Topic 3 Hedging strategies using futures

Objectives

Understand the concept of hedging; Know about nature and features of hedging; Study different issues associated with the way the hedges are set up. Understand risk traded in index futures market; To know about speculation in the futures market To study arbitrage opportunities in the futures market. To understand hypothesis in futures market

Hedgers & speculators

Introduction:
Today, the corporate units operate in a complex business environment. Profitability of their organizations heavily depends upon such factors which are beyond their control like commodity prices, stock prices, interest rates, exchanges rates, etc. As a result modern business has become more complex, uncertainty & risk. Futures market is permit managers to reduce or control risks by transferring it to others who are willing to bear risk.

In other words, futures markets can provide the managers certain tools to reduce and control their price risks. So the activity of trading futures with the objectives of reducing or controlling risk is called Hedging.
Ex. 1: Firm A is a manufacturer of automobile cars and they import auto parts from USA. Firm view that parts may increase in futures and thereby increase in cost of cars & significantly affect the profitability of the firm. So to hedge risk firm A enter into derivatives futures contract by locking todays prices for imported parts.

Ex 2: A farmer expects that there will be 5000 quintals of foodgrain, which he will harvest in coming month. He fears that price of food grain fluctuate in coming month. He enters into derivatives futures contract by delivering next month at an acceptable price known as anticipating hedging. Ex 3: A corporate treasurer intends to borrow money in middle of March for a three-months period. He may fear that interest rates will risen. So treasurer can do heding.

The Basic Long & Short Hedges: Basically, the hedging refers to by taking a position in the futures that is opposite to a position taken in cash market or to a future cash obligation that one has or will incur. Thus, the hedges can be classified into two categories; 1. Short Hedge 2. Long Hedge

1.

2.

Short Hedge: A short hedge is a hedge that involves short position in futures contract. It occurs when a firm/trader plans to purchase or produce a cash commodity sells futures to hedge the cash position. Being a short having a net sold position, or a commitment to deliver, etc. Long Hedge: A long hedge involves where a long position is taken in a futures contract. A long hedge is appropriate when a firm has to purchase a certain asset in futures and wants to lock in a price now. It is called as being long or having a net bought position or an actual holding of an asset.

Long Hedge: example

With an initial margin of Rs.1,25,000 in June, Ramesh, the speculator buys one September contract of gold at Rs.2500 per gram, for a total of 1,000 grams or Rs.25,00,000. By buying in June, Ramesh is Going Long with the expectation that the price of gold will rise by the time the contract expires in September. By August, the price of gold increases by Rs125 to Rs.2625 per grams and Ramesh decides to sell the contract in order to realize a profit. The 1,000 gram contract would now be worth Rs.26,25,000 and the profit would be Rs.1,25,000.

Given the very high leverage, by going long, Ramesh made a 100% profit. Of course, the opposite would be true if the price of gold per gram had fallen by Rs.125. Then speculator may realized a 100% loss.

Short Hedge: Example

With an initial margin deposit of Rs.9,000, Mr. X sold one May crude oil contract (one contract is equivalent to 1,000 barrels) at Rs.75 per barrel, for a total value of Rs.75,000.

By March, the price of oil had reached Rs.65 per barrel and

Mr.X felt it was time to cash in on his profits.

As such, he bought back the contact which was valued at Rs.65,000. By going short, Mr.X made a profit of Rs.10,000!

If Mr.X research had not been thorough, and he had made a

different decision, his strategy could have ended in a big loss.

Hedging Concept:
Hedging is act of protecting oneself against futures loss. Hedging is regarded as the use of futures transactions to avoid or reduce price risk in the spot market. In other words, a hedge is position that is taken as a temporary substitute for a later position in another asset (or liability) or to protect the value of existing position in an asset (or liability) until the position is liquidated.

Ex: In the month of Sep, 2010 A jute mill anticipate to sell

10000 candies of Jute in the month of Dec, 2010. Current price of Jute is Rs.1000 per candy. They buy 10,000 candies at Rs.1000 and enter into forward contract (Short) to sell at Rs.1470 per candy. Profit/Loss profile on Dec, 2010 Jute purchased = Rs.1000 per candy Jute proceeds (futures price) = Rs.1470 per candy Current market price = Rs.1500 Profit on sale = Rs.470 per candy Net cost of candy to mill = Rs.1030 (Rs.1000 + Rs.30)

The perfect Hedging model:

The perfect hedge is referred to that position which completely eliminate the risk. In other words, the use of futures or forward position to reduce completely the business risk is called perfect hedge. Ex: A jeweler manufacturer want to lock in a price for purchasing silver for the coming December. He can do by going Long futures if the silver prices rise or he can do by going Short futures if the silver prices fall.

Ex: A firm has inventory of 100 kg of silver and intends to sell in December. current price = Rs.60000/kg Price of silver may fall, to avoid the risk firm enters into Short position for Rs.60500/kg Revenue/Loss under two price scenarios: 1. Spot price rise to Rs.60800/kg 2. Spot price falls to Rs.59800/kg

1. Scenario Spot price = Rs.60800 Revenue = Rs.60800 x 100 = Rs.60,80,000 Profit/Loss = Qnty. (Future price Spot price) 100 ( 60500 60800) = Rs. -30,000 (loss) 2. Scenario: spot price = Rs.59,800 Revenue = Rs.59800 x 100 = Rs.29,80,000 Profit/Loss = 100 (60500 x 59800) = Rs.70000 (Profit)

Foreign currency futures: An Illustration

Contract : Long Position in a pound Contract Day : Monday Morning Maturity Day : Wednesday afternoon Agreed price : $1.70 for every1 (say for 62,000) Close price : Monday : $1.72 Tuesday : $1.73 Wednesday : $1.71 Find out Profit / Loss if the investor takes delivery of the pounds at the prevailing price of $1.71.

Solution:
Time Mon-Mng Close Action Cashflow Investor buys at $1.70 None Future price rises to $1.72 +1240 (receive) 62000 x (1.72 1.70) Tues-close Price rises to $1.73 + 620 (receive) 62000 x (1.73 - 1.72) Wed-close Price falls to $1.71 -1240 (pay) 62000 x (1.71 - 1.73)

Solution contd.. Investor takes delivery of

62,000

Investor pays 62,000 x 1.71 = $1,06,020 Net profit is $1240 + $620 - $1240 = $620

Speculation in the Futures market:

In order to make profits, speculators often take positions in the futures market without having a position in the underlying cash market based upon their expectations regarding the price movement of underlying asset.
These may be either naked positions or spread positions.

Ex: long hedging

Mr. X enter futures contracts on corn with one month expiration at a price $5.25 per bushel, he believe that price after one month will be in excess of $5.50 and he go for long on 100 contracts, each for 5,000 bushel. On the expiry if spot is $5.80, he make a profit of 100 x 5,000 x (5.80 5.25) = $275,000 If spot price is $4.75, then loss will be 100 x 5,000 x (4.75-5.25) = -$250,000

Hedging portfolio using Index Futures:

Stock Index Futures can be used to manage investment exposure & control the risk related to movements in equity market in a well diversified portfolio of stocks through the use of hedging strategies.
Investor takes a long position in a stock, he believes that it is undervalued and hopes to gain when its price increases & vice-versa in case of short position.

Adjusting the Beta of a portfolio using

Stock Index Futures

Portfolio managers adjust their portfolio betas in keeping with the changes in the risk-return offered by the stock market. When they believe that the stock market offers a relatively high expected return, for a given level of risk, they would increase the beta value of their portfolio. When they turn more bearish or feel that the market risk has increased, they would tend to lower their portfolio betas.

Risk management using Futures (Hedging):

Use of Index Futures: It is possible to manage only the systematic / market risk component of the price risk using index-based derivative products. An important concept in risk management must be considered, Beta. Beta is a measure of systematic risk. It measures the sensitivity of a scrip/portfolio vis--vis index movement.

Ex: A scrip with beta 2 will indicate a return of 20 per cent, when the index generates a return of 10 percent. If the index falls by 10 per cent, the scrip will fall by 20 percent. This indicates that the scrip is more volatile / risky than the index. Scrips/portfolios with beta in excess of 1 are called aggressive and with beta lower than 1 are called conservative scrips/portfolios.

Interpretation of Beta of Security:

The bench-mark, the index beta, is equal to 1.0. If the stock has if > 1, it is riskier than the market. Ex: if = 1.25 for a given stock
When the market increases by 10 percent, its value will increase by 12.5%, while if the market falls by 10 percent, the value of the stock would fall by 12.5 percent.

if = 0.92 for a given stock, then a 1% rise in the stock price index would lead to 0.92 percent rise in the stock value and a 1% fall in the index value would imply a 0.92% fall in the stock value. High beta shares -----prefer in bullish market condition. Low beta shares . Prefer in bearish market condition.

Portfolio Risk and Portfolio Beta:

Like for an individual security, the total risk of a portfolio of securities can also be decomposed as systematic and unsystematic risk. Total risk is a function of the number of securities in a portfolio.

Non-systematic risk can be reduced in a portfolio by increasing the number of securities in the portfolio.

Systematic Risk can be reduced in a portfolio by hedging with the index products. Beta factor for the portfolio: p = w1 1+ w2 2++ wn n Where, w1 w2 is the fraction of total investment placed in the respective securities. 1 2 . Corresponding beta factors.

Ex: Portfolio Beta

A portfolio managers own three securities, as detailed below; Security No. of shares Price per share Beta 1 15,000 Rs. 40 1.2 2 25,000 Rs. 20 1.8 3 15,000 Rs. 60 0.8 The beta value his portfolio is: Secty. Value Weight i iwi (Rs. in lax) (wi) 1 6 6/20=0.30 1.2 0.36 2 5 5/20=0.25 1.8 0.45 3 9 9/20=0.45 0.8 0.36 Total 20 1.17

Affects of changing portfolio:

The changes in the portfolio beta can be effected by selling or buying part of the portfolio and substituting risk free securities. Also, instead of buying/selling and substituting the securities which may involve significant transaction costs, the manager can bring about the desired changes by buying or selling index futures contracts instead.

Portfolio to Zero Hedging

* Portfolio Beta: p = w1 1+ w2 2++ wn n

No. of contracts =

Value of spot position requiring hedging ----------------------------------- x Portfolio Beta Beta Value of a futures contract

No. of contracts to sell (desired beta of the portfolio is less than existing beta) i.e., go for Short position: P (p p) = ----------------F No. of contracts to Buy (desired beta of the portfolio is less than existing beta) i.e., go for Long position: P (p p) = ----------------F where, P the value of the given portfolio

p - the value of the beta of the portfolio p - the desired value of beta F - the value of a futures contract Illustration: PP 73-74

Example: 2 (worksheet S&P Nifty)

Assume an investor has a portfolio & he fears a fall in the prices of the shares in the near future. In this situation, there are two options available to protect his portfolio: (i) To sell shares now and repurchase them later when they are cheaper; (ii) To sell the Nifty futures contracts and keep the portfolio intact.

Implications..

Option 1:

- It is likely to be more costly since selling the shares and repurchase require occurrence of transactions cost like brokerage, stamp duty, taxes etc. He likely lose amount because of illiquidity in the market. While selling he might have to quote a price slightly lower than the best bid to sell his entire portfolio. While buying shares, he might have to quote higher price to procure his purchases.

Option 2: - Impact cost and transaction costs are likely be lower in derivatives market than cash market. - If the share prices do fall, the investor would lose on the value of portfolio but gain on the futures contracts since he would have sold futures at relatively higher price. - If the share prices go up, he would lose on the futures contracts and gain in terms of the portfolio value. He can protected in Option 2

Arbitrage opportunities in the futures market:

Arbitrage is the simultaneous purchase and sale of an asset or replicating an asset in the market in an attempt to profit from discrepancies in its price. Arbitrager faces several issues; As arbitrage entails the simultaneous purchase & sale. In reality there is time lag between the execution of any two trades due to electronic, order driven markets, they move swiftly within seconds. The cost of transaction is the second key issue. It involved in different instruments and markets are generally different.

There are three types of arbitrage in the futures market; 1. Cash and carry arbitrage: long position in the cash or underlying market and a short position in the futures market. 2. Reverse cash and carry arbitrage: long position in the futures market and a short position in the underlying or cash market. 3. Inter-exchange arbitrage: two positions on the same contract in two different markets.

Basis Risk

Basis is the difference between the spot and futures price Basis risk arises because of the uncertainty about the basis when the hedge is closed out

38

Long Hedge
We define F1 : Initial Futures Price F2 : Final Futures Price S2 : Final Asset Price If you hedge the future purchase of an asset by entering into a long futures contract then Cost of Asset=S2 (F2 F1) = F1 + Basis

Illustration: 3.2 pp 64
39

Short Hedge
Again we define F1 : Initial Futures Price F2 : Final Futures Price S2 : Final Asset Price If you hedge the future sale of an asset by entering into a short futures contract then Price Realized=S2+ (F1 F2) = F1 + Basis

Illustration: 3.1 pp 64
40

Divergence of Futures and Spot Prices: The BASIS

Commodities are generally traded in cash market
or spot market at the market price, P0. The future price, Pt is the price of the commodity at some future point in time. The difference between the future price and

current price is know as the Basis.

Basis = Spot price Future price (Commodities)

Convergence:
In case of agricultural commodities, the basis may be expected to be Positive (ignoring the market pricing inefficiencies) due to
carrying costs with particular commodity storage costs, cost of funds invested in them & other costs incurred to keep the commodity in inventory until its delivery date. When the delivery month approached Future price equals to spot price. This phenomenon is known as Convergence

Convergencecontd.
Arbitrage opportunities: If the future price is higher than the spot price, an investors do well; (F1 > S1) - short sell a future contract; - buy the asset; - make the delivery to reap a profit. If the future price is lower than the spot price. (F1 < S1) - buy the future contract; - take the delivery.

Convergence of Futures and Spot Prices

Price
Price Spot Price

Futures Price

Spot Price

Futures Price Time

Time

Normal Market: When the future price is increase with maturity.

Inverted Market: When the future price is decrease with maturity.

Expected basis hypothesis:

In case of uncertainty, there are 3 hypothesis to the expected basis. These are; (a) Backwardation: (FP < SP) : If the future price is less than the spot price, or if the price of a near month contract is more than the price of far month contract, then the market is said to be in Backwardation.

Hedgers -- Sell the contract Speculators Buy the Contract Example; Contract
Spot March futures June futures

Price
500 485 470

September
December

450
440

(b) Contango (FP > SP):

With the price of futures contracts above the spot price initially, and declining over time, is known as Contango. Hedgers - buy the contract Speculators Sell the Contract Example: Contract Price
Spot March futures June futures September December 500 510 520 525 540

(c) Expectation Principle (FP = SP): The future prices are an unbiased estimate of expected future spot prices, in an efficient market. No return to Hedgers or Speculators.

End