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ISSUES
ASSUME
4. What is the optimal size of the futures position for reducing risk
ASSUME
1 Hedge-and forget
Increase Increase
Increase None
b1
b1 = S1 F1
b2 =S2 F2
F1
Long Hedge :
Futures price S2
b2 You hedge the future purchase of an asset by entering into a
long futures contract
F2
The effective price( ) that is paid with hedge is
S2 + F1 F2 = F1 + b2
basis risk()
Short Hedge :
You hedge the future sold of an asset by entering into a short
t1 t2 futures contract
Figure 3.1 Variation of basic over time The effective price( ) that is obtained for the asset
with hedge is S2 + F1 F2 = F1 + b2
3.3 Basis Risk
Choice of Contract
One key factor affecting basis risk is the choice of the futures contract
to be used for hedging. This choice has two components:
1. The choice of the assets underlying the futures contracts
2. The choice of the delivery month
S
h*
F
h* : Hedge ratio that minimizes the variance of the hedgers position.
: Coefficient of correlation between S and F
S : Change in spot price, S, during a period of time equal to the life of the hedge.
F : Change in future price, F, during a period of time equal to the life of the hedge.
S : Standard deviation of S
F : Standard deviation of F
3.4 Cross Hedging
Optimal Number of Contracts
()
h* NA
N* The futures contracts used should
QF have a face value of h* NA
P
N*
A
N*: Optimal number of futures contracts for hedging
P : Current value of the portfolio
A : Current value of one futures contract
: From the capital asset pricing model to determined
the appropriate hedge ratio
3.5 Stock Index Future
Example
Value of index in
900 950 1 ,000 1,050 1,100
three months
Time to maturity
Futures price of
1,010 1,010 1,010 1,010 1,010
index today
1
( 0.04 0.01)
Futures price of index 900 e 12
902 952 1,003 1,053 1,103
in three months
The gain from the short futures position
Gain on futures
= 30* ( 1,010 902 ) *250 = $ 810,000
810,000 435,000 52,500 697,500
position 322,500
The loss on the index = 10 %
Return on market 9.750% The
4.750%
index pays 0.250%
a dividend of5.250%
0.25%per 310.250%
months
The risk-free interest rate = 1 % per 3 months
Expected return An investor in the index would earn = 9.75 %
Expected
7.625% return on portfolio
0.125% 7.375% 14.875%
on portfolio 15.125%
==$15,000,000*(1
+ 1.5*( 9.75 0.15125)
1 ) = 15.125 %
= $4,243,750
Expected portfolio
5,368,75
value in three months 4,243,750 4,618,750 4,993,750 5,743,750
0
(including dividends) =$ 4,243,750 + $810,000
Total expected value
5,046,25
of position in three 5,053,750 5,053,750 5,046,250 5,046,250
0
months
3.5 Stock Index Future
A hedge using index futures removes the risk arising from market
and leaves the hedger exposed only to the performance of the
portfolio relative to the market.
P 5,000,000
( *) (1.5 0.75) 15( short )
A 250,000
To increase the beta of the portfolio to 2.0
P 5,000,000
( * ) (2 1.5) 10(long )
A 250,000
3.5 Stock Index Future