Chapter 3 Hedging Strategies Using Futures

Cash Settled Futures

In 1972, the CME introduced nancial futures that consisted of 8 currency futures. The 1st cash-settled futures contractCME Eurodollarwas introduced in 1981. The establishment of cash settlement rather than physical delivery allowed the futures market to
expand into products that either cant be delivered or would be difcult to deliver physically, such as futures based on stock indexes, such as the S&P 500 stock index, that was introduced in 1982.

Today, its diversity of products includes

agricultural commodities, foreign exchange products, interest rate products, equity products largely
based on major indexes,

alternative investment products, which includes energy, weather, economic derivatives, and housing
index products, and TRAKRS (Total Return Asset Contracts), which are based on commodities, euro currency, and gold, for instance.

Hedgers
Hedgers use futures to minimize risk like the farmers who use futures to guarantee a price for their
product,

or a miller who wants a set price for grain when it is harvested. Futures can also be used to hedge investment portfolios. Thus,
futures is a signicant means of price risk transfer

transferring price risk to someone with an opposite risk, or to a

speculator who is willing to accept risk to make a prot.

Speculators/Liquidity Providers
Speculators use futures to make a prot, by buying low and selling high (not necessarily in
that order).

The speculator has no intention of making or taking delivery. A speculator is making a bet on the future price of a commodity. If he thinks the price of the commodity will drop, he takes a short position by selling a
futures contract.

If he thinks that the price of the commodity will increase, then he takes a long position
by buying a futures contract.

Later, he will close out his position by offsetting the contract. If he sold short, he will buy
back the contract, and if he bought long, then he will sell the contract.

Arbitrageurs
Arbitrageurs continually look for abnormal spreads, where abnormal
spread is the price difference between 2 different, but related futures contracts, is greater or smaller than the usual difference between the contracts.

If there appears to be no good reason for the difference, or if the cause giving rise to the discrepancy is expected to change
within the year,

then arbitrageurs will take the spread in the hope of making a prot
later.

Individual Orders
Either buying or selling a contract is either an opening or closing transaction, because, Thus, it is possible to be long in Chicago wheat and short in Kansas city wheat, but
it is not generally permissible to be long and short in Chicago wheat in the same futures account. except in special cases, you cannot be both long and short in the same futures contract at the same exchange in the same account.

For instance, if you rst sell a contract, you open a position in that contract, being However, if you had bought the contract rst, then you would be long in the
contract, and your purchase would be considered an opening transaction.

short. If you subsequently buy it back, then your broker will treat the purchase as a closing transaction.

Individual Investors Orders

After opening a futures account, you can place orders with your futures commission
merchant or broker to buy and sell futures. Any such order must specify:

whether it is to buy or sell, the quantity, the delivery month along with the year if necessary, the underlying commodity, the exchange if the commodity is sold on more than 1 exchange, the type of order, such as a market order or a limit order, and any contingencies.

Individual Orders..(contd)
Thus, whether the purchase or sale of a futures contract is an opening
or closing transaction depends on what contracts are already in the account.

When the exchange receives your order, the oor trader doesnt know
nor does he care whether it is an opening or closing transaction, but it matters for you, since it will determine your position in the futures market.

Structure of Futures Trade

The Mechanics Of Order Flow

The old method, and still commonly used method of trading futures is, after sending an order to a broker, the broker sends it to the trading oor of a futures exchange for that
particular futures contract,

where oor traders and exchange members, through hand and visual signals
the so-called open outcry methodtransmit buy and sell orders.

Open outcry trading also uses electronic tickers and display boards, hand-held
computers, and electronic entry and reporting of transactions.

The display boards also show quotes from other American futures exchanges.

Futures Trading Volume

Trading volume is the number of trades. When someone buys a contract, then someone else has to sell it. This would seem like 1 transaction. However, because the clearinghouse is actually the buyer to every seller and the So when there is a seller and buyer for a particular contract, then the
seller to every buyer, each buy increments trading volume by 1, and so does each sale. clearinghouse intervenes in the transaction, buying the contract from the seller and selling it to the buyer, resulting in a trading volume increment of 2.

Open Interest
Open interest is the number of outstanding contracts on a given asset that matures at
a specied time.

It is equal either to the number of long positions or the number of short positions. Thus, a single trade, both the short side and the long side, is counted as an open
interest of 1.

Open interest is low when the contracts rst start trading, then increase as the last
month of the contract approaches.

Then most traders close out their positions before the nal day of the contract.

Open Interest (contd...)

A short seller closes his position by buying back the same contract,
and the long buyer closes her position by selling the contract.

Because most traders of futures are either speculators trying to

make a prot, or hedgers trying to protect a portfolio position, few of them make or take actual delivery of the underlying commodity.

Only about 1%-3% take actual delivery of the contracts asset for

those assets that have a delivery settlement (in contrast to a cashsettled futures contract).

Types Of Futures Orders

A market order is lled immediately at the current market price. A limit order is an order to buy or sell at a specied price or a better
price.

A market-limit order is lled at the best available price, but if there are
not enough contracts at that price to complete the order, the rest of the order becomes a limit order at that price. reaches a certain price, and is generally used to limit losses.

A stop-loss order is a market order that is only triggered if the contract

Settlement
The settlement of a futures contract is either by delivery of the commodity or by cash
settlement.

Delivery for agricultural commodities is made by transfer of warehouse receipts from approved
warehouses.

Financial futures may be settled by a wire transfer, and stock index futures are settled in cash. Cash-settled futures contracts are closed out either by an offsetting trade, or by a nal mark-tomarket settlement adjustment, using the Final Settlement Price as determined by the exchange, of the traders account.
nal day of trading.

A nal mark-to-market adjustment is made to the traders performance bond account the day after the

Prot & Loss

Long Prot = Spot Price at Maturity Original Futures Price Short Prot = Original Futures Price Spot Price at Maturity What makes futures so potentially protable is the low margin requirements. Whereas, the typical initial margin requirement for stocks is 50%, the typical initial
margin requirement for futures is 5% - 15%.

The reason why margin requirements are much less for futures than for stocks is
because commodities have a much narrower trading range. zero, nor will it climb too high.

There is virtually no chance that the price of oil or corn, for instance, will drop to Furthermore, the daily marking to market helps to keep account balances from
getting too low in relation to potential liabilities.

Futures & Taxes

Because futures accounts are marked to market daily, with earnings
credited and losses debited from the accounts at the end of every day, taxes must be paid on accrued earnings for the year, regardless of when the position is closed out. be treated as a long-term capital gain or loss, and 40% will be treated as a short-term capital gain or loss.

Under the marked to market system, 60% of your capital gain or loss will This is true regardless of how long you actually held the property. A section 1256 contract that you hold at the end of the tax year will
generally be treated as sold at its fair market value on the last business day of the tax year, and you must recognize any gain or loss that results.

The 60/40 Rule

On June 23, 2009, you bought a regulated futures contract for $50,000.
On December 31, 2009 (the last business day of your tax year), the fair market value of the contract was $57,000. long-term and 40% short-term capital gain.

You recognized a $7,000 gain on your 2009 tax return, treated as 60% On February 2, 2010, you sold the contract for $56,000. Because you recognized a $7,000 gain on your 2010 return, you
recognize a $1,000 loss ($57,000 - $56,000) on your 2010 tax return, treated as 60% long-term and 40% short-term capital loss.

Regulation
The futures market is regulated in the United States by
The Securities and Exchange Commission (SEC), The Commodity Futures Trading Commission (CFTC) The National Futures Association (NFA)

The CFTC, created by the Commodity Futures Trading Commission Act of 1974, is a
federal agency that regulates all futures trading in the United States, and oversees the NFA. introduction of any new futures or options on futures. procedures approved by the CFTC.

The exchanges must obtain approval for any regulatory changes, and for the All futures exchanges must have trading rules, contracts, and disciplinary

National Futures Association

The NFA, a self-regulatory agency created by Section 17 of the
Commodity Exchange Act of 1981, regulates the activities of its members, which includes any brokers trading futures and their agents. persons applying to conduct business in the futures industry.

NFA's responsibilities include screening, testing and registering NFA and the exchanges have responsibility for auditing and enforcing
compliance with industry rules, such as nancial requirements, segregation of customers' funds, accounting procedures, sales activities, and oor trading practices.

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 and want to lock in the price

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Arguments in Favor of Hedging

Companies should focus on the main business they are in and take steps to minimize risks arising from interest rates, exchange rates, and other market variables

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Arguments against Hedging (continued)

Shareholders are usually well diversied and can make their own hedging decisions It may increase risk to hedge when competitors do not Explaining a situation where there is a loss on the hedge and a gain on the underlying can be difcult

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Basis Risk
Basis is usually dened as the spot price minus the futures price Basis risk arises because of the uncertainty about the basis when the hedge is closed out

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Long Hedge for Purchase of an Asset

Dene
F1 : Futures price at time hedge is set up F2 : Futures price at time asset is purchased S2 : Asset price at time of purchase b2 : Basis at time of purchase

Cost of asset Gain on Future Net amount paid

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S 2 ( F2 F1 ) = F1 + b 2
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S2 F 2 F1

Short Hedge for Sale of an Asset

Dene
F1 : Futures price at time hedge is set up F2 : Futures price at time asset is sold S2 : Asset price at time of sale b2 : Basis at time of sale

Price of asset Gain on Futures Price of asset

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S2
S 2 + ( F1 F2 ) = F1 + b 2
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F 1 F2

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.

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Sources of Basis Risk

The asset being hedged might be different that the one underlying the futures contract, i.e. using a 30y T-bill to hedge a 10y T-note; The hedger might be uncertain about the exact time that the delivery has to take place, i.e. a new oil ring that is expected to start extracting next summer, without knowing exactly when; and The futures contract matures after the delivery date that the hedger has in mind, i.e. the hedger needs to buy steel in January but steel futures expire on March

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Visual Representation: Basis Risk

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Optimal Hedge Ratio

Suppose we expect to sell NA units of asset at time t2 and choose to hedge at time t1 by shorting futures contracts on NF units of a similar asset. The hedge ratio, which we denote by h, is NF (1) h= NA We will denote the total amount realized for the asset when the prot or loss on the hedge is taken into account by Y, so that Y = S 2 N A ( F2 F1 ) N F or Y = S 1 N A + ( S 2 S 1 ) N A ( F 2 F1 ) N F (2) Where S1 and S2 are the asset prices at times t1 and t2, and F1 and F2 are the futures prices at times t1 and t2. From equation 1, the expression for Y in equation 2 can be written as Where
Y = S1 N A + N A ( S h F )
S 2 S 1 and F = F2 F1

(3)

Optimal Hedge Ratio

Because S1 and NA are known at time t1, the variance of Y in equation (3) is minimized when the variance of S - hF is minimized. The variance of S-hF is
2 2 v = S + h2 F 2hS F

Where S, F, and are as dened so that

dv 2 = 2hF 2S F dh
Setting this equal to zero, and noting that d2v/dh2 is positive, we see that the value of h that minimizes the variance is

Cross Hedge
Sometimes, a hedger will have to sell or buy something that a futures contract doesnt
exactly cover, but the price movement will be similar.

For instance, a futures contract for live cattle may specify that the cattle be corn-fed. So a rancher raising grass-fed cattlea lower quality cattlemay buy a futures
contract for corn-fed cattle, to cross-hedge his position. fulll the contract by delivering grass-fed cattle.

He will have to close out of his position before expiration, because he cannot Cross hedging is hedging one commodity with a futures contract for a related commodity. In addition to basis risk, there is also a price risk in cross hedging in that the futures
contract price will diverge from the hedged commodity.

Example: Cross Hedge

Table 1: Data to calculate minimum variance hedge ratio when heating oil futures contract is used to hedge purchase of jet fuel. Month i
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15

Change in future price per gallon (=xi)

0.021 0.035 -0.046 0.001 0.044 -0.029 -0.026 -0.029 0.048 -0.006 -0.036 -0.011 0.019 -0.027 0.029

Change in fuel price per gallon (=yi)

0.029 0.020 -0.044 0.008 0.026 -0.019 -0.010 -0.007 0.043 0.011 -0.036 -0.018 0.009 -0.032 0.023

Example: Cross Hedge

An airline expects to purchase 2 million gallons of jet fuel in 1 month and decides to use heating oil futures for hedging. We suppose that Table 1 gives, for 15 successive months, data on the change, S, in the jet fuel price per gallon and the corresponding change, F, in the future price for the contract on heating oil that would be used for hedging price changes during the month. The number of observations, which we will

xi = 0.013
yi = 0.003

xi yi = 0.0107

x2 i = 0.0138
2 yi = 0.0097

Example: Cross Hedge

Standard formulas for statistics give the estimate of F as
2 x2 ( xi ) i = 0.0313 n 1 n(n 1) 2 yi ( yi ) 2 = 0.0263 n 1 n(n 1) n x i yi x i yi 2 2 2 = 0.928 2 [n xi ( xi ) ][n yi ( yi ) ]

The estimate of S is The estimate of is

From equation (1), the minimum variance hedge ratio, h*, is therefore

0.928

0.0263 = 0.78 0.0313

Each heating oil contract traded on NYMEX is on 42,000 gallons of heating oil. From equation (2), the optimal number of contracts is 0.78 2, 000, 000
42, 000 = 37.14

or, rounding to the nearest whole number, 37.

Optimal Number of Contracts

QA
QF
VA

Spot Price Futures price Size of position being hedged (units) Size of one futures contract (units) Value of position being hedged Value of one futures contract
(= FA QF ) (= SA QA )

VF

Optimal number of contracts if no tailing adjustment

h Q A = QF
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Optimal number of contracts after tailing adjustment to allow or daily settlement of futures
h V A = VF
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Example

Airline will purchase 2 million gallons of jet fuel in one month and hedges using heating oil futures From historical data we have,

0.0263 h = 0.928 = 0.7777 0.0313

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Example continued

The size of one heating oil contract is 42,000 gallons The spot price is 1.94 and the futures price is 1.99 (both dollars per gallon) so that
VA = 1.94 2, 000, 000 = 3, 880, 000 VF = 1.99 42, 000 = 83, 580

Optimal number of contracts assuming no daily settlement =

0.7777 2, 000, 000/42, 000 = 37.03

Optimal number of contracts after tailing =

0.7777 3, 880, 000/83, 580 = 36.10

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Hedging Using Index Futures

To hedge the risk in a portfolio the number of contracts that should be shorted is

VA VF
where VA is the value of the portfolio, is its beta, and VF is the value of one futures contract

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Example

S&P 500 futures price is 1,000 Value of Portfolio is $5 million Beta of portfolio is 1.5 What position in futures contracts on the S&P 500 is necessary to hedge the portfolio?

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Changing Beta

What position is necessary to reduce the beta of the portfolio to 0.75? What position is necessary to increase the beta of the portfolio to 2.0?

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Hedging an Equity Portfolio

Stock index futures can be used to hedge a well-diversied equity portfolio. Let

P: Current value of the portfolio A: Current value of the stocks underlying one futures contract
If the portfolio mirrors the index, the optimal hedge ratio, h*, equals 1.0, hence the number of futures contracts that should be shorted is P N = A For example, a portfolio worth $1 million mirrors the S&P 500. The current value of the index is 1,000, and each futures contract is on $250 times the index. In this case P = 1,000,000 and A = 250,000, so that 4 contracts should be shorted to hedge the portfolio.
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Hedging an Equity Portfolio continued

When the portfolio does not exactly mirror the index, we can use the parameter beta from the capital asset pricing model to determine the appropriate hedge ratio. A portfolio with a beta of 2.0 is twice as sensitive to market movements as a portfolio with a beta 1.0. It is therefore necessary to use twice as many contracts to hedge the portfolio. Similarly, a portfolio with a beta of 0.5 is half as sensitive to market movements as a portfolio with a beta of 1.0 and we should use half as many contracts to hedge it. In general, h* = , so that
P N = A

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Hedging an Equity Portfolio: Example

Value of S&P 500 index=1,000 Value of portfolio=$5,000,000 Risk-free interest rate= 4% per annum Dividend yield on index=1% per annum Beta of portfolio= 1.5 We assume that a futures contract on the S&P with 4 months to maturity is used to hedge the value of the portfolio over the next 3 months and that the current futures price of this contract is 1,010. One futures contract is for delivery of $250 times the index. It follows that A=250x1,000=250,000 and from equation (3.4), the number of futures contract that should be sorted to hedge the portfolio is

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Expected Gain from Hedging w/ Futures

Suppose the index turns out to be 900 in 3 months and the futures price 902. The gain from the short futures position is then The loss on the index is 10%. The index pays a dividend of 1% per annum, or 0.25% per 3 months. When dividends are taken into account, an investor in the index would therefore earn -9.75% in the 3-month period. The risk-free interest rate is approximately 1% per 3 months. Because the portfolio has a of 1.5, the capital asset pricing model gives
Expected return on portfolio Risk-free interest rate = 1.5 x (Return on index Risk- free interest rate)

It follows that the expected return (%) on the portfolio during the 3 months is

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Expected Gain from Hedging w/ Futures

The expected value of the portfolio (inclusive of dividends) at the end of the 3 months is therefore $5,000,000 x (1-0.15125) = $4,243,750 It follows that the expected value of the hedgers position, including the gain on the hedge, is $4,242,750 + $810,000 = $5, 053, 750

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Hedging with Futures

If an company knows that it has to sell a particular asset at a particular time in the future, it can hedge by taking a short position, therefore locking in the price of delivery. This is called a short hedge. Similarly, a company that knows that it will need an asset in the future can take a long hedge, thus locking in the price of purchase. It is very important to note that hedging does not necessarily improve the nancial outcome, it just reduces the uncertainty. In practice, hedging is not perfect, the basis risk arises due to a number of reasons.

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Why Hedge Equity Returns

May want to be out of the market for a while. Hedging avoids the costs of selling and repurchasing the portfolio Suppose stocks in your portfolio have an average beta of 1.0, but you feel they have been chosen well and will outperform the market in both good and bad times. Hedging ensures that the return you earn is the risk-free return plus the excess return of your portfolio over the market.

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Stack and Roll

We can roll futures contracts forward to hedge future exposures Initially we enter into futures contracts to hedge exposures up to a time horizon Just before maturity we close them out and replace them with new contract that reects the new exposure

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Rolling The Hedge Forward

Sometimes the expiration date of the hedge is later than the delivery dates of all the futures contracts that can be used. The hedger must then roll the hedge forward by closing out one futures contract and taking the same position in a futures contract with a later delivery date. Hedges can be rolled forward many times.

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Rolling The Hedge Forward

Consider a company that wishes to use a short hedge the price to be received for an asset at time T. If there are futures contracts 1, 2, 3, ,n with progressively later delivery dates, the company can use the following strategy:
Time t1 : Time t2 : Time t3 : Short futures contract 1 Close out futures contract 1 Short futures contract 2 Close out futures contract 2 Short futures contract 3 : Close out futures contract n-1 Short futures contract n Close out futures contract n
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Time tn : Time T :

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Basis Risk: Rolling The Hedge Forward

Suppose that in April 2004 a company realizes that it will have 100,000 barrels of oil to sell in June 2005 and decides to hedge its risk with a hedge ratio of 1.0. The current spot price is $19. We suppose that only the rst 6 delivery months have sufcient liquidity to meet the companys needs. The company therefore shorts 100 October 2004 contracts. In September 2004 it rolls the hedge forward into the March 2005 contract. February 2005 it rolls the hedge forward again into the July 2005 contract.
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Basis Risk: Rolling The Hedge Forward (continued)

One possible outcome is shown in table below. The October 2004 contract is shorted at $18.20 per barrel and closed out at $17.40 per barrel for a prot of $0.80 per barrel; the march 2005 contract is shorted at $17.00 per barrel and closed out at $16.50 par barrel for a prot of $0.50 per barrel. The July 2005 contract is shorted at $16.30 per barrel and closed out at $15.90 per barrel for a prot of $0.40 per barrel. The nal spot price is $16. The dollar gain per barrel of oil from the futures contracts, ignoring the time value of money, is
(18.20 17.40) + (17.00 16.50) + (16.30 15.90) = 1.70
Data for the example on rolling oil hedge forward Date Oct. 2004 futures price Mar. 2005 futures price July. 2005 futures price Spot Price 19.00 Apr. 2004 18.20 Sept. 2004 17.40 17.00 16.50 16.30 15.90 16.00 Feb. 2005 June 2005

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Rolling the hedge forward: Risk

The problem was illustrated dramatically by the activities of a German company, Metallgesellschaft (MG), in the early 1990s. MG sold a huge volume of 5- to 10-year heating oil and gasoline xedprice supply contracts to its customers at 6 to 8 cents above market prices. It hedged its exposure with long positions in short-dated futures contracts that were rolled forward. As it turned out, the price of oil fell and there were margin calls on the futures positions.
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Considerable short-term cash ow press

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Rolling the hedge forward: Risk

The members of MG who devised the hedging strategy argued that these short-term cash outows were offset by positive cash ows that would ultimately be realized on the long-term xed-price contracts. However, the companys senior management and its bankers became concerned about the huge cash drain. As a result, the company closed out all the hedge positions and agreed with its customers that the xed-price contracts would be abandoned.

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Liquidity Issues

In any hedging situation there is a danger that losses will be realized on the hedge while the gains on the underlying exposure are unrealized This can create liquidity problems One example is Metallgesellschaft which sold long term xed-price contracts on heating oil and gasoline and hedged using stack and roll The price of oil fell.....
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