Hedging Strategies

Using Futures
Hedging Strategies Using Futures
Learning Objectives
• Understand basic principles of hedging with futures
• Distinguish between short and long hedges
• Learn about basis risk and its impact
• Calculate minimum variance hedge ratios
• Apply hedging to stock index portfolios
• Explore stack and roll strategies

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What is Hedging?
• Definition: Using futures markets to reduce specific risks
• Goal: Neutralize risk as much as possible
• Perfect Hedge: Completely eliminates risk (rare in practice)
• Key Participants: Companies exposed to price fluctuations in commodities,
currencies, interest rates, etc.

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Basic Hedging Principle
Objective: Take a position that neutralizes risk
Example: Oil producer expecting to sell 1 million barrels in 3 months
• Risk: Oil price might decrease
• Solution: Take short futures position
• Outcome: Gain on futures offsets loss on physical oil if price falls

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Short Hedges
When to Use:
• Already own an asset and expect to sell it in the future
• Will own an asset at some future time

Examples:
• Farmer with hogs ready for sale in 2 months
• U.S. exporter expecting euros in 3 months
• Oil producer with crude oil ready for delivery

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Short Hedge Example - Oil Producer
Scenario: May 15, oil producer will sell 1 million barrels in August
• Spot price: $50/barrel
• August futures: $49/barrel
• Strategy: Short 1,000 futures contracts

Outcome 1 (Price falls to $45):

• Spot revenue: $45 million
• Futures gain: $4 million
• Total: ~$49 million

Outcome 2 (Price rises to $55):

• Spot revenue: $55 million
• Futures loss: $6 million
• Total: ~$49 million

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Long Hedges
When to Use:
• Know you will purchase an asset in the future
• Want to lock in price now

Examples:
• Copper fabricator needing copper in 4 months
• Company planning future asset purchases
• Airline wanting to hedge fuel costs

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Long Hedge Example - Copper Fabricator
Scenario: January 15, need 100,000 pounds copper on May 15
• Spot price: 340 cents/pound
• May futures: 320 cents/pound
• Strategy: Long 4 futures contracts (25,000 pounds each)

If spot price on May 15 = 325 cents:

• Futures gain: 100,000 × ($3.25 - $3.20) = $5,000
• Net cost: approximately $320,000 (320 cents/pound)

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Arguments FOR Hedging
1.Risk Management: Companies lack expertise in predicting price variables
2.Focus on Core Business: Avoid unpleasant surprises
3.Cost Efficiency: Cheaper than individual shareholder hedging
4.Transaction Costs: Lower for companies than individuals
5.Market Access: Companies have better access to hedging instruments

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Arguments AGAINST Hedging
1.Shareholder Diversification: Well-diversified shareholders may not need
company-level hedging
2.Competitive Considerations: Industry norms matter
3.Potential for Worse Outcomes: Hedging can lead to opportunity costs

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Hedging Can Lead to Worse Outcomes
Example: Oil producer hedges at $50/barrel
• If oil price rises to $59, company loses $10/barrel on futures
• Treasurer may face criticism despite logical hedging decision
• Key Point: Hedging reduces risk but may reduce profits when prices move
favorably

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Long Hedge Example - Copper Fabricator
Scenario: January 15, need 100,000 pounds copper on May 15
• Spot price: 340 cents/pound
• May futures: 320 cents/pound
• Strategy: Long 4 futures contracts (25,000 pounds each)

If spot price on May 15 = 325 cents:

• Futures gain: 100,000 × ($3.25 - $3.20) = $5,000
• Net cost: approximately $320,000 (320 cents/pound)

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Basis Risk
The Challenge: Hedging is often not straightforward because:
1.Asset to be hedged may differ from futures contract asset
2.Uncertainty about exact hedge timing
3.Hedge may require closing before delivery month
▪ Basis = Spot Price - Futures Price

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Strengthening vs Weakening Basis
Strengthening Basis: Basis increases unexpectedly
• Benefits: Short hedgers
• Hurts: Long hedgers

Weakening Basis: Basis decreases unexpectedly

• Benefits: Long hedgers
• Hurts: Short hedgers

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Choice of Contract
Two Key Decisions:
1.Choice of underlying asset: Find futures contract most closely correlated with
asset being hedged
2.Choice of delivery month:
1. Choose month close to but later than hedge expiration
2. Consider liquidity (shorter maturity contracts often more liquid)

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Cross Hedging
Definition: Using futures on different asset than the one being hedged
Example: Airline hedging jet fuel using heating oil futures
Key Concept: Hedge ratio - ratio of futures position size to exposure size
• When assets match: hedge ratio = 1.0
• When cross hedging: hedge ratio ≠ 1.0

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Minimum Variance Hedge Ratio
Formula: h* = ρ(σₛ/σf)
Where:
• ρ = correlation coefficient between spot and futures price changes
• σₛ = standard deviation of spot price changes
• σf = standard deviation of futures price changes
▪ Optimal Contracts: N* = h*Q_A/Q_F

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Minimum Variance Hedge Ratio

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Hedge Ratio Example
Airline Hedging Jet Fuel:
• σf = 0.0313, σₛ = 0.0263, ρ = 0.928
• h* = 0.928 × (0.0263/0.0313) = 0.78
▪ Need: 2 million gallons jet fuel Contract Size: 42,000 gallons heating oil Optimal
Contracts: 0.78 × 2,000,000/42,000 = 37 contracts

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Hedge Ratio Example (daily)

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Stock Index Futures - Overview
Purpose: Hedge systematic risk in equity portfolios
Key Indices:
• Nifty: 50 most liquid stocks on NSE
• Bank Nifty: Banking sector index
• CNX IT: Information technology index
▪ Contract Details: Cash settled, no physical delivery

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Hedging Equity Portfolio
Basic Formula: N* = βV_A/V_F
Where:
• β = portfolio beta
• V_A = portfolio value
• V_F = value of one futures contract

Example: $5,050,000 portfolio, β = 1.5, futures price = 1,010

• V_F = 1,010 × 250 = $252,500
• N* = 1.5 × 5,050,000/252,500 = 30 contracts

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Stack and Roll Strategy
When to Use: Hedge expiration later than available futures delivery dates
Process:
1.Enter short futures contract for nearest delivery
2.Close position and "roll" to next delivery month
3.Repeat until hedge expiration
Example: April 2017 hedge for June 2018 exposure
• Use October 2017 → March 2018 → July 2018 contracts

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Daily Settlement Impact
Key Difference: Futures vs forwards
• Futures: Daily mark-to-market
• Forwards: Settlement at maturity

Refinement for Daily Settlement: N* = ĥV_A/V_F

▪ Where ĥ = ρ̂δₛ/δ_f (using daily percentage changes)

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Key Takeaways
1.Hedging reduces risk but may limit profit potential
2.Basis risk is the main source of hedging uncertainty
3.Minimum variance hedge ratio optimizes risk reduction
4.Stock index futures effectively hedge systematic risk
5.Stack and roll enables long-term hedging
6.Daily settlement requires strategy adjustments
7.Perfect hedges are rare - always consider basis risk

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