $1.9 billion bailout, and share prices cut in half
78
Should You Hedge?

Just because you have a particular nancial exposure does not

necessarily mean you should hedge it:
1 Not all risk matters to shareholders. If they can diversify it away, there
is little benet to you hedging it for them.
2 Hedging goes both ways: it reduces the downside, but also reduces the
upside.
3 You may already have an osetting cash ow/exposure. You always
want to look at hedging the prots of the rm, and not necessarily
individual contributors to that.

79
Should You Hedge
To understand the last point, think of the example of an oil rening
rm: they buy crude oil and sell rened oil products

You could say they are exposed to crude oil prices, and argue they
should go into a long hedge for crude oil

But, if that's all they did, they would be increasing their risk!
▶ Output product (rened oil) and input product (crude oil) prices tend

to move together
▶ Without any hedge, the rm earns the dierence, which tends not to

uctuate too much

▶ If they just hedged the input, then they would be fully exposed to the

output price
▶ For example, with the long hedge in crude oil, if rened prices fall, the

rm is paying a high price for oil but getting a low price for its product

(This is actually a bad example: in reality oil rms eectively hedge

both sides.)

80
Quick Note on Forwards

In theory, a forward contract is a contract to buy the underlying

asset at the delivery date at the specied forward price. No cash is
exchanged in advance, and everything happens at the delivery date.

These are exible contracts, traded in over-the-counter markets.

In theory, you fully bear the counterparty risk: the risk that the other
side defaults.

81
Forwards in Practice

In practice, forwards are starting to look more like futures.

Since the 2008 nancial crisis, we have been moving toward central
clearing for forwards that are somewhat standardized

A central counterparty (CCP) acts analogously to a clearing house:

▶ Two parties agree to a standard OTC transaction
▶ They then approach a CCP

▶ The single trade is replaced by two trades, each with the CCP
▶ The CCP has margin, default funds, etc.

As a result, even OTC markets for forwards have started to behave

much more like exchange-traded markets for futures

82