Hedging Using

Futures and
Forwards
Readings: Chapter 3
 Hedging with Futures/Forwards
 Hedging is as a way to reduce or eliminate risk of a position
(or, of a portfolio)
 In the context of futures/forwards , we will interpret hedging as
minimizing or eliminating the variance of the return on a
portfolio (i.e., a set of positions) at a particular date in the
future.
 Examples
• Pension/Mutual fund managers holding stock/bond
portfolios.
• Airlines purchasing fuel.
• Nestle and Hershey buying cocoa for chocolate production.
 Questions when deciding to hedge:
1. Where is your exposure coming from?
2. Should you hedge it?
3. If so, how much should you reduce the risk of your
portfolio?
4. What futures contract (underlying asset, maturity) to use?
5. How many contracts to trade?
 Ch. 3 (and these notes) are about answering questions 2
through 5
 Hedges: Some Definitions
 A hedge is a trade used to reduce some pre-
existing risk exposure due to uncertainty
about the evolution of asset prices.
 A static hedge is a hedge that, once entered,
is not rebalanced during the chosen hedging
horizon.
 A dynamic hedge is a hedge that must be
rebalanced periodically to continue to reduce
the pre-existing risk.
 For today and until otherwise indicated, we
will consider static hedges with futures and
forwards
 Short Hedges
 Involves a short position (commitment to
deliver/sell the underlying) in the futures
contract
 It is appropriate when the hedger owns
the underlying asset, expects to sell it in
the future and wants to lock in the selling
price
• Natural Long Positions: owns/holds underlying
now, or expects to receive underlying in the
future. Either way, needs to sell it. E.g., US
exporter and euros, farmer and wheat,
portfolio manager and S&P500, oil producer
• Concern (or, risk) is about decreasing prices
 If price decreases, profit on futures will
(fully or partially) offset losses in the spot
asset
 Long Hedges
 Involves a long position (commitment to
receive/buy the underlying) in the futures
contract
 It is appropriate when the hedger has (or,
expects) to purchase the asset in the future
and wants to lock in the buying price.
• Natural Short Positions: needs underlying, does
not have it yet. E.g., US importer and euros,
cereal producer and wheat, Portfolio manager
and S&P500
• Also appropriate for someone who is short the
underlying (e.g. from a short-sale)
• Concern is about increasing prices
 If price increases, profit on futures offset
higher costs in the spot market
 Short Hedge: Example
 April 20: Farmer negotiates to sell 50,000 bu of
corn at the spot price on June 20
 June 20 is futures maturity (or, expiry) date
 Quotes are given as follows:
• Spot price of corn: $3.50/bu
• June corn futures price: $3.35/bu (each
contract is for 5,000 bu) Sell corn at spot price
Short 10 June futures Close out futures

Apr 20 June 20

 Assume at June 20 (expiry) that spot price (ST) = futures

price (FT)
 What price overall (i.e., combining spot price with
futures gains and losses) will the farmer receive?
 Short Hedge: Example (cont’d)
 Scenario 1: Spot price June 20 $3.10/bu
Spot: Farmer sells corn at ($3.10)(50,000) = 155,000
Futures: Gain ($3.35 – $3.10)(50,000) = $12,500
Total received: $155,000 + $12,500 = $167,500.
price/bu = $167,500 / 50,000 = $3.35

 Scenario 2: Spot price June 20 $3.70/bu

Spot: Sell corn at ($3.70)(50,000) = $185,000
Futures: Loss ($3.70 – $3.35)(50,000) = $17,500
Total received: $185,000 – $17,500 = $167,500.
Price/bu = $167,500 / 50,000 = $3.35

 Either way, price is locked in (even though there is no

delivery in the futures market!)
 Notation

 S0: Spot price today

 St: Spot price at time t
 ST: Spot price at expiration
 F0: Futures price today
 Ft: Futures price at time t
 FT: Futures price at expiration
 t: some point prior to expiration
 T: last day of the hedge
Price paid/received from Futures Hedge
 How much does the futures hedger end up
paying/receiving for the underlying?

 Effective Pt = St + (F0 – Ft)

• Example: Gold Futures price today for Dec.
delivery is $1,800. On expiration, gold spot price
is $1,790 and gold futures price (for the Dec.
contract) is $1,820. What effective price does
short hedger receive for gold?
•  Pt = 1790 + (1800 – 1820) = $ 1770

 Notice that price effectively paid/received

depends on St and Ft, which are not known
today (time 0)
 But, then, Pt is not locked in today, is it??
 Perfect vs. Imperfect Hedges
 In the short hedge example (farmer…) we saw that
price risk is fully eliminated.
 Such a situation is defined as perfect hedge
 Perfect hedges occur if
• A) Derivative is written on the same assets being
hedged (corn  corn)
• B) Date asset being hedged will be traded is
known with certainty (Farmer knows it will be
June 20)
• C) Expiration date of derivative matches with
certainty date asset being hedged is traded
(June 20)
 Forwards (tailored) can achieve perfect hedge
 …if you find counterparty (but perhaps default risk)
 Perfect vs. Imperfect Hedges
 Hedging with futures contracts may not
yield a perfect hedge because:
• 1) There may be differences between the
hedged asset and the asset underlying the
futures contract
 i.e. hedging jet fuel with gasoline futures
• 2) The date on which the asset will be
purchased or sold may not be known with
certainty
• 3) There may be a mismatch between futures
contract expiration date and date when the
asset is bought or sold

 Each of these issues is related to the

concepts of basis and basis risk
 The Basis
 Basis = Spot price of asset to be
hedged – futures price of contract
used to hedge
 If the hedged asset is the same as
the asset underlying the futures
contract, the basis equals 0 on the
expiration day of the futures
(otherwise  arbitrage)
 Before the expiration day, the basis
can be positive or negative
 The Basis
 Initial basis: b0 = S0 – f0
 Basis at t: bt = St – ft
 Basis at expiration: bT = ST – fT
 The effective price received from a short
hedge closed out at time t is
 Pt = St + (F0 – Ft)
 = F0 + bt
hedge replaces the uncertainty about the
spot price with the uncertainty about the
basis
 The Basis: example

 Say the spot price today is $2.50,

the spot price at t is $2.00. The
current futures price is $2.20 and
the futures price at t is $1.90.
 What is the basis at each point in
time?
• b0 = S0 – F0 = $0.30
• bt = St – Ft = $0.10
 The Basis: Example (cont’d)
 The hedger owns the asset today (worth S0 ) and
will sell it for St at t. Today, he will also take a
short position in the futures. Thus, he will
• Receive St at t
• Gain f0 – ft on the futures position
• Total: St+f0-ft = f0+bt
• Total: 2.00+2.20-1.90 = 2.20+0.10
• Total: 2.30 = f0+bt, since bt = St – ft
 f0 is known today, but bt is unknown since St is
unknown today
 Since the change in the basis is less volatile than
changes in the spot price, the hedged position is
less risky than the unhedged one
 Basis and Basis Risk: Summary
 Basis risk arises because of the uncertainty
about the basis when the hedge is closed out
 Perfect hedges may not be possible due to
basis risk
 If hedges are held until expiration and there is
no asset mismatch, basis and basis risk are
reduced to zero (see slide #7)
 However, most hedges are either rolled forward
or are closed out prior to expiration, and/or are
subject to asset mismatch
  in those cases, basis risk arises and cannot
be hedged
 Asset Mismatch & Cross Hedging
 Sometimes a futures contract does not
exist for the asset to be hedged
 A cross-hedge in constructed using a
futures contract so that there is the
highest possible correlation among the
asset to be hedged and the asset
underlying the futures contract
 A typical example of cross-hedging is
using gasoline futures to hedge jet fuel
price risk (done by airlines)
 Rolling the Hedge Forward
 What happens if the expiration date on
the position to be hedged is later than
the delivery dates for all (or, liquid)
contracts available?
• The hedger can roll the hedge forward by:
 Closing out the initial futures position
 Taking the same position in the same contracts
with a later delivery date
 Doing it many times, if necessary
• Also referred to as “Stack and Roll”
• It may run into liquidity problems (see
Metallgesellschaft in Business Snap 3.2)
 Basis and Choice of Maturity
 Generally, basis risk increases as the time
difference between delivery month (for futures)
and date the underlying is traded increases
 Typically, one chooses contracts where such
difference is as close as possible but delivery
month for the futures is later
• Ex: Choose March contract for hedge
expirations in Dec, Jan, Feb
• Futures prices may be “too” volatile during
delivery month
• Taking delivery can be expensive and/or
inconvenient for, e.g., a cereal producer (long
hedger on wheat)
 Liquidity considerations may alter the choice
 Basis Risk and Size of Hedge
 I have a Natural Long Position of 1 million
barrels of crude oil: how many futures
contracts should I short?
 Restated, for every $ I’m exposed, what
% of that $ should I hedge?

 If there is no basis risk (and it was

decided that hedging should be done)
  the size of the hedge should equal the
size of the exposure. E.g.: Natural Long
Position of 1 million barrels of crude oil
should be hedged with short futures
position on 1000 contract (each contract is
for 1000 barrels)
 Basis Risk and Size of Hedge
 If basis risk is present the size of the
hedge that minimizes volatility does
not need to equal the size of the
exposure
 How do we, then, implement the
hedge in order to minimize volatility?
I.e., how many futures contracts do
we use?
 Optimal (i.e., Minimum Variance)
Hedge Ratio
 Hedge ratio: the ratio of the size of the
position taken in the futures contract to the
size of the exposure (natural position)

 Optimal hedge ratio is generally not 1,

unless…..

 Criterion for the optimal hedge is to minimize

the risk (specifically, variance) of the hedger’s
position

 Remember that the hedger’s position results

from the combination (i.e., a portfolio) of
futures and spot positions
 (More) Notation

• S: change is spot price during life of

hedge
• F: change in futures price during life of
the hedge
• S: standard deviation of S
• F: standard deviation of F
• : correlation between S & F
• h: hedge ratio
• h*: optimal (minimum variance) hedge
ratio
 Deriving h*
 Assume that the hedger is short the
futures and long the asset
• Then, the change in the value of the
position is S - hF
• The variance of the changes in the value
of the hedged position, ௉ଶ , is then
=Var(S)+h2Var(F)-2hSF
= S2+h2 F2-2hSF
 Deriving h *

 To minimize the variance of the

hedger’s position, compute the partial
derivative of portfolio variance w.r.t. h
ଶ
௉ ଶ
ி ௦ ி

 Set the first derivative equal to zero and

solve for h:

 This is the optimal hedge ratio

 Computationally, it is the slope coefficient of a
linear regression of ΔS on ΔF
 Optimal Hedge Ratio: Example
 A company will buy 1 million gallons of jet
fuel in 3 months
 (jet fuel, gasoline) = 0.80
 S = 0.032
 F = 0.040
 What is the optimal hedge ratio?
 h* = 0.80*(0.032/0.040) = 0.64
• The company needs 640,000 of gasoline to
hedge their jet fuel needs. Since each gasoline
contract covers 42,000 gallons, they need 15
or 16 contracts
 Optimal Number of Contracts
 From the last example we can justify the
formula for the optimal # of futures
contracts, N*
 N*= h*QA / QF

 where QA is the size of the position (# of

units of the underlying in the natural
position)
 and QF is the futures contract size
 Notice, though, that all of the above
derivations were based on quantities (S,
F, ,S,F ) defined over the life of the
hedge, i.e., ignoring daily settlements.
 Optimal Number of Contracts
 So, mathematically speaking, the previous
formulas for N* applies to hedges with forwards
 To compute N* for futures hedges a (typically
small) adjustment can be made. It can be shown
that for futures N* becomes
 N*= h*VA / VF

 where VA is the $$$ value of the position being

hedged and VF is the $$$ value of one futures
contract (= futures price*contract size)
 The above adjustment is known as tailing the
hedge
 It would suggest that N* should be adjusted very
frequently  transactions costs
 In many practical situations, though, tailing the
hedge makes little difference
 Hedging with Stock Index Futures
 We can use stock index futures to
hedge an existing equity portfolio
• Pension funds, mutual funds
 Define:
• VA: Current value in the spot mkt of the
portfolio to be hedged
• VF: Current value of one futures
contract (=futures price x contract size)
 Hedging with Stock Index Futures
 If the portfolio exactly mimics the
index and if the maturity of available
futures matches the hedging horizon
then the optimal hedge ratio should
be 1
 In such case, the optimal number of
contracts to be shorted is
N* = VA/VF
 Stock Index Futures Hedging
Example
 Suppose you have a portfolio worth
$10 million which mirrors the S&P
500 index. The current index value
in the futures market is 1254 and
each futures is $250 times the index
value. How many contracts should
be shorted?
 N* = VA/VF = 10 mill/(1254*250) =
31 or 32 contracts should be shorted
 Stock Index Futures Hedging
 What happens when the portfolio does not
perfectly mirror the index?
 We used the  from the CAPM to “weight”
the appropriate hedge ratio:
N* = (VA/VF)
 Note1: the formula assumes (again) no
maturity mismatch (or very small
mismatch such as a few days)
 Note2: if forwards are used instead of
futures, VF is the $ value of the assets
(index) underlying the forward
 Stock Index Futures Hedging:
Example
 S&P500 Spot = 1000
 Hedging horizon = 3 months
 S&P500 Futures 3 months = 1010
 Contract size = $250 times index
 Portfolio Value $5,050,000
 Portfolio beta = 1.5
 Risk-free rate = 4% p.a.
 Dividend yield on S&P500 = 1%
  N* = 1.5*5,050,000/(1010*250) = 30
 Stock Index Futures Hedging
Example cont’d: See Table 3.4 for Hedging
Performance (need to remember CAPM)
 Assume S&P500 spot in 3 months ends up at 900
and futures ends up at 902
 Need to include dividends when calculating
profits/losses on spot position
  Index Return Spot = -10% + 1%/4 = -9.75%
 Need to use CAPM to compute expected portfolio
return = 1% + 1.5*(-9.75%-1%) = -15.125%
 Need to compute value of overall (spot + futures
position)
 Repeat for different values of S&P spot and
futures in 3 months
 Table 3.4 shows that the overall value of the
hedger’s position does not vary (much) as the
S&P does. Actually, the hedger makes the risk
free rate. Why hedging then????
 Stock Index Futures:
Changing Betas
 Suppose instead you want to use
futures not to reduce betas to zero,
but to some other value (larger or
smaller than the current portfolio
beta)
 If the current beta is greater (less)
than the desired beta: a short (long)
position in N* contracts is required,
where N* = ( - *)(VA/VF) [or N* =
(* - )(VA/VF)]
 Arguments in Favor of Hedging
 Companies should focus on the main
business they are in and take steps to
minimize risks arising from interest
rates, exchange rates, and other
market variables
 Restated, most companies do not
have the (relative) expertize to
consistently predict those variables
 Yet, many risks are left unhedged…
 Arguments against Hedging
 Shareholders are usually well diversified
and can make their own hedging decisions
 To hedge when competitors do not may
increase risk
 Arguments against Hedging
 Explaining (to shareholders, to your
boss…) a situation where there is a loss
on the hedge and a gain on the
underlying can be difficult
 So, to hedge or not to hedge?
 It is crucial that the entire organization fully
understands the nature of chosen hedging
program
• At the very basic level, understand the hedging
is meant to reduce the risk (stdev) of outcomes,
not to increase their expected value!
 Ideally, hedging strategies should be set by board
of directors and clearly communicated to
management and shareholders
 Debate is far from obvious…
 And, hence, far from settled
 See FT article on “Gold Bulls” (to be covered in
Week 3)
 See https://www.macrotrends.net/1333/historical-gold-prices-100-year-chart