Chapter 3

Chapter 3
Hedging Strategies Using

Futures
Options, Futures, and Other Derivatives, 10th Edition, Copyright ©

John C. Hull 2017 1
Futures and Hedging
Many participants in the futures markets are
hedgers
Their objective is to neutralize the risk as far
as possible
However, perfect hedges are rare
We will learn how to use futures contracts to
design hedging strategies that perform as
close to perfectly as possible
Options, Futures, and Other Derivatives, 10th Edition,
Copyright © John C. Hull 2017 2
Basic Risk Management
Firms convert inputs into goods and services
output input
commodity
producer buyer
A firm is profitable if the cost of what it produces
exceeds the cost of its inputs
A firm that actively uses derivatives and other
techniques to alter its risk and protect its profitability
is engaging in risk management
The Producer’s Perspective
A producer selling a risky commodity has an
inherent long position in this commodity
When the price of the commodity decreases, the
firm’s profit decreases (assuming costs are fixed)
Some strategies to hedge profit
Shorting forward contract
Long put options
The Buyer’s Perspective
A buyer that faces price risk on an input has an
inherent short position in this commodity
When the price of the input increases, the firm’s

profit decreases
Some strategies to hedge profit

Long forward contracts
Long call options
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 power supplier who wants to buy oil after three months
An importer who needs to buy Swiss francs in 4 months
A short futures hedge is appropriate when you know
you will sell an asset in the future and want to lock in
the price
A wheat farmer who wants to sell his harvest after two
months
An exporter who will receive euros in 6 months
6
Short Hedge Example
On May 15, An oil producer made a deal to sell 1 million
barrels of oil
The price will be the market price (spot price) on August
15
Gain $10,000 for each 1 cent increase in the oil price
Lose $10,000 for each 1 cent decrease in the oil price
On May 15, the spot price is $50 and the futures price
for August delivery is $49
The company decided to hedge it exposure by shorting
1000 futures contract (each is for the delivery of 1000
barrels)
What could happen on August 15? 7
Short Hedge Example (Cont.)
August 15, scenario 1
Spot price = $45
The futures price for delivery in August is very close to $45
The company closes it futures position
How much did it gain (lose)?
August 15, scenario 2
Spot price = $55
The futures price for delivery in August is very close to $55
8
Long Hedge Example
On Jan 15, a copper fabricator plans to buy
100,000 copper on May 15 to meet a sales
contract of a product it manufactures
The spot price now is 340 cent per pound
The futures price for May delivery is 320 cents per
pound
The company decided to hedge by taking a long
position in 4 futures contract (each is for the delivery
of 25,000 pounds)
What could happen on May 15?
9
Long Hedge Example (Cont.)
May 15, scenario 1
Spot price = 325 cent per pound
The futures price for delivery in May is very close to 325
May 15, scenario 2
Spot price = 305 cent per pound
The futures price for delivery in May is very close to 305
10
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

Basis Risk
What is wrong with the previous example?
Are the following assumptions realistic?
• The hedger was able to find a futures contract that has
an underlying assets that is exactly the same as the asset
to be hedged
• The hedger was able to determine exactly when the asset
will be bought or sold
• The futures position could be closed at the same time the
sales transaction will take place
13
Basis Risk
Basis is usually defined as the spot price minus
the futures price
Basis = 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
Is there a basis if the asset to be hedged and the

asset underlying the futures contract are the
same? Options, Futures, and Other Derivatives, 10th Edition,
Basis Risk
Strengthening of the basis versus weakening
of the basis

Basis Risk
Define:
S1 : Spot price at time t1
S2 : 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

Example
the spot and futures prices at the time the hedge is
initiated are $2.50 and $2.20, respectively
the spot and futures prices at the time the hedge is
closed out are $2.00 and $1.90, respectively
If a hedger takes a short position, what is the price
realized for the asset when the hedge is closed out?
If a hedger takes a long position, what is the price

realized for the asset when the hedge is closed out?
17
Long Hedge for Purchase of an Asset
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

Short Hedge for Sale of an Asset
Define
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 S2
Gain on Futures F1 −F2
Net amount received S2 + (F1 −F2) =F1 + b2

Elements of a Hedging Strategy
The choice of the contract
The choice of the underlying
The delivery month
The number of contracts
The hedge ratio
The required position
Short or long
20
Choice of Contract
The choice of the futures contract affect the
basis risk. This choice has two components:
The choice of the asset underlying the futures
contract
The choice of the delivery month

Choice of Contract
A good rule of thumb
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.

Cross Hedging
Sometimes, the asset that give rise to the hedger’s
exposure is different from the asset underlying the
futures contract that is used for hedging. This is
called Cross Hedging
How does cross hedging affect basis risk?
The Hedge Ratio is the ratio of the size of the
position taken in futures contracts to the size of the
exposure
When cross hedging is used, a hedge ratio equals to 1 is
not always optimal
The hedger should choose a value that minimizes the
variance of the value of the hedged position 23
Optimal Hedge Ratio (page 59)
Proportion of the exposure that should optimally be
hedged is sS
*
h =r
sF
where
sS is the standard deviation of DS, the change in the
spot price during the hedging period,
sF is the standard deviation of DF, the change in the
futures price during the hedging period
r is the coefficient of correlation between DS and DF.

Example (Page 61)
Nas Airline will purchase 2 million gallons of
jet fuel in one month and hedges using
heating oil futures
From historical data sF =0.0313, sS =0.0263,
and r= 0.928
0.0263
h = 0.928 
*
= 0.78
0.0313

Example continued
The size of one heating oil contract is 42,000 gallons
Optimal number of contracts is
∗
ℎ 𝑄𝐴
𝑁∗ =
𝑄𝐹
𝑁∗ = 0.78  2, 000, 000 42, 000
which rounds to 37

Alternative Definition of Optimal
Hedge Ratio
Optimal hedge ratio is
ˆ sˆ S
h=r
ˆ
sˆ F
where variables are defined as follows
r̂ Correlation between percentage daily changes for

spot and futures
sˆ S SD of percentage daily changes in spot
sˆ F SD of percentage daily changes in futures

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 time QA)
VF Value of one futures contract (=futures price times QF)
Optimal number of contracts

Optimal number of contracts if after “tailing adjustment” to
there is no adjustment for daily allow for daily settlement of
settlement futures
h *Q A ˆ
hV
= = A
QF VF
Example (Page 62)
Airline will purchase 2 million gallons of jet fuel
in one month and hedges using heating oil
futures
The spot price and the futures price are $1.94
and $1.99 per gallon. Then VA = 2,000,000*1.94
VF = 42,000 * 1.99. If ℎ෠ = 0.75, the optimal
number of contracts is
0.75 × 3,880,000
= 34.82 ≈ 35
83,850
Hedging Using Index Futures
(Page 64)
To hedge the risk in a portfolio the

number of contracts that should be
shorted is V A
b
VF
where VA is the value of the portfolio, b is
its beta, and VF is the value of one
futures contract

Example
S&P 500 futures price is 1,000
Each futures contract is on $250 × the index
futures price
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?
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?

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.
Stack and Roll (page 68-69)
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 an
replace them with new contract reflect the
new exposure
etc
Liquidity Issues (See Business Snapshot 3.2)
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 fixed-price contracts on heating oil
and gasoline and hedged using stack and roll
The price of oil fell.....

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Hedging Strategies Using

Options, Futures, and Other Derivatives, 10th Edition, Copyright ©

When the price of the input increases, the firm’s

Some strategies to hedge profit

Options, Futures, and Other Derivatives, 10th Edition,

Options, Futures, and Other Derivatives, 10th Edition,

Basis risk arises because of the uncertainty about

Is there a basis if the asset to be hedged and the

Options, Futures, and Other Derivatives, 10th Edition,

Options, Futures, and Other Derivatives, 10th Edition,

If a hedger takes a long position, what is the price

Options, Futures, and Other Derivatives, 10th Edition,

Options, Futures, and Other Derivatives, 10th Edition,

Options, Futures, and Other Derivatives, 10th Edition,

Options, Futures, and Other Derivatives, 10th Edition,

Options, Futures, and Other Derivatives, 10th Edition,

Options, Futures, and Other Derivatives, 10th Edition,

𝑁∗ = 0.78  2, 000, 000 42, 000

Options, Futures, and Other Derivatives, 10th Edition,

r̂ Correlation between percentage daily changes for

sˆ F SD of percentage daily changes in futures

Options, Futures, and Other Derivatives, 10th Edition,

Optimal number of contracts

To hedge the risk in a portfolio the

Options, Futures, and Other Derivatives, 10th Edition,

What position in futures contracts on the S&P

Options, Futures, and Other Derivatives, 10th Edition,

We can roll futures contracts forward to

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