Forwards and Futures

Hedging
Hedging Issues
• Hedge by taking position in futures market
opposite to position taken in spot market.
• Gain (loss) on cash position offset by loss (gain)
on futures contract.

Example
• Investor holds 100 troy ounces of gold. Current
gold price is $1300/ounce. Investor concerned
that gold price may fall.
• Could sell the gold today. However:
– Large sale may depress market prices.
– Potentially large transactions costs.
– Investor may not want to sell gold (but simply
wants to protect against price declines).
• Can use forwards/futures to `lock in' position.

• Write (=sell) gold futures on 100 ounces, e.g., 6
month futures @ $1310/ounce sell for $10 each
(i.e., price is per ounce).
– (forward rate generally higher than spot, due
to `cost of carry').
– Investor receives $10 * 100 = $1000 today.
• Outcome in 6 months’ if gold falls to e.g., $1290: 
– Loss in value of gold: 100 * ($1290 - $1300) = -$1000
– Gain on futures 100*(1310 – 1290) = $2000.
– Net gain = 1000-1000+2000 = $2000.

• Outcome if gold rises to e.g., $1315
– Gain in value of gold: 100*(1315-1300) = $1500
– Loss on Futures: 100*(1310-1315) = -$500
– Net gain = 1000+1500-500 = $2000.
• Note that the above example starts with a non
marked-to-market contract (i.e., one that has a
market value not zero).
• Such price is what you see during the trading day.
• At the end of the day all contracts are marked-to
-market and hence as if they are ‘re-issued’ with
a new forward rate equal to that of the end-of
day price of the gold.
• In general, for marked-to-market contracts, the
gain/loss from movement in the spot price of
gold = change in the basis.
• If on day t the basis = $5, and on day t+1 it is $10
then the gain is 10-5 = $5.
• Similarly, if on day t the basis is $5 and on day t+1
is -$10 then the gain is -10-5=-$15
• Profit from hedges, therefore, is simply the
change in the basis.
• Thus, fluctuations in the basis, basis risk, is the
main concern in hedging.
• If contract prices move in tandem (perfect
positive correlation) with spot prices then basis
is constant and basis risk is zero.
• The lower the correlation the higher is basis risk.
• However, most times, futures price is positively
correlated (not perfectly) with the spot, i.e., basis
changes are less variable than spot price
changes.
• Thus, hedged positions are less risky than
unhedged positions.
• Because basis risk exists, hedging is usually not
perfect and hedging is a speculative activity that
produces lower risk levels than unhedged
positions.
Types of Hedges
• Cash Hedge
– Selling futures to cover a positive (spot or
cash) position. This is a ‘short hedge’.
• Anticipatory Hedge
– Buying futures to cover short position in the
spot, i.e., in anticipation of later cash/spot
purchase. This is a ‘long hedge’.
• Perfect hedges usually difficult to build.
• Risk is reduced to the extent that gain (loss) on
futures position offsets loss (gain) on cash
position.

Hedging Difficulty
Basis risk
• Perfect hedge only possible if futures and spot
prices of asset vary exactly in parallel (constant
basis).
• Seldom the case => basis risk.
• Generally, the longer the maturity of contract,
the larger the basis.

• Basis = forward rate (as specified in futures
contract) + MV of futures contract - CURRENT
spot price of asset.

• Basis due to timing differences.

Example – Stock Index Futures
• Current (spot) level of index = 3,000 points.
• Short term interest rate = 8%
• Expected dividend yield = 4%
• One year forward rate:
3,000*(1+0.08-0.04) = 3,120 points.

• When contract signed
– Spot level of index = 3,000
– Forward rate (fixed price specified in contract)
= 3,120
– MV of contract = 0
– Basis = + 120
• Note: when forward contracts entered into no
money exchanges hands as it is simply an
agreement on a transaction in the future, i.e., at t
= 0, MV of contract = 0.

• Prior to expiry between t = 0 and t = T, the basis
may not be =0.
• As index increases, MV of contract may increase
too but, due to less than perfect +1 correlation,
possibly by a different amount, i.e., basis risk.

• Example, half way through the contract maturity.
– Spot level of index e.g., = 3,100
– Forward rate = 3,120
– MV of contract e.g., = 50
– Basis = + 70
• At end of contract, no basis:
– Spot level of index e.g., = 3,400
– Forward rate = 3,120
– MV of contract MUST be = 280
– Since Basis Must be = 0
• Otherwise arbitrage is possible.
• At delivery (maturity), total cost of futures (MV +
forward rate price) = spot price (no basis)
• => no basis risk if hold contract to maturity.

• Less basis risk with short-term futures contracts
(better hedge), but more expensive (transactions
costs) than using long-term hedge.
Cross-hedging
• Futures contracts not available for all assets.
May have to use cross-hedge (futures contract
on different asset than asset to be hedged).

• Cross hedge established so that price of the
selected futures contract most closely
correlates with price of asset.

• E.g., hedge portfolio of shares. May hedge using
FTSE100 futures. However, your portfolio may
not match FTSE100 index.
• Futures prices volatile due to leverage
– =>small change in price of asset => large
change in futures price.

• While futures useful for hedging, futures trading
can result in large losses if speculate or
incorrectly hedge.



END