Quantitative methods for economics and business

LECTURE N. 5

G. Oggioni
[email protected]

September 28th, 2020

G. Oggioni [email protected] Lecture 5 1 / 20

Hedging Strategies Using Futures

When an individual or company chooses to use futures markets to hedge a risk, the objective
is usually to take a position that neutralizes the risk as far as possible.

Example
Consider a company that knows it will gain $10,000 for each 1 cent increase in the price of a
commodity over the next 3 months and lose $10,000 for each 1 cent decrease in the price during
the same period. To hedge, the company’s treasurer should take a short futures position that is
designed to offset this risk.

The futures position should lead to a loss of $10,000 for each 1 cent increase in the price of
the commodity over the 3 months and a gain of $10,000 for each 1 cent decrease in the price
during this period.
If the price of the commodity goes down, the gain on the futures position offsets the loss on
the rest of the company’s business.
If the price of the commodity goes up, the loss on the futures position is offset by the gain
on the rest of the company’s business.

G. Oggioni [email protected] Lecture 5 2 / 20

Hedging Strategies Using Futures (2)

LONG FUTURES HEDGE SHORT FUTURES HEDGE

⇓ ⇓

A long futures hedge is appropriate when you A short futures hedge is appropriate
know you will purchase an asset in the future when you own or you will own an
and want to lock in the price asset and already know you will sell
an asset in the future. You want to
lock in the price

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
Arguments against Hedging
Shareholders are usually well diversified 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 difficult

G. Oggioni [email protected] Lecture 5 3 / 20

Hedging Strategies Using Futures (3)

Example (1)
Suppose that it is May 15 today. An oil producer now negotiates a contract to sell 1 million
barrels of crude oil. It has been agreed that the price that will apply in the contract is the market
price on August 15.
In addition, the oil producer knows it will gain $10,000 for each 1 cent increase in the price of oil
over the next 3 months and lose $10,000 for each 1 cent decrease in the price during this period.
Spot price is $80 per barrel on May 15;
Crude oil futures price for August delivery is $79 per barrel;
Each futures contract is for the delivery of 1,000 barrels.
What about the hedging strategy?

Example (2)
Suppose that it is now January 15. A copper fabricator knows it will require 100,000 pounds of
copper on May 15 to meet a certain contract.
Spot price of copper is $340 cents per pound;
Copper futures price for May delivery is $320 cents per pound.
Each contract is for the delivery of 25,000 pounds of copper.
What about the hedging strategy?

G. Oggioni [email protected] Lecture 5 4 / 20

 2. The hedger may be uncertain as to the exact date when the asset will be bought
or sold.

Basis Risk 3. The hedge may require the futures contract to be closed out before its delivery
month.
These problems give rise to what is termed basis risk. This concept will now be explained.

The Basis
Basis = Spot price of asset to be hedged - Futures price of contract used.
The basis in a hedging situation is as follows: 2

Basis ¼ Spot price of asset to be hedged " Futures price of contract used
Basis risk arises because of the uncertainty about the basis when the hedge is closed out.
If the asset to be hedged and the asset underlying the futures contract are the same, the
basis should be zero at the expiration of the futures contract. Prior to expiration, the
The asset whose price is to be basis
hedged mayornot
may be positive beFrom
negative. exactly
Table 2.2,the
we seesame as 26,
that, on May the2010,asset
the underlying
basis was negative for gold and positive for short maturity contracts on soybeans.
the futures contract. As time passes, the spot price and the futures price for a particular month do not
necessarily change by the same amount. As a result, the basis changes. An increase in
The hedger may be uncertain as to isthe
the basis exact
referred date when
to as a strengthening thea asset
of the basis; decrease inwill beis referred
the basis bought or sold.
to as a weakening of the basis. Figure 3.1 illustrates how a basis might change over time
The hedge may require the futures contract
in a situation to isbe
where the basis closed
positive prior toout before
expiration its delivery
of the futures
To examine the nature of basis risk, we will use the following notation:
contract. month.
S1 : Spot price at time t1
S2 : Spot price at time t2
If the asset to be hedged and theF : asset underlying
Futures price
1 at time t the futures contract are the same, the
1

basis should be zero at the expiration ofprice

F : Futures the
2 futures
at time t contract. 2
b1 : Basis at time t1
Prior to expiration, the basis may be positive or negative.
b2 : Basis at time t2 .

Figure 3.1 Variation of basis over time.

Spot price

Futures price

Time
t1 t2

2
This is the usual definition. However, the alternative definition Basis ¼ Futures price " Spot price is
sometimes used, particularly when the futures contract is on a financial asset.
G. Oggioni [email protected] Lecture 5 5 / 20
Basis Risk (2)

Let us assume that a hedge is put in place at time t1 and closed out at time t2 .
S1 : Asset spot price at time t1
S2 : Asset spot price at time t2
F1 : Futures price at time t1
F2 : Futures price at time t2
b1 : Basis at time t1
b2 : Basis at time t2
From the definition of a basis it results:

b 1 = S1 − F 1 and b2 = S2 − F2

G. Oggioni [email protected] Lecture 5 6 / 20

Basis Risk (3)

Assume that a hedge is put in place at time t1 and closed out at time t2 and consider the case
where the spot and futures prices at the time the hedge is initiated are $2.50 and $2.20,
respectively, and that at the time the hedge is closed out they are $2.00 and $1.90, respectively.
This means:
S1 = $2.50
F1 = $2.20
S2 = $2.00
F2 = $1.90

⇒ b1 = S1 − F1 = $2.50 − $2.20 = $0.30

⇒ b2 = S2 − F2 = $2.00 − $1.90 = $0.10

G. Oggioni [email protected] Lecture 5 7 / 20

Short Hedge for Sale of an Asset

Example (1)
Consider the situation of a hedger who knows that the asset will be sold at time t2 and takes a
short futures position at time t1 .
The price realized for the asset is S2
The profit on the futures position is F1 − F2 .

The effective price that is obtained for the asset with hedging is therefore:

S2 + F1 − F2 = F1 + S2 − F2 = F1 + b2

S2 + F1 − F2 = F1 + b2
where b2 is the basis risk!

The value of F1 is known at time t1 . If b2 were also known at this time, a perfect hedge would
result. The hedging risk is the uncertainty associated with b2 !!!

G. Oggioni [email protected] Lecture 5 8 / 20

Short Hedge for Sale of an Asset (2)
Define:
F1 : Futures price at time hedge is set up (t1 )
F2 : Futures price at time asset is sold (t2 )
S2 : Asset price at time of sale (t2 )
b2 : Basis at time of sale (t2 )

Price of asset S2
Gain on futures F1 − F2
Net amount received S2 + (F1 − F2 ) = F1 + b2

Table: Short Hedge for Sale of an Asset

Considering the example above:

Price of asset (revenue) S2 =$2.00

Gain on futures F1 − F2 =$2.20-$1.90=$0.30
Net amount received S2 + (F1 − F2 ) = $2.00 + $0.30 = $2.30
or equivalently
F1 + b2 = $2.20 + $0.10 = $2.30

G. Oggioni [email protected] Lecture 5 9 / 20

Long Hedge for Purchase of an Asset

Example (2)
Consider the situation where a company knows it will buy the asset at time t2 and initiates a long
hedge at time t1 .
The price paid for the asset is S2
The profit on the futures position is F2 − F1 .

The effective price paid with hedging is therefore:

S2 − (F2 − F1 ) = S2 + F1 − F2 = F1 + S2 − F2 = F1 + b2

S2 + F1 − F2 = F1 + b2
where b2 is the basis risk!

The value of F1 is known at time t1 . If b2 were also known at this time, a perfect hedge would
result. The hedging risk is the uncertainty associated with b2 !!!

G. Oggioni [email protected] Lecture 5 10 / 20

Long Hedge for Purchase of an Asset (2)
Define
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 S2
Gain on futures F2 − F1
Net amount Paid S2 − (F2 − F1 ) = F1 + b2

Table: Long Hedge for Purchase of an Asset

Considering the example above:

Cost of asset S2 = $2.00

Gain on futures F2 − F1 = $1.90 − $2.20 = −$0.30
Net amount Paid S2 − (F2 − F1 ) = $2.00 − (−$0.30) = $2.30
or equivalently
F1 + b2 = $2.20 + $0.10 = $2.30

G. Oggioni [email protected] Lecture 5 11 / 20

Choice of Contract

One key factor affecting basis risk is the choice of the futures contract to be used for hedging.

This choice has to be taken considering these two components:

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.

What’s the optimal hedging strategy?

G. Oggioni [email protected] Lecture 5 12 / 20

Choice of the delivery month

Example (1)
It is March 1. A US company expects to receive 50 million Japanese yen at the end of July. Yen
futures contracts on the CME Group have delivery months of March, June, September, and
December. One contract is for the delivery of 12.5 million yen.

⇒The company therefore shorts four September yen futures contracts on March 1.

We suppose that:
t1 = March 1
t2 = July (when the yen are received and the company closes out the position)
F1 = 0.7800 cents per yen
S2 = 0.7200 cents per yen
F2 = 0.7250 cents per yen

Price of asset (revenue) S2 =0.7200

Gain on futures F1 − F2 =0.7800-0.7250=0.0550
Basis in t2 b2 = 0.7200 − 0.7250 = −0.0050
Net amount received S2 + (F1 − F2 ) = 0.7200 + 0.0550 = 0.7750
or equivalently
F1 + b2 = 0.7800 − 0.0050 = 0.7750

G. Oggioni [email protected] Lecture 5 13 / 20

Choice of the delivery month (2)

Example (2)
It is June 8 and a company knows that it will need to purchase 20,000 barrels of crude oil at
some time in October or November. Oil futures contracts are currently traded for delivery every
month on the NYMEX division of the CME Group and the contract size is 1,000 barrels.

⇒ The company decides to use the December contract for hedging and takes a long position in
20 December contracts.

We suppose that:
t1 = June 8
t2 = November 10 (when the company is ready to purchase the crude oil)
F1 = $68.00 per barrel
S2 = $70.00 per barrel
F2 = $69.10 per barrel

Cost of asset S2 = $70.00

Gain on futures F2 − F1 = $69.10 − $68.00 = $1.10
Basis in t2 b2 = $70.00 − $69.10 = $0.90
Net amount Paid S2 − (F2 − F1 ) = $70.00 − ($1.10) = $68.90
or equivalently
F1 + b2 = $68.00 + $0.90 = $68.90
G. Oggioni [email protected] Lecture 5 14 / 20
Cross hedging

There is cross hedging when the asset that gives rise to the hedger’s exposure is sometimes
different from the asset underlying the futures contract that is used for hedging.

Example
Airline that is concerned about the future price of jet fuel, but jet fuel futures are not traded.
Substitutes could be heating oil futures!

⇓
It leads to an increase in basis risk.
Define:
S2∗ : Price of the asset underlying the futures contract at time t2
S2 : Price of the asset being hedged at time t2

By hedging, a company ensures that the price that will be paid (or received) for the asset is:

S2 + F 1 − F 2
This can be written as:

F1 + (S2∗ − F2 ) + (S2 − S2∗ )

where b2 = (S2∗ − F2 ) + (S2 − S2∗ )
G. Oggioni [email protected] Lecture 5 15 / 20
Hedge ratio

The hedge ratio is the ratio of the size of the position taken in futures contracts to the size
of the exposure.
It is calculated to make certain that there are enough futures contracts to provide financial
protection in the event that the price of the asset to be hedged either rises or falls.
When the asset underlying the futures contract is the same as the asset being hedged, the
hedge ratio equals 1.0.
When cross hedging is used, setting the hedge ratio equal to 1.0 is not always optimal.

The hedger should choose a value for the hedge ratio that
minimizes the variance of the value of the hedged position

G. Oggioni [email protected] Lecture 5 16 / 20

Optimal Hedge Ratio

The minimum variance hedge ratio (optimal hedge ratio) denoted as h∗ is defined as follows:

σS
h∗ = ρ
σF

where
σS : is the standard deviation of ∆S, the change in the spot price during the hedging period;
σF : is the standard deviation of ∆F , the change in the futures price during the hedging
period;
ρ : is the coefficient of correlation between ∆S and ∆F .

It can be shown that h∗ is the slope of the best-fit line from a linear regression of ∆S
against ∆F .
⇒ If ρ = 1 and σF = σS , then h∗ = 1 (the future price mirrors the spot price perfectly)
⇒ If ρ = 1 and σF = 2σS , then h∗ = 0.5 (the future price always changes by twice as much as
the spot price)

G. Oggioni [email protected] Lecture 5 17 / 20

Optimal Number of Contracts
QA : Size of position being hedged (units)
QF : Size of one futures contract (units)
VA : Value of position being hedged (=spot price times QA )
VF : Value of one futures contract (=futures price times QF )
N∗ : Optimal number of futures contracts for hedging

Optimal number of contracts if no tailing Optimal number of contracts after tailing

adjustment is applied adjustment to allow for daily settlement of
futures

⇓ ⇓

h∗ QA h ∗ VA
N∗ = N∗ =
QF VF

Remark: when futures are used for hedging, a small adjustment, known as tailing the hedge, can
be made to allow for the impact of daily settlement. This is not applied if forward contracts are
used rather than futures.
G. Oggioni [email protected] Lecture 5 18 / 20
Example

Example
An airline will purchase 2 million gallons of jet fuel in one month and hedges using heating oil
futures. From historical data σF = 0.0313, σS = 0.0263, and ρ = 0.928.
The size of one heating oil futures contract is 42,000 gallons, the spot price is 1.94 and the
futures price is 1.99 (both dollars per gallon). Determine the optimal hedging strategy.

The optimal hedging ratio is

0.0263
h∗ = 0.928 ·
= 0.7777
0.0313
The optimal number of contracts assuming no daily settlement is:
2, 000, 000
0.7777 · = 37.03
42, 000
The values VA and VF are respectively:

VA = 1.94 · 2, 000, 000 = 3, 880, 000

VF = 1.99 · 42, 000 = 83, 580

The optimal number of contracts after tailing is:

3, 880, 000
0.7777 · = 36.10
83, 580

G. Oggioni [email protected] Lecture 5 19 / 20

 Table 3.2 Data to calculate minimum variance hedge ratio
when heating oil futures contract is used to hedge purchase of
Example (Data) jet fuel.
Change in Change in
heating oil futures jet fuel
Month price per gallon price per gallon
i ð¼ !F Þ ð¼ !S Þ
1 0.021 0.029
2 0.035 0.020
3 &0.046 &0.044
4 0.001 0.008
5 0.044 0.026
6 &0.029 &0.019
7 &0.026 &0.010
8 &0.029 &0.007
9 0.048 0.043
10 &0.006 0.011
11 &0.036 &0.036
12 &0.011 &0.018
13 0.019 0.009
14 &0.027 &0.032
15 0.029 0.023

G. Oggioni [email protected] Lecture 5 20 / 20