HEDGING STRATEGIES USING FUTURES

DERIVATIVES AND RISK MANAGEMENT

DERIVATIVES AND RISK MANAGEMENT :: ACV SUBRAHMANYAM Friday, 05 April 2024 1

 Basic Principles
Short Hedges
Long Hedges
Arguments for and Against Hedging
Shareholders
Competitors
Worse outcomes
Live cases
Regulation on Unhedged Forex Exposures – Moral Hazard
Basis Risk

DERIVATIVES AND RISK MANAGEMENT :: ACV SUBRAHMANYAM Friday, 05 April 2024 2

INTRODUCTION
• Participants in Futures markets is
mainly for the purpose of hedging

• Hedge offers protection from

unwanted movement

• In this case it is the prices of

underlying asset – crude oil, forex,
shares, commodities

• A prefect hedge eliminates all the

risks – they are rare

DERIVATIVES AND RISK MANAGEMENT :: ACV SUBRAHMANYAM Friday, 05 April 2024 3

BASIC PRINCIPLES
Hedgers (a company) takes a position in futures market to “neutralize” the risk to the maximum
What is in the control of the company – asset or product in its control
Produces oil, agricultural commodity
No control on market prices of the inputs or outputs (Principles of Economics – Perfect
Competition)
Movement in market prices away from expectation leads to gains or losses
Say ₹ 1,00,000/- is the expected profit or loss for ₹ 1 increase or decrease in output prices
What will happen to companies' revenue if the price “Ceteris Paribus” – All other things being equal
Increases by ₹10/- ( ₹ 10 Lakh higher revenue)
Decreases by ₹5/- (₹ 5 Lakh lower revenue)
The company wants to avoid this volatility in revenue / profit
Remember the company gains from increase in price and looses when prices fall
This is characteristic of a long position – the company should take a “short position” to neutralize risk
It can take a futures trade “short position” to counterbalance the price movement

DERIVATIVES AND RISK MANAGEMENT :: ACV SUBRAHMANYAM Friday, 05 April 2024 4

SHORT HEDGES • May Spot price of crude is $50
• Aug Futures price is $ 49
Short Position in Futures Contract • Locking price around $ 49
It is best when the company owns the asset/
underlying • Scenario 1:
Or expected to receive it in some time in future • Aug Spot price $ 45
• Market loss (45-49) = $(-4)
Exports who will receive forex for a sale in 2-3 • Futures gains (49-45) = $(+4)
Months • Neutralized
Wants to protect against volatility
No one know “future” price – best Knowledge is • Scenario 2:
current futures price • Aug Spot price $55
• Market gain (55-49) = $(+6)
Compute your revenue at the Current futures Price • Futures loss (49-55) =$(-6)
Fix a band for upside (price goes down) and • Neutralized
downside (price goes up) – Short Position
Take a futures position for offsetting the risk Ignore the effects of daily
settlements

DERIVATIVES AND RISK MANAGEMENT :: ACV SUBRAHMANYAM Friday, 05 April 2024 5

LONG HEDGES • May Spot price of copper is $340
• Aug Futures price is $ 320
• Locking price around $ 320
Long Hedge when party takes a Long Position
• Scenario 1:
Ideal for companies expecting to buy goods or underlying • Aug Spot price $ 325
Importer intending to pay for the goods in forex in future • Market loss (320-325) = $(-5)
Locking the price • Futures gains (325-320) = $(+5)
• Neutralized
Same as short position – no one knows future price
Compute profit and loss within a “band” around current • Scenario 2:
futures price • Aug Spot price $305
Long position • Market gain (320-305) = $(+15)
• Futures loss (305-320) =$(-15)
Price goes up – gain
• Neutralized
Price goes down – loss
Ignore the effects of daily settlements

DERIVATIVES AND RISK MANAGEMENT :: ACV SUBRAHMANYAM Friday, 05 April 2024 6

ARGUMENTS FOR AND AGAINST HEDGING

Hedging on the face of it looks very interesting and everyone should hedge their incomes/
revenues
Income hedge – Inflation indexed bonds – positive return over inflation
Sovereign Gold Bonds – always enables you to buy enough weight of gold at the market price
Hedging from a share holders' perspective
Hedging is not without costs – the aim is protecting some level of revenue / profits
[ neutralizes both upside and downside]
A well diversified share holder may hold stocks that counterbalance market movements
Suppose the shareholder has both stocks in copper producer and consumer - overall balance

DERIVATIVES AND RISK MANAGEMENT :: ACV SUBRAHMANYAM Friday, 05 April 2024 7

ARGUMENTS FOR AND AGAINST HEDGING

Hedging from Market/ competition perspective

Elastic prices of inputs and outputs without frictions
The producer can pass the costs/benefits without loosing market share
No need to hedge revenue remains neutral
Management does not support “risk aversion”
Loss is feared, but profits are preferred – No body thanks for risks avoided

DERIVATIVES AND RISK MANAGEMENT :: ACV SUBRAHMANYAM Friday, 05 April 2024 8

 HEDGING FROM A REGULATORY PERSPECTIVE – MORAL HAZARD

Explanatory Note to Reserve Bank of India (Unhedged Foreign Currency

Exposure) Directions, 2022
Unhedged foreign currency exposures of any entity are an area of concern not only
for the individual entity but also to the entire financial system.
Entities which do not hedge their foreign currency exposures can incur significant
losses during the period of heightened volatility in foreign exchange rates.
These losses may reduce their capacity to service the loans taken from the banking
system and increase their probability of default thereby affecting the health of the
banking system.
Source: Reserve Bank of India (Unhedged Foreign Currency Exposure) Directions, 2022

DERIVATIVES AND RISK MANAGEMENT :: ACV SUBRAHMANYAM Friday, 05 April 2024 9

HEDGING BY GOLD MINE COMPANIES – BUSINESS CASE

Gold Mines – willing to hedge future production of gold with gold futures prices
Sell 1000 Kg gold in 1 year at fixed price
How to Hedge this risk
Investment banker
Borrow gold from central bank – sell immediately in spot market
Take the proceeds and invest in risk free asset ( say t-bill for 1 year)
Buy gold from gold company and return to central bank
Set a fixed forward rate to the gold company
Forward price is fixed
As gold quantity is being exchanged risk is hedged

DERIVATIVES AND RISK MANAGEMENT :: ACV SUBRAHMANYAM Friday, 05 April 2024 10

LIVE EXAMPLES OF COMPANIES USING HEDGING FOR RISK MANAGEMENT
Apple Inc – Balance Sheet (10 K SEC Filing) HPCL Annual report
Derivative Instruments and Hedging The Company may use
derivative instruments to partially offset its business exposure 2.23. Derivative financial instruments
to foreign exchange and interest rate risk. However, the
Company may choose not to hedge certain exposures for a The Corporation uses derivative financial instruments, such
variety of reasons including accounting considerations or the
prohibitive economic cost of hedging particular exposures. as forward contracts, interest rate swaps to mitigate its
There can be no assurance the hedges will offset more than a
portion of the financial impact resulting from movements in foreign currency risk, interest risk and commodity price risk
foreign exchange or interest rates. The Company classifies arising out of highly probable forecast transactions and are
cash flows related to derivative instruments in the same section
of the Consolidated Statements of Cash Flows as the items presented in Financial Statements, either as Financial
being hedged, which are generally classified as operating
activities. Assets or Financial liabilities as the case may be

DERIVATIVES AND RISK MANAGEMENT :: ACV SUBRAHMANYAM Friday, 05 April 2024 11

“BASIS” RISK
Perfect Hedges are Rare in reality – at times there may not be market/ liquidity for the asset
class
Asset to be hedged may not be same as the underlying asset in futures contract
Jet fuel – Heating oil futures
Non-index stock ( say Union Bank using Bank NIFTY)
Uncertainty as to the exact date the asset will be bought or sold
Hedge may need to be closed before [Settled Before] delivery month of futures contract
All this will lead to Basis Risk
Basis = Spot price of the asset to be hedged – futures price of the contract used
Recall ! as contract approaches maturity “Spot Prices Converge to Futures Prices”
But before expiry or maturity the spot and futures prices may differ (non-zero deviation)
Strengthening of basis (increase in basis)
Weakening of basis (decrease in basis)

DERIVATIVES AND RISK MANAGEMENT :: ACV SUBRAHMANYAM Friday, 05 April 2024 12

CONVERGENCE OF SPOT AND FUTURE PRICES – LIVE EXAMPLES
Movement in NIFTY 50 and NIFTY 50 FUTURES Movement in BANK NIFTY and BANK NIFTY FUTURES
CLOSE PRICE FOR FEB-29-2024 EXPIRY CLOSE PRICE FOR FEB-29-2024 EXPIRY
23000 49000

22250 47250

21500 45500

20750 43750

20000 42000
1-Mar-28 17-Feb-28 6-Feb-28 21-Jan-28 10-Jan-28 28-Dec-27 14-Dec-27 29-Dec-27 19-Dec-27 8-Dec-27 29-Nov-27 17-Nov-27 8-Nov-27 28-Oct-27 18-Oct-27 7-Oct-27
NIFTY 50 NIFTY 50 Futures CP BANK NIFTY CLOSE BANK NIFTY FUTURES

DERIVATIVES AND RISK MANAGEMENT :: ACV SUBRAHMANYAM Friday, 05 April 2024 13

“BASIS” RISK (CONTD.)
Basis changes can improve or
S1 : Spot Price at time t1 worsen hedgers’ position

S2 : Spot Price at time t2 Short hedge:

F1 : Futures prices at time t1 Basis strengthens (increases)
F2 : Futures prices at time t2 Spot prices >> future prices
Benefits
b1 : Basis at time t1
Losses if Basis weakens
b2 : Basis at time t2
“ A futures contract is entered at time t1 and closed out at time t2” Long hedge:
b1 = S1 – F1 and b2 = S2 –F2 Basis strengthens (increases)
Spot prices >> future prices
Short futures position : S2 + F1-F2 (closing out) = F1+b2
losses
Long futures position : S2+F1-F2 (closing out) = F1+b2 gains if Basis weakens
F1 is known at time t1 and b2 is “basis risk”

DERIVATIVES AND RISK MANAGEMENT :: ACV SUBRAHMANYAM Friday, 05 April 2024 14

“BASIS” RISK WHEN UNDERLYING ASSET IS DIFFERENT – CROSS HEDGING
Asset being hedged is different from the asset used for futures
contract
S1 : Spot Price at time t1
S2 : Spot Price at time t2
S2* : Spot price of underlying asset in futures contract at t2
F1 : Futures prices at time t1
F2 : Futures prices at time t2
b1 : Basis at time t1
b2 : Basis at time t2
S2 + F1-F2
S2+F1-F2+S2*-S2*
F1+(S2*-F2) +(S2-S2*)
S2*-F2 : basis that would exist if hedged asset and underlying are
same
S2-S2*: this is due to difference in two assets

DERIVATIVES AND RISK MANAGEMENT :: ACV SUBRAHMANYAM Friday, 05 April 2024 15

Choice of Contract
Cross Hedging
Minimum Variance Hedge Ratio
Stock Index Futures
Stock indices
Hedging an Equity Portfolio
Reasons for Hedging an Equity Portfolio
Changing the Beta of a Portfolio
Locking in the Benefits of Stock Pricing
Stack and Roll
Hedging in India
Summary

DERIVATIVES AND RISK MANAGEMENT :: ACV SUBRAHMANYAM Friday, 05 April 2024 16

CHOICE OF CONTRACT
• Basis risk increases when time
difference between hedge expiration
and delivery month increases
Basis risk is influenced by two factors
The choice of asset underlying the futures contract • Rule
Simple case – asset hedged and underlying are same (else) • Chose delivery month close to
Complex case – finding underlying asset which are expiration, but later month
correlated with prices of hedged asset
The Choice of delivery month • QTLY settlement : March, June,
Expiration is in delivery month – chose delivery month ( Take September, December
position for May take 2M futures)
High volatility in delivery month – so generally next month is • December, January, February –
chosen for May take June Futures) March
Long hedger – taking position in delivery month may run the • March, April, May – June
risk of taking physical delivery
Generally close out the position and buy from regular • Liquidity for short maturity is higher
supplier (This neutralizes the Risk)
• Break down the hedging period to
short-term and re-take positions at
expiry (roll forward)
DERIVATIVES AND RISK MANAGEMENT :: ACV SUBRAHMANYAM Friday, 05 April 2024 17
“BASIS” RISK WHEN UNDERLYING ASSET IS DIFFERENT – CROSS HEDGING

https://
www.google.com/
finance/quote/
UNIONBANK:NSE?
sa=X&ved=2ahUKEwi
WrLzgxqeFAxXGRmc
HHTXqBcMQ3ecFeg
QIZhAf&window=6M&
comparison=NSE%3
ASBIN%2CNSE%3A
MAHABANK

DERIVATIVES AND RISK MANAGEMENT :: ACV SUBRAHMANYAM Friday, 05 April 2024 18

 CROSS HEDGING
Asset underlying futures contract same as the asset whose price is being hedged - SBI share and SBI
futures
Cross Hedging occurs when the two assets are different
Jet fuel Price hedged using heating oil
Non-Nifty stock using NIFTY futures
Necessity of cross hedge { the asset to be hedged might not have active futures market with adequate depth and
liquidity}
Hedge Ratio is the ratio of the size of the position taken in futures contracts to the size of the exposure

=
asset that is being hedged is same as the asset used in futures contract
6000 shares of SBIN
Lot size is 1500 * 4 Contracts = 6000
Hedge ratio is 1.0
Else (in case of cross hedge) the ratio is chosen to minimize the variance value of the hedged position
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 MINIMUM VARIANCE HEDGE RATIO

∆= h , h h h h
∆= h , h h h h
Let ∆ = + ∆ + ∈ ( a and b are constants with ∈ being the error term)
Variance value of hedge
position depends on ‘hedge
h hedge ratio defined as percentage ‘h’ of exposure S is hedged with futures
ratio’
∆ -h ∆ = + ( − h) ∆ + ∈ [ finding minimal value – first order conditions]
This equation is at minimum of b= h ; let this is be h* Hedge effectiveness can be
h= ∗ / defined as the proportion of
the variance eliminated by
Where hedging is equal to
∆
is the standard deviation of and
is the standard deviation of ∆ Observing historical data to
is the correlation coefficient between ∆ and ∆ compute , ,
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 Optimal Number of Contracts
= h ( ); = ( ) Absolute Change
∗ ^ ∗S
= optimal number of futures contract for hedging ^∗
h = ∗
Futures contracts should be on h* units of the asset (to be hedged) • ^ ∗F
Number of futures contracts required is therefore given by
∗
= ∗ / ^ ∗S∗
∗
= ^∗
• ^ ∗F ∗
Impact of Daily Settlements
^ = h − h (Absolute) Percentage Change
^ = h − h ( )
^ = Correlation between percentage one-day change in spot and futures prices
^h = ^ ∗ ^
S = spot price • ^
F = futures price
= h ( ); ^ ∗
= ( ) ∗
= ^∗
• ^ ∗
= ∗ h h h ;
= ∗ h h

= h^ ∗
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•
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 Stock Index Futures (Used for hedging risks to equity portfolios)
CGPA is an index ( average of (credits* grade points) across courses and semesters)
Stock Index tracks changes in value of hypothetical portfolio of stocks

∑
Weighted =
=
Weight of stock is equal to portion of the hypothetical portfolio invested in the stock
% increase in the stock index is equal to % increase in the value of hypothetical portfolio
Dividends are generally not considered (Total returns index – assumes dividends are reinvested)
Hypothetical portfolio of stocks remain fixed then weights are changed
Price of one stock rises faster than others it gets more weight
Alternatively construct portfolio with one stock each with weights being market prices
Some indices are constructed using weights based on market capitalization (No. of Shares *
Price)
Adjustments for stock splits, dividend, new equity issues etc.
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DERIVATIVES AND RISK MANAGEMENT :: ACV SUBRAHMANYAM Friday, 05 April 2024 22
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 • The Nifty 50 is computed
Stock Indices using a float-adjusted, market
•Nifty 50 capitalization weighted
•Nifty Next 50 methodology*, wherein the
•Nifty 100 level of the index reflects the
•Nifty 200 total market value of all the
•Nifty 500 stocks in the index relative to
•Nifty Midcap 150 a particular base period.
•Nifty Midcap 50
•Nifty Midcap Select • The methodology also takes
•Nifty Midcap 100 into account constituent
•Nifty Smallcap 250 changes in the index and
•Nifty Smallcap 50 corporate actions such as
•Nifty Smallcap 100 stock splits, rights issuance,
•Nifty LargeMidcap 250 etc., without affecting the
•Nifty MidSmallcap 400 index value.
•Nifty500 Multicap 50:25:25 https://www.niftyindices.com/indices/equity/
broad-based-indices/NIFTY-Next-50/NIFTY-50
•Nifty Microcap 250
•Nifty Total Market Cash Settlement - No Delivery

DERIVATIVES AND RISK MANAGEMENT :: ACV SUBRAHMANYAM Friday, 05 April 2024 23

 Hedging an Equity Portfolio Portfolio value : Rs. 5.00 Crore
Stock index futures used to hedge a well- diversified equity portfolio Index Futures Price is Rs. 1000
=
Contract lot size 250
= Current Value of the “one” futures contract (the futures price times the
contract (lot) size)
Compute N*
Two cases.
Va = 5.00 Crore
Case 1: Portfolio mirrors the index exactly hedge ratio can be
Vf = 250* 1000 = 2.50 Lakh
taken as “1” then Contracts to be shorted is ∗
= h^ ∗
N* = 5 CR/ 2.5 Lakh = 200 Contracts
Case 2: Portfolio does not mirror the index – a hedge ratio other
than “1” for optimal hedging (minimum variance hedge) Portfolio value : Rs. 5.00 Crore
Use of “Capital Asset Pricing Model CAPM” Computation of
Index Futures Price is Rs. 1000
∗
= ∗ { =1 , 1.5, 0.5, and 2 cases) Contract lot size 250, = 1.5

is the slope of the best-fit line when the return from the portfolio is Compute N*
regressed against the return for the index Va = 5.00 Crore
h is the slope of the best-fit line when percentage one day changes in Vf = 250* 1000 = 2.50 Lakh
the portfolio are regressed against percentage one day changes in the
futures price index N* = 1.5 *(5 CR/ 2.5 Lakh)
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= 300 Contracts
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DERIVATIVES AND RISK MANAGEMENT :: ACV SUBRAHMANYAM Friday, 05 April 2024 24
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 Changing the beta of a
portfolio

Hedging an Equity Portfolio ! objective is to protect the value of portfolio Altering using short or long
CAPM Model : Expected return = Risk Free Return + (Excess Market Return) ! Rf + (Rm-Rf) futures
Futures contract with 4 months to maturity used to protect portfolio for next three months
Portfolio value $ 5,050,000 ; Risk free rate 4 % per annum; Dividend Yield on index 1% per annum 30 contracts
Index value is 1000 and futures prices is 1010 and is 1.5 ( Index futures lot size is 250)
Compute number of contracts = 1.5 * 5,050,000 / (250*1010) = 30 • = 1.5 to reduce it to 0.75
10% upward and downward movement : 1000 ! 902 1000 ! 1100 • Take 15 short contracts
Gain in futures position (short position) 30 * (1010-902) * 250 = 8,10,000
Gain on portfolio compute the return • = 1.5 to increase to 2.0
Risk free return = 1 % ( 4% per annum i.e., 1% per quarter) • Take 10 long contracts
Return on index = negative 10 % ( 1000 to 902)
Dividend yield = 0.25%( 1% per annum i.e., 0.25% per quarter) • Reduce to * ( > ∗)
Actual Return = Return on Index + Dividend Yield = -9.75% Short
Expected return = Rf + (Rm-Rf) ! 1.0% + 1.5*( -9.75% - 1.0%) = -15.125%
Value of portfolio with expected return A(1+r) = 5,050,000 *(1+(-0.15125)) =$ 42,86,187
∗
= ( − ∗) ∗
Total Portfolio value = Value of portfolio + Gains from futures trade = $ 42, 86,187 + $ 8,10,000 = $50,96,187
Gain on total portfolio value = $ 50,96,187 - $ 5,050,000 = 46,187 ( ~0.9145% ~ 1% - the risk-free rate)
• Increase to *
( ∗ > )
∗
=( ∗− )∗
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DERIVATIVES AND RISK MANAGEMENT :: ACV SUBRAHMANYAM Friday, 05 April 2024 25
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 Reasons for Hedging an Equity Portfolio
Investor has 20000 shares @ ₹100 per
Hedging allows investor to grow the portfolio at risk free rate share
(Why take the trouble)
CAPM model Expected return = Rf + β (Rm-Rf) of the company is 1.1 with index
Market volatility affects expected return
Hedging using index futures (Rm) risk from market NIFTY contract 50 ; current price 2100
movements is eliminated
∗
Only exposed to risks to the portfolio return relative to market = ∗
Locking in the Benefits of Stock Picking
Investor is confident about his stock but not about the
market ( Domain or market analysis etc.) N = 1.1 * (20000*100 / 2100*50) ~ 21
contracts to be shorted
Investor View: Portfolio will outperform the index ( then
∗
short the index futures) = ∗ ( Short this Let's say Price of stock falls from 100 to 90
And index falls from 2100 to 1850
position)
Investor wants to hold for longer tenure and protect from Portfolio loss= 20000( 100-90) = -200000
short term market movements Futures gain = 21 *50 * (2100-1850) =
Alternative is to sell and buy later (but risks of transaction 262500
cost)
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Net gain = 62500/-
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DERIVATIVES AND RISK MANAGEMENT :: ACV SUBRAHMANYAM Friday, 05 April 2024 26
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 In April 2021, a Company knows it will have 100000
Stack and Roll barrels of oil in June 2022 ! Time gap 15 months
Hedge is required for a longer date than the delivery futures
Roll forward the position at the end of expiry 1 lot = 1000 barrels 100 contracts
Stack and roll
T1, T2, T3 and T4 Only 6 months delivery is available
Short at t1 and
Short at t2 close out Contract entered at T1 1. April 2021 Short 100 Contracts for Oct 2021
Short at t3 close out Contract entered at T2 2. Sept. 2021 Short 100 Contracts for Mar 2022
T Close out contract entered at T3 3. Feb. 2022 Short 100 Contracts for July 2022
Hedging in India
• Equity Markets – Futures and options
April spot price $ 49 and June 2022 spot is $ 46
• Currency Markets – Forwards and options
OCT 2021 Futures $ 48.20 closed at $47.40 = +$0.80
• Interest Rate Markets – Futures, forwards, and swaps
Mar 2022 Futures $ 47.00 closed at $ 46.50 = +$0.50
• Commodity Markets – Futures Contracts
July 2022 Futures $ 46.30 closed at $ 45.90 = +$0.40
Requirement of Hedging – Exposure
Total gain $1.70 ; loss if not hedged $ 3 (49 – 46)
Commodity / Currency/ Interest rates
Equity no requirement – speculative trades
Total loss cannot be averted but can be minimized
when futures price is below spot price

DERIVATIVES AND RISK MANAGEMENT :: ACV SUBRAHMANYAM Friday, 05 April 2024 27