Chapter 7

Risk Management with Futures Contracts

Be sure to read Sections 4.1 and 4.3 along with this
chapter.
Trading futures contracts with the objective of
reducing price risk is called hedging.
Not all risks faced by a business can be hedged via a
futures marketi.e., quantity risk.

David Dubofsky

Hedging Fundamentals
Hedging with futures typically involves taking a position in
a futures market that is opposite the position already held
in a cash market.
A Short (or selling) Hedge: Occurs when a firm holds a long
cash position and then sells futures contracts for protection
against downward price exposure in the cash market.
A Long (or buying) Hedge: Occurs when a firm holds a short
cash position and then buys futures contracts for protection
against upward price exposure in the cash market. Also known
as an anticipatory hedge.
A Cross Hedge: Occurs when the asset underlying the futures
contract differs from the product in the cash position
Firms can hold long and short hedges simultaneously (but for
different price risks).

David Dubofsky

Profit Profile for a Long Hedge

Change in profit

Q: Whats the Complaint

about flattening the payoff
profile to a horizontal line?

Change in price

A long hedge is
appropriate: buy
futures to hedge

A rise in the price of a

good will lower profits (or
firm value)

David Dubofsky

Profit Profile for a Short Hedge

Change in profit

Change in price

A decline in the price

of a good will lower
profits (or firm value)

A short hedge is
appropriate: sell
futures to hedge

David Dubofsky

Which Contract Should be Used?

If there is no futures contract on the asset being
hedged, use a cross hedge, and select a contract
whose price changes are as highly correlated as
possible with those of the spot asset.
The liquidity of the contract is also important.
The delivery month should be the same as, or just
after, the date the hedge will be lifted.
David Dubofsky

A Strip Hedge vs. a Stacked Hedge

Suppose a firm faces a series of dates (or periods) on
which it faces price risk. That is, it has a year (or longer)
of production. It can:
Use a strip of futures contracts, each with a different delivery
date.
Use a stack hedge, in which the most nearby and liquid contract
is used, and it is rolled over to the next-to-nearest contract as
time passes.

David Dubofsky

Strip Hedge Versus Stacked Hedge:

An Example

On March 1, an oil distributor agrees to deliver 10,000 bbl of crude oil in each of
the next 8 quarters, at a fixed price. The firm faces the risk that crude oil prices
will ___ (rise or fall?), and therefore will enter into a ___ (long or short?) hedge.

On March 1, the firm can:

trade 10 contracts for delivery in each of the next 8 quarters (This process is
known as a strip hedge.)
trade 80 June contracts. Then, in May, offset the June contracts and trade 70
Sept contracts. Then, in August, offset the Sept contracts and trade 60 Dec
contracts, etc. (This process is known as a stacked hedge.)

(Note: The last trading day of the June crude oil futures contract is
the last business day in May, etc.)

David Dubofsky

Basis and Basis Risk

Basis = Cash price (S) futures price (F). On the initiation day, basis (S 0
F0) is known.

The basis on the day the hedge is lifted is unknown (a random variable)
unless:
The day the hedge is lifted is the contracts delivery day
The contracts underlying asset, its quality and its location, are the same as
the cash item being hedged.

~ ~
Otherwise, S1 F1 is a random variable, and the hedger faces basis
risk.

In a cross hedge, there is always basis risk.

David Dubofsky

The Risk Minimizing Hedge Ratio

Consider the following: VH = (S)(QS) (F)NFQF, where:
VH = the value of the hedged portfolio
QS = the quantity of the spot/cash position being hedged
QF = the number of units of the underlying asset in one futures contract
used to hedge (on the opposite side of the cash market position)
NF = the number of futures contracts
S = change in the spot price of the good
F = change in the futures price

If VH = 0, then (S)(QS) = (F)NFQF, and the risk-minimizing number of

futures contracts to trade, NF*, is

NF*

Q S S
QF F

The fractional term, S/ F, is the Hedge Ratio.

David Dubofsky

Example Using the Hedge Ratio

Suppose you are long 1000 oz. of gold (in the cash market).
There are 100 oz. of gold per futures contract.
For every $0.90 change in the cash market, the futures price
changes by $1.00.
You want to engage in a risk minimizing hedge.
What position should you take in the futures market?
How many contracts should you use?

David Dubofsky

Example: Solution
Because you are long in the cash market, using a risk
minimizing hedge means that you should take a short position
in the futures market. Concerning the number of contracts:

Q S
*
N S
F Q F
F
N* (1000/100) (0.9/1.0)
F
N* 9
F

David Dubofsky

Optimal Hedge vs. A Full Hedge

A nave hedger might think 10 futures contracts should be sold to offset

the spot position of long 1000 oz. of gold. This is an example of a full
hedge, which will not be an optimal hedge when there is basis risk and
futures and cash prices dont move together.

Recall: VH = (S)(QS) (F)NFQF

Suppose you do the optimal hedge, i.e., long 1000 in spot and short 9
futures: VH = (90)(1000) (100)(9)(100) = 0.

Instead, suppose you do a full hedge, i.e., long 1000 in spot and short
10 futures: VH = (90)(1000) (100)(10)(100) = -100.

David Dubofsky

Note Bene:
It is really important to note here that we are
assuming that the relationship between the changes
in the spot price and changes in the futures price will
remain the same (i.e., at 0.90 to 1.00) over the time
period we are hedging.

David Dubofsky

Hedge Ratio: Example 2

Running the following regression equation results in an estimate

of the hedge ratio:
S = + F +

Then, = S/F, is an estimate of the hedge ratio.

Suppose you have a long position of 410,000 gallons of heating

oil.

You are concerned heating oil prices are going to ___ (rise or
fall?), and you want to protect your inventory value. Therefore,
you ___ (buy or sell?) heating oil futures).

David Dubofsky

Example 2, Cont.

There are 42,000 gallons of heating oil in one futures contract.

You estimate the following regression equation:

S = 0.0177 + 0.9837 F
R2 = 0.80

R2 is a goodness of fit measure for the regression model.

It should exceed 0.50 for effective hedging.
The higher it is, the more confident you will be of getting good results.
That is, the higher it is, the more confident you will be that the two prices
will move together in the future.

David Dubofsky

Example 2, Cont.
Q S
*
N S
F Q F
F
N* (410,000/4 2,000) (0.9837)
F
N* 9.60
F

So, sell either 9 or 10 contracts for a risk-minimizing hedge.

Sometimes, hedging is an Art.
David Dubofsky

The T-Account Approach

Cash Market:
Today: You are long 410,000
bbl of heating oil; S0 =
$0.74/bbl.

Later: Sell your oil at

$0.70/bbl

Futures Market:

Sell 9 heating oil futures

at F0 = $0.78/bbl.

Offset futures at: a)

$0.72/bbl, b) $0.741/bbl, c)
$0.77/bbl. (Basis risk!)

David Dubofsky

Another Example
Using historical data, you estimate:

S 21.47 1.31F.
You have committed to sell 5000 units of the cash good at the
market price one month hence. There are 1000 units of the
asset underlying each futures contract.
So: [buy/sell?] (1.31)(5000/1000) = 6.55 contracts.

David Dubofsky

Today:
Spot
Commitment to sell
5000 units; S0 = 23.00

Futures
Sell 6.55 futures at
F0 = 22.00

Suppose the model works perfectly (S/F = 1.31):

One month hence (scenario 1: ST =24.00; FT =22.763):
Sell good; receive $120,000 Futures Loss = $5,000
TOTAL REVENUE: $115,000 ($23.00/unit)
One month hence (scenario 2: ST = 20.00; FT = 19.710):
Sell good; receive $100,000 Futures Gain = $15,000
TOTAL REVENUE: $115,000 ($23.00/unit)

David Dubofsky

Note Bene:
If the futures price and the spot price change in the
predicted manner, you lock in the spot price. But in
general, you face basis risk. That is
You sell at S2, the spot price in the future, and
You realize profits or losses on the change in F.

With convergence (no basis risk at time T), just sell 5

futures contracts (a full hedge), and you lock in the
futures price. Example:

David Dubofsky

Today
Spot
Commitment to sell
5000 units; S0 = 23.00

Futures
Sell 5 futures at
F0 = 22.00

Suppose we have convergence:

One month hence (scenario 1: ST = 24 = FT )
Sell good; receive $120,000 Loss = $10,000
TOTAL REVENUE: $110,000 ($22.00/unit)
One month hence (scenario 2: ST = 20 = FT)
Sell good; receive $100,000 Gain = $10,000
TOTAL REVENUE: $110,000 ($22.00/unit)

David Dubofsky

When Running Your Regression Model,

the R2 is Important.

.
.

. .

.
High R

Low R2
David Dubofsky

Dollar Equivalency
Often, you cannot run a regression model to estimate a
hedge ratio. In this case, you must estimate the
following:
If the spot price changes adversely by, say, a dollar, how much
will you lose on your cash position? (= VS)
If the spot price changes by a dollar, how much of a change do
you estimate there will be in the futures price, and hence, in
the value of one futures contract? (= VF)

Then, trade NF* contracts so that

VS = (NF*)(VF)

David Dubofsky

Tailing the Hedge, I.

You want to tail a hedge when interest rates are high and/or the
time until the hedge-lifting date is long.
Instead of trading NF* contracts (as defined previously), trade the
present value of NF* contracts:
*
NF
rd

365

Where:
d = the number of days until the hedge is anticipated to be lifted.
r = the annualized appropriate interest rate.

David Dubofsky

Tailing the Hedge, II.

As time passes, the present value factor approaches
1.0, and by the day the hedge is lifted, your futures
position will equal NF*.
Tailing converts the futures position into a forward
position. It negates the effect of daily resettlement, in
which profits and losses are realized before the day
the hedge is lifted.

David Dubofsky