Unit 3

Futures Hedging Strategies

Concept of Hedging
• Hedging is a type of transaction designed to reduce or,
in some cases, eliminate risk.
• It is simply a technique designed to offset some
existing or anticipated risk which also causes one to
give up the possibility of a gain.
• The most commonly used financial derivative tools to
hedge risk are option, future, forward and swap.
• For e.g. if you subscribe to a magazine for three years
instead of subscribing one year at a time, you are
hedging against the risk of a rise in the price of the
magazine. You eliminate the potential loss due to an
increase in the price of a subscription, but you give up
the gain from a potential drop in subscription prices in
future.
 Fundamental Principles of Hedging
1. Long Hedge
 It means to hedge by going long in the futures market.
 Long hedge situation is faced when a party plans to purchase an asset at a
later date where the party is concerned about increase in the price of the
assets.
 For e.g. for a bread maker there is a worry that the price of wheat can
increase in future, so the bread maker would buy futures contract to reduce
upside price risk of wheat.
 Long hedge involves an anticipated transaction, so it is also called
anticipatory hedge.
2. Short Hedge
 It means to hedge by going short in the futures market.
 A trader who holds an asset and is concerned about a decrease in its price
might consider to hedge the risk of loss by taking short position in futures.
 For e.g. a farmer by agreeing through a futures contract to deliver a certain
amount of wheat at a specified future date and price avoids exposure to
unfavorable price movements. Such hedging reduce downside price risk of
wheat.
Arguments for and against Hedging
 There is an issue about hedging; (i) Why do corporation hedge? (ii) Should they
hedge?
 Many corporations hedged in different variables like interest rate, exchange rate and
price of different assets and still some risks are left unhedged.
 Arguments for and against hedging are discussed below:
1. Hedging and Shareholders
 One argument sometimes put forward is that the shareholders can, if they wish, do the
hedging themselves. They do not need the company to do it for them. This argument is,
however, open to question.
 It assumes that shareholders have as much information as the company’s management
about the risks faced by a company. In most instances, this is not the case. The argument
also ignores commissions and other transactions costs. These are less expensive per dollar
of hedging for large transactions than for small transactions.
 Hedging is therefore likely to be less expensive when carried out by the company than
when it is carried out by individual shareholders. Indeed, the size of futures contracts
makes hedging by individual shareholders impossible in many situations.
 One thing that shareholders can do far more easily than a corporation is diversify risk. A
shareholder with a well-diversified portfolio may be immune to many of the risks faced by
a corporation.
 For example, in addition to holding shares in a company that uses copper, a well-
diversified shareholder may hold shares in a copper producer, so that there is very little
overall exposure to the price of copper.
 If companies are acting in the best interests of well-diversified shareholders, it can be
argued that hedging is unnecessary in many situations. However, the extent to which
managers are in practice influenced by this type of argument is open to question.
Cont..
2. Hedging and Competitors
 Competitive pressures within the industry may be such that the prices of the goods and
services produced by the industry fluctuate to reflect raw material costs, interest rates,
exchange rates, and so on.
 A company that does not hedge can expect its profit margins to be roughly constant.
However, a company that does hedge can expect its profit margins to fluctuate!
 To illustrate this point, consider two manufacturers of gold jewelry, SafeandSure
Company and TakeaChance Company. We assume that most companies in the industry
do not hedge against movements in the price of gold and that TakeaChance Company is
no exception. However, SafeandSure Company has decided to be different from its
competitors and to use futures contracts to hedge its purchase of gold over the next 18
months.
 If the price of gold goes up, economic pressures will tend to lead to a corresponding
increase in the wholesale price of jewelry, so that TakeaChance Company’s gross profit
margin is unaffected. By contrast, SafeandSure Company’s profit margin will increase
after the effects of the hedge have been taken into account.
 If the price of gold goes down, economic pressures will tend to lead to a corresponding
decrease in the wholesale price of jewelry. Again, TakeaChance Company’s profit
margin is unaffected. However, SafeandSure Company’s profit margin goes down.
 In extreme conditions, SafeandSure Company’s profit margin could become negative as
a result of the hedging carried out.
 This example emphasizes the importance of looking at the big picture when hedging. All
the implications of price changes on a company’s profitability should be taken into
account in the design of a hedging strategy to protect against the price changes.
Cont…
3. Hedging can lead to a worse outcome
 Hedging does not guarantee that the outcome from hedging will
be good than the outcome from without hedging.
 It is important to realize that a hedge using futures contracts can
result in a decrease or an increase in a company’s profits relative
to the position it would be in with no hedging.
 Hedging reduces gains potential as well as loss potential and
sometimes lead to worst outcome if market goes in favor.
 For e.g. oil producer firm can enter into short future hedge for
protection from downside price risk. If price decreases, firm will
be better off but if price increases, firm cannot be in position to
sell at high price and regret for taking short hedge position.
Basis Risk
 Basis risk is the risk faced by hedged investor when the basis
will change.
 The basis in hedging situation is as follows:
Basis = Spot price of asset to be hedged (S0) - Futures price of contract
used (F0)
 If the asset to be hedged and the asset underlying the futures
contract are the same, the basis should be zero at the
expiration of the futures contract. Prior to expiration, the
basis may be positive or negative.
 An increase in the basis is referred to as a strengthening of
the basis and a decrease in the basis is referred to as a
weakening of the basis.
 For example, if the price of oil is $55 per barrel and the future
contract being used to hedge this position is priced at $54.98,
the basis is $0.02.
Cross Hedging
 A cross hedge is used to manage risk by investing in two
positively correlated securities that have similar price movements.
 The asset that gives rise to the hedger’s exposure is sometimes
different from the asset underlying the futures contract that is used
for hedging. This is known as cross hedging .
 Cross hedging occurs when the two assets are different it means
the assets whose price is to be hedged and the asset underlying
futures contract are not identical.
 The investor takes opposing positions in each investment in an
attempt to reduce the risk of holding just one of the securities.
Although the two securities are not identical, they have enough
correlation to create a hedged position, providing prices move in
the same direction.
 For instance, for an airline corporation, if futures on jet fuel are not
available in the international market then hedgers may use
contracts on other available energy products like crude oil or
gasoline due to its close association with jet fuel for hedging
purpose.