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Hedging Strategies Using Futures

1) Futures contracts allow parties to agree to buy or sell an asset in the future at a set price. Initial and maintenance margin requirements are used to manage counterparty risk. 2) Hedging with futures locks in future prices. A long hedge is used when expecting future price increases, while a short hedge locks in prices when expecting future decreases. 3) The optimal hedge ratio depends on the correlation between the hedged asset and futures contract prices, minimizing risk for the hedged position.

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Venkatesh Swamy
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233 views18 pages

Hedging Strategies Using Futures

1) Futures contracts allow parties to agree to buy or sell an asset in the future at a set price. Initial and maintenance margin requirements are used to manage counterparty risk. 2) Hedging with futures locks in future prices. A long hedge is used when expecting future price increases, while a short hedge locks in prices when expecting future decreases. 3) The optimal hedge ratio depends on the correlation between the hedged asset and futures contract prices, minimizing risk for the hedged position.

Uploaded by

Venkatesh Swamy
Copyright
© Attribution Non-Commercial (BY-NC)
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PPT, PDF, TXT or read online on Scribd
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Hedging Strategies Using

Futures

LECTURE 3
Futures

A futures contract is an agreement to buy (if you


are long) or sell (if you are short) something in
the future, at an agreed price (the futures price).
Futures exist on financial assets (debt instruments,
currencies, stock indexes), and real assets (gold,
crude oil, wheat, cattle, cotton, etc.)

Note that a futures contract is like a portfolio of
forward contracts (time series).
Margin Requirements

Default risks
Margin is a crucial aspect of futures transactions and
has played vital roles in managing counter party risk
and market volume.
Initial Margin: The initial margin is the money a
trader must deposit into a trading account (margin
account) when establishing a futures position.
Margin Requirements

Each futures exchange is responsible for setting


the minimum initial margin requirements for their
futures contracts
Most computer algorithms to set IM is called
SPAN (Standard Portfolio ANalysis of risk).
An exchange can change the required margin
anytime.
Initial Margin will increase if price volatility
increases, or if the price of the underlying
commodity rises substantially.
The Operation of Margin

If the equity in the account falls to, or below, the


maintenance margin level, additional funds must
be deposited to restore the account balance to the
initial margin level.
The margin that is deposited in order to meet
margin calls is called variation margin. If the
trader does not promptly meet the margin call, the
position will be forced to liquidated.
Marking-to-Market
Example

At 10am, 7th May 2009, John sold one gold future
contract (100 oz) for delivery in August 2009 at the
future price of £285/oz. The initial margin is £1000
and maintenance margin is set at £750.
Example (Cont.)

On all subsequent days, the account is marked to market. If the


futures price falls, your equity rises. If the futures price rises, your
equity declines. Maintenance margin calls will have to be met if
your account equity falls to a level equal to or below £750.
Maint.
Gold Cash Begin. Margin Ending
Date Price Flow Equity Call Equity
05/7 285.00 1000
05/7 (end) 286.40 (140) 860 0 860
05/8 288.80 (240) 620 380 1000
05/9 289.00 (20) 980 0 980
05/10 288.60 40 1020 0 1020
05/11 290.70 (210) 810 0 810
05/12 292.80 (210) 600 400 1000
05/13 292.80 0 1000 0 1000
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
Examples

A manufacturer of gold jewellery knows it will


require 1000 ounces of gold to meet a certain
contract in 6 months. The manufacturer expects the
price of gold will increase in 6 months.
A firm is expecting to receive $30m 3 months later
from its exporting goods to US. The firm thinks the
dollar will devalue further in 3 months.
Choice of Contract

Choose a delivery month that is as close as possible


to, but later than, the end of the life of the hedge
When there is no futures contract on the asset being
hedged, choose the contract whose futures price is
most highly correlated with the asset price. This is
known as cross hedging.
Optimal Hedge Ratio
3.
11

Consider a position which is long in an asset


but short in future.
ΔS: change in spot price S over length of
hedge (σs)
ΔF: change in future price F over length of
Hedge (σF)
h: hedge ratio
Optimal Hedge Ratio

Proportion of the exposure that should optimally be


hedged is

 S
F
where
S is the standard deviation of S, the change in the
spot price during the hedging period,
F is the standard deviation of F, the change in the
futures price during the hedging period
 is the coefficient of correlation between S and F.
Optimal number of Contracts

NA
N*  h *
QF
NA: Size of position being hedged
QF: Size of one futures contract
N*: Optimal number of futures contracts for
hedging
3.13
Hedging an Equity Portfolio

Stock Index Futures


To hedge the risk in a portfolio the number of
contracts that should be shorted is
 P
A

where P is the value of the portfolio, is its beta,


and A is the value of the assets underlying one
futures contract
Example

Consider the value of S&P 500 is currently 1,000.


An investor wants to use the future to hedge the
value of the portfolio $5m over the next 3 months.
One future contract is for delivery of $250 times
the index and currently priced at $1010. The beta
of the portfolio is 1.5.
What position in futures contracts on the S&P 500
is necessary to hedge the portfolio?
Payoff of Hedging

What is the total payoff from this hedging strategy


when the index future value becomes 902 in 3
months and the portfolio value fell to $4.2m.
What is the total payoff from this hedging strategy
when the index value becomes 1050 in 3 months and
the portfolio value increases to $5.3m.
Changing Beta

What position is necessary to reduce the beta of


the portfolio to 0.75?
Hedging Price of an Individual Stock

Similar to hedging a portfolio


Does not work well because only the systematic risk
is hedged
The unsystematic risk that is unique to the stock is
not hedged

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