Scribd
Upload
27 views

Hedging: Long and Short

Hedging using futures contracts can help companies and investors manage risks from changes in prices, interest rates, and other market variables. Long futures positions can hedge against rising prices when purchasing an asset in the future, while short positions hedge against falling prices when planning to sell an asset. However, hedging also introduces basis risk from differences between the futures and cash prices. Choosing the optimal hedge ratio minimizes risk based on the correlation and volatility of the cash and futures positions. Rolling hedges forward using multiple futures contracts extends the time horizon but increases basis risk over time.

Uploaded by

Mahesh Suvarna
Copyright
© Attribution Non-Commercial (BY-NC)
Available Formats
Download as PPT, PDF, TXT or read online on Scribd
27 views

Hedging: Long and Short

Hedging using futures contracts can help companies and investors manage risks from changes in prices, interest rates, and other market variables. Long futures positions can hedge against rising prices when purchasing an asset in the future, while short positions hedge against falling prices when planning to sell an asset. However, hedging also introduces basis risk from differences between the futures and cash prices. Choosing the optimal hedge ratio minimizes risk based on the correlation and volatility of the cash and futures positions. Rolling hedges forward using multiple futures contracts extends the time horizon but increases basis risk over time.

Uploaded by

Mahesh Suvarna
Copyright
© Attribution Non-Commercial (BY-NC)
Available Formats
Download as PPT, PDF, TXT or read online on Scribd
You are on page 1/ 11

Hedging: Long and Short

 Long futures hedge appropriate when you


will purchase an asset in the future and fear
a rise in prices
– If you have liabilities now, what do you fear?
 Short futures hedge appropriate when you
will sell an asset in the future and fear a fall
in price
– If you expect to issue liabilities, what do you
fear?

1
Arguments For Hedging
 Companies should focus on their main
business and minimize risks arising from
interest rates, exchange rates, and other
market variables
– Non-intrusive risk management tool
 Hedging may help smooth income and
minimize tax liabilities
 Hedging may help smooth income and
reduce managerial salaries

2
Arguments Against Hedging
 Well-diversified shareholders can make
their own risk management decisions
 It may increase business risk to hedge
when competitors do not
 Explaining a loss on the hedge and a
gain on the underlying can be difficult

3
Basis Risk
 Basis is the difference between spot and
futures prices
 Basis risk arises because of uncertainty
about the price difference when the hedge
is closed out
 Basis risk usually less than the risk of price
or rate level changes
 Basis risk depends on futures pricing forces

4
Choice of Hedging Contract
 Delivery month should be as close as
possible to, but later than, the end of the
life of the hedge
 If no futures contract hedged position,
choose the contract whose futures price
is most highly correlated with the asset
price
– Called cross-hedging
– Additional basis risk

5
Naive Hedge Ratio
 Divide the face value of the cash position by
the face value of one futures contract
 Problems:
– Market values should be focus
– Ignores differences between the cash and
futures instruments
 Variation: divide the market value of the
cash position by the market value of one
futures contract

6
Minimum Variance Hedge
Ratio
 Proportion of the exposure that
should optimally be hedged is
 S  S,F
h   2
F F
hedge per dollar of cash market value
 Hedge ratio estimated from:
CPt    FPt  

7
Hedging Stock Portfolios
 If hedging a well-diversified stock portfolio
with a well-diversified stock index futures
contract, what are implications?
– No diversifiable risk in the cash stock portfolio
and futures hedge removes systematic risk
– Since no risk, systematic or unsystematic,
what can an investor expect to earn by
hedging a well-diversified stock portfolio?

8
Hedging Stock Portfolios
 But has all risk been eliminated?
 Problems:
– Stock portfolio being hedged may have a
different price volatility than the stock-index
futures
– Hedging goal is not to reduce all systematic
risk
 Price sensitivity to market movements
determined by beta

9
Hedging Stock Portfolios
 Optimal number of contracts to
hedge a portfolio is
(S   )
*
MV of spot portfolio

F MV of one futures contract
 Future contracts can be used to
change the beta of a portfolio
– If * >(<) S, hedging implies a long
(short) stock index futures position

10
Rolling The Hedge Forward
 What if hedging further in the future than
available delivery dates?
 Series of futures contracts used to
increase the life of a hedge
 Each time a futures contract matures,
switch position into another, later
contract
– Basis risk, cash flow problems possible

11

You might also like