Scribd
Upload
69 views

Risk Management Using Futures Contracts

The document discusses various risk management strategies using futures contracts, including long futures, short futures, long hedging, and short hedging. It also defines hedge ratio as the number of futures contracts used per unit of the underlying spot position. An optimal hedge ratio can be calculated using regression analysis by regressing changes in the spot price on changes in the futures price. The example shows calculating profits and losses from hedging a long spot position using the optimal hedge ratio.

Uploaded by

kurt09
Copyright
© Attribution Non-Commercial (BY-NC)
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PPT, PDF, TXT or read online on Scribd
69 views

Risk Management Using Futures Contracts

The document discusses various risk management strategies using futures contracts, including long futures, short futures, long hedging, and short hedging. It also defines hedge ratio as the number of futures contracts used per unit of the underlying spot position. An optimal hedge ratio can be calculated using regression analysis by regressing changes in the spot price on changes in the futures price. The example shows calculating profits and losses from hedging a long spot position using the optimal hedge ratio.

Uploaded by

kurt09
Copyright
© Attribution Non-Commercial (BY-NC)
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PPT, PDF, TXT or read online on Scribd
You are on page 1/ 17

Risk Management Using Futures

Contracts

By
Dr Surya Dev
Long Futures

• Strategy Buy futures contact.


• Situation Bullish outlook for the market. Price of
the underlying expected to increase.
• Risk Unlimited as the price of the
underlying, and hence of futures, falls, until it
reaches zero.
• Profit Unlimited. Depends on the upward
price movement.
• Break-even The price of the underlying (on
maturity) equal to the futures price contracted.
Profit

Stock price

Futures price

Loss
Short Futures
• Strategy Sell futures contact.
• Situation Bearish outlook for the market. Price of
the underlying expected to fall.
• Risk Unlimited as the price of the underlying,
and hence of futures, increase.
• Profit Unlimited. Depends on the downward
price movement until the price of the underlying
reaches zero.
• Break-even The price of the underlying (on
maturity) equal to the futures price contracted.
Profit

Futures price

Stock price

Loss
Long Hedging
• Strategy Short in spot market and long in futures
market, using appropriate hedge ratio.
• Situation Bullish outlook. Prices expected to rise.
• Risk No upside risk. Strategy meant to protect
against rising markets.
• Profit No profits, no loss. In case of price increase,
loss on the spot position offset by gain on futures
position. In case of price fall, gain on the spot position
offset by loss on futures position.
• Break-even None.
Long Futures

Profit

Stock price

Loss
Short Spot
Short Hedging
• Strategy Long in spot market and short in futures
market, using appropriate hedge ratio.
• Situation Bearish outlook. Prices expected to fall.
Protection needed against risk of falling prices.
• Risk No downside risk. Strategy meant to
protect against falling markets.
• Profit No profits, no loss. In case of price
increase, loss on the spot position offset by gain on
futures position. In case of price increase, gain on
the spot position offset by loss on futures position.

• Break-even None.
Long spot

Profit

Stock price

Loss
Short futures
Hedge Ratio
It is defined as the number of futures contracts to buy or sell
per unit of the spot good position.
One would believe that the size of the position taken in the
futures contracts should be the same as the size of the exposure
in the cash market so that hedge ratio is implicity 1.0. However
the optimal hedge ratio, depends on the extent and nature of
relative price movements of he futures prices and the cash good
prices.
Hedge Ratio
Calculation

The optimal hedge ratio, h*, for a risk minimising hedger can
be obtained by regressing changes in spot prices (∆ s) on
changes in futures prices(∆ f).

From the regression model we get

∆ s=α +β ∆ f

Where β = estimated yield ratio


Illustration
Month Spot Nearby FP Distant FP ∆s ∆f
price
Jan 603 617.2 Mar 624.6 Jun
Feb 609 619.5 Mar 627.8 Jun 6 2.3
Mar 601 603.2 Mar 614.7 Jun -8 -16.3
Apr 587 599.0 Jun 606.3 Sept -14 -15.7
May 598 608.4 Jun 612.7 Sept 11 9.4
Jun 596 597.1 Jun 604.9 Sept -2 -11.3
Jul 612 621.7 Sept 627.3 Dec 16 16.8
Aug 616 623.3 Sept 629.6 Dec 4 1.6
Sept 623 621.8 Sept 623.7 Dec 7 -1.5
Oct 614 622.4 Dec 628.4 Mar -9 -1.3
Nov 620 627.8 Dec 631.1 Mar 6 5.4
Dec 615 623.7 Dec 627.2 Mar -5 -4.1
Jan 621 629.2 Mar 632.8 Jun 6 2.0
Feb 618 627.2 Mar 631.2 Jun -3 -2.0
Mar 627 628.1 Mar 632.4 Jun 9 0.9
Apr 624 629.2 Jun 633.7 Sept -3 -3.2
May 630 639.3 Jun 642.1 Sept 6 10.1
Illustration

From Regression analysis we get

nΣ XY - Σ X Σ Y
β =
nΣ X2 - (Σ
X)2

Where X = change in futures price


Y = change in spot price
β = optimal hedge ratio

Ans beta is equal to 0.782


Illustration

Let us assume the current spot price is Rs 603 per quintal


and the futures price is Rs 630 per quintal. Suppose after
a certain period the spot price declines by Rs 7.2 and
the futures price would decline -7.2/0.782 = -9.21.
Therefore the futures price ids equal to Rs 620.79.

Apply optimal hedge ratio to check the movements of profit


and loss in both spot and futures market.
Illustration
Spot Market
Total quantity of wheat = 1200 quintals
Decline in spot price over the period = Rs 7.2 per quintal
thus, loss = 1200(595.8 - 603) = 1200 (-7.2) = Rs 8640

Futures market
No.of Futures contract sold = 0.782*1200/100 = 9.384
Selling price = Rs 630(per quintal)
Buying price = Rs 620.79 (per quintal)
therefore profit = 9.384 *100*(630 -620.79) = Rs 8642
Illustrations
• Hedging of a long position of 10,000 tonnes of XYZ by
selling XYZ futures. Assume that for every Rs 50 change
in futures prices, there is a Rs 35 change in cash prices. To
establish a minimum variance hedge, how many futures
contracts should be sold.

• A short position of 1000 shares of BPL Ltd is hedged by


shares of ACC ltd. Assume that every Rs 30 change in
futures price there is Rs 20 change in BPL cash prices.
Determine how many number of contracts are required to
minimize the risk.
Thank You

You might also like