Chapter 11: Forward and Futures Hedging,

Spread, and Target Strategies

The beauty of finance and speculation was that they could

be different things to different men. To some: poetry or
high drama; to others, physics, scientific and immutable;
to still others, politics or philosophy. And to still others,
war.

Michael M. Thomas
Hanover Place, 1990, p. 37

Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 11: 1
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 Important Concepts in Chapter 11

 Why firms hedge

 Hedging concepts
 Factors involved when constructing a hedge
 Hedge ratios
 Examples of foreign currency hedges, intermediate- and
long-term interest rate hedges, and stock index futures
hedges
 Examples of spread and target strategies

Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 11: 2
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 Why Hedge?
 The value of the firm may not be independent of financial
decisions because
 Shareholders might be unaware of the firm’s risks.
 Shareholders might not be able to identify the correct
number of futures contracts necessary to hedge.
 Shareholders might have higher transaction costs of
hedging than the firm.
 There may be tax advantages to a firm hedging.
 Hedging reduces bankruptcy costs.
 Managers may be reducing their own risk.
 Hedging may send a positive signal to creditors.
 Dealers hedge their market-making activities in
derivatives.

Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 11: 3
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 Why Hedge? (continued)
 Reasons not to hedge
 Hedging can give a misleading impression of the
amount of risk reduced
 Hedging eliminates the opportunity to take advantage
of favorable market conditions
 There is no such thing as a hedge. Any hedge is an act
of taking a position that an adverse market movement
will occur. This, itself, is a form of speculation.

Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 11: 4
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 Hedging Concepts
 Short Hedge and Long Hedge
 Short (long) hedge implies a short (long) position in
futures
 Short hedges can occur because the hedger owns an
asset and plans to sell it later.
 Long hedges can occur because the hedger plans to
purchase an asset later.
 An anticipatory hedge is a hedge of a transaction that is
expected to occur in the future.
 See Table 11.1 for hedging situations.

Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 11: 5
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 Hedging Concepts (continued)
 The Basis
 Basis = spot price - futures price.
 Hedging and the Basis
  (short hedge) = S - S (from spot market)
T 0
- (fT - f0) (from futures market)
  (long hedge) = -S + S (from spot market)
T 0
+ (fT - f0) (from futures market)
 If hedge is closed prior to expiration,

 (short hedge) = St - S0 - (ft - f0)

 If hedge is held to expiration, S = S = f = f .
t T T t

Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 11: 6
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 Hedging Concepts (continued)
 The Basis (continued)
 Hedging and the Basis (continued)
 Example: Buy asset for $100, sell futures for $103. Hold

until expiration. Sell asset for $97, close futures at $97. Or

deliver asset and receive $103. Make $3 for sure.
 Basis definition
 initial basis: b = S - f
0 0 0
 basis at time t: b = S - f
t t t

basis at expiration: bT = ST - fT = 0


 For a position closed at t:

  (short hedge) = S - f - (S - f ) = -b + b
t t 0 0 0 t

Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 11: 7
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 Hedging Concepts (continued)
 The Basis (continued)
 This is the change in the basis and illustrates the
principle of basis risk.
 Hedging attempts to lock in the future price of an asset
today, which will be f0 + (St - ft).
 A perfect hedge is practically non-existent.
 Short hedges benefit from a strengthening basis.
 All of this reverses for a long hedge.
 See Table 11.2 for hedging profitability and the basis.

Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 11: 8
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 Hedging Concepts (continued)

 The Basis (continued)

 Example: March 30. Spot gold $1,387.15. June
futures $1,388.60. Buy spot, sell futures. Note:
b0 = 1,387.15 − 1,388.60 = −1.45. If held to expiration,
profit should be change in basis or 1.45.
 At expiration, let S = $1,408.50. Sell gold in spot
T
for $1,408.50, a profit of 21.35. Buy back futures at
$1,408.50, a profit of −19.90. Net gain =1.45 or
$145 on 100 oz. of gold.

Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 11: 9
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 Hedging Concepts (continued)
 The Basis (continued)
 Example: (continued)
 Instead, close out prior to expiration when

St = $1,377.52 and ft = $1,378.63.

 Profit on spot = −9.63. Profit on futures = 9.97.

 Net gain = 0.34 or $34 on 100 oz.

 Note that change in basis was b − b or

t 0
−1.11 − (−1.45) = 0.34.
 Behavior of the basis, see Figure 11.1.
 In forward markets, the hedge is customized so there is no basis
risk.

Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 11: 10
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 Hedging Concepts (continued)

 Some Risks of Hedging

 cross hedging
 spot and futures prices occasionally move opposite
 quantity risk

Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 11: 11
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 Hedging Concepts (continued)
 Contract Choice
 Which futures underlying asset?
 High correlation with spot

 Favorably priced

 Which expiration?
 The futures with maturity closest to but after the

hedge termination date subject to the suggestion not

to be in a contract in its expiration month
 See Table 11.3 for example of recommended

contracts for T-bond hedge

 Concept of rolling the hedge forward

Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 11: 12
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 Hedging Concepts (continued)
 Contract Choice (continued)
 Long or short?
 A critical decision! No room for mistakes.

 Three methods to answer the question.

See Table 11.4.

• worst case scenario method
• current spot position method
• anticipated future spot transaction method

Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 11: 13
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 Hedging Concepts (continued)
 Margin Requirements and Marking to Market
 low margin requirements on futures, but
 cash will be required for margin calls

Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 11: 14
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 Determination of the Hedge Ratio
 Hedge ratio: The number of futures contracts to hedge a
particular exposure
 Naïve hedge ratio
 Appropriate hedge ratio should be
 N = −S/f
−
f
 Note that this ratio must be estimated.

Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 11: 15
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 Determination of the Hedge Ratio (continued)
 Minimum Variance Hedge Ratio
 Profit from short hedge:
  = S + fN
f
 Variance of profit from short hedge:
   2 +  2N 2 + 2
 S f f SfNf
 The optimal (variance minimizing) hedge ratio is
 N = −
S f /   f
2
f
 This is the beta from a regression of spot price

change on futures price change.

Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 11: 16
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 Determination of the Hedge Ratio (continued)
 Minimum Variance Hedge Ratio (continued)
 Hedging effectiveness is
 e* = (risk of unhedged position − risk of hedged

position)/risk of unhedged position

 This is coefficient of determination from regression.

Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 11: 17
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 Determination of the Hedge Ratio (continued)
 Price Sensitivity Hedge Ratio
 This applies to hedges of interest sensitive securities.
 First we introduce the concept of duration. We start
with a bond priced at B:
T
CPt
B t 1 (1  y B ) t

 where CPt is the cash payment at time t and yB is the

yield, or discount rate.

Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 11: 18
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 Determination of the Hedge Ratio (continued)
 Price Sensitivity Hedge Ratio (continuation)
 An approximation to the change in price for a yield change is

DUR B (y)
B   B
1  yB
 with DURB being the bond’s duration, which is a weighted-average
of the times to each cash payment date on the bond, and 
represents the change in the bond price or yield.
 Duration has many weaknesses but is widely used as a measure of
the sensitivity of a bond’s price to its yield.
 Modified duration (MD) measures the bond percentage price
change for a given change in yield.

Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 11: 19
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 Determination of the Hedge Ratio (continued)
 Price Sensitivity Hedge Ratio (continuation)
 The hedge ratio is as follows:

 MD B  B 
N *f  
 MD 
 f 
 f  
 Where MDB −(/B) /yB and
MDf −(f/f) /yf
 Note the concepts of implied yield and implied duration
of a futures. Also, technically, the hedge ratio will
change continuously like an option’s delta and, like
delta, it will not capture the risk of large moves.

Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 11: 20
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 Determination of the Hedge Ratio (continued)
 Price Sensitivity Hedge Ratio (continued)
 Alternatively,
 N = −(Yield beta)PVBP /PVBP
f B f

• where Yield beta is the beta from a regression of

spot bond yield on futures yield and
• PVBPB, PVBPf is the present value of a basis
point change in the bond and futures prices.

Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 11: 21
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 Determination of the Hedge Ratio (continued)
 Stock Index Futures Hedging
 Appropriate hedge ratio is
 N = −(
−( S/f)(S/f)
f
 where  is the beta from the CAPM and  is the
S f
beta of the futures, often assumed to be 1.

Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 11: 22
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 Hedging Strategies

 Long Hedge With Foreign Currency Futures

 American firm planning to buy foreign inventory and
will pay in foreign currency.
 See Table 11.5.
 Short Hedge With Foreign Currency Forwards
 British subsidiary of American firm will convert
pounds to dollars.
 See Table 11.6.

Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 11: 23
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 Hedging Strategies (continued)
 Intermediate and Long-Term Interest Rate Hedges
 First let us look at the CBOT T-note and bond contracts
 T-bonds: must be a T-bond with at least 15 years to

maturity or first call date

 T-note: three contracts (2-, 5-, and 10-year)

 A bond of any coupon can be delivered but the

standard is a 6% coupon. Adjustments, explained in

Chapter 10, are made to reflect other coupons.
 Price is quoted in units and 32nds, relative to $100

par, e.g., 93 14/32 is $93.4375.

 Contract size is $100,000 face value so price is

$93,437.50

Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 11: 24
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 Hedging Strategies (continued)
 Intermediate and Long-Term Interest Rate Hedges
(continued)
 Hedging a Long Position in a Government Bond
 See Table 11.7 for example.

 Anticipatory Hedge of a Future Purchase of a Treasury

Note
 See Table 11.8 for example.

 Hedging a Corporate Bond Issue

 See Table 11.9 for example.

Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 11: 25
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 Hedging Strategies (continued)
 Stock Market Hedges
 First look at the contracts
 We primarily shall use the S&P 500 futures. Its

price is determined by multiplying the quoted price

by $250, e.g., if the futures is at 1300, the price is
1300($250) = $325,000
 Stock Portfolio Hedge
 See Table 11.10 for example.

 Anticipatory Hedge of a Takeover

 See Table 11.11 for example.

Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 11: 26
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 Spread Strategies
 Intramarket Spreads
 Based on changes in the difference in carry costs
 See Figure 11.2 for illustration.
 Treasury Bond Futures Spreads
 See Figure 11.3 and Figure 11.4 for illustration the
relationship between changes in spreads and interest
rates.
 See Table 11.12 for calculation of Tbond futures spread
profits.
 See Figure 11.5 for illustration of stock index spreads

Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 11: 27
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 Intermarket Spread Strategies

 Intermarket spread strategies involve two futures contracts

on different underlying instruments
 Intermarket spread strategies tend to be more risky than
intramarket spreads because there is both the change in
spreads and the change in underlying instruments
 NOB denotes notes over bonds
 Intermarket spread strategies could also involve various
equity markets

Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 11: 28
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 Target Strategies: Bonds

 Target Duration with Bond Futures

 Number of futures needed to change modified duration

 MD T - MD B  B 
N *f  
 
 f 
 MD f  

 Goal is to move the modified duration from its current

value to a new target value
 See Table 11.13 for illustration.

Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 11: 29
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 Target Strategies: Equities

 Alpha Capture
 Number of futures to hedge systematic risk

S
N *f  S  
f 
Goal is to move the eliminate systematic risk
 See Table 11.14 for illustration.
 Target Beta (see Table 11.15 for illustration.)
S
N *f    T  S   
f 

Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 11: 30
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 Target Strategies: Equities (continued)

 Tactical Asset Allocation

 Strategic asset allocation – long run target weights for
each asset class
 Tactical asset allocation – short run deviations in
weights for each asset class
 See Table 11.16 for illustration.

Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 11: 31
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 Summary
 Table 11.17 recaps the types of hedge situations, the nature
of the risk and how to hedge the risk

Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 11: 32
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 Appendix 11: Taxation of Hedging

 Hedges used by businesses to protect inventory and in

standard business transactions are taxed as ordinary
income.
 Transactions must be shown to be legitimate hedges and
not just speculation outside of the norm of ordinary
business activities. This is called the business motive test.

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