Hedging with Forwards & Futures

Hedging Fundamentals
 Hedging: The activity of trading futures with the objective of
reducing or controlling price risk (due to uncertainty about
future price levels) is called hedging.
 Output Price Risks: A farmer who is growing corn and
planning to sell it in six months (after harvest) cannot be
certain about what the price of corn will be in six months.
 Input Price Risks: An airline career that wish to set
passenger fares that remain fixed for the next six months
cannot be certain about what the price of jet fuel will be in six
months.
 Both output and input price risks can be reduced or controlled
by hedging.
 Hedging Fundamentals
The Basic Long and Short Hedges
 Hedging typically involves taking a position in forwards/futures that
is opposite either to
 A position that one already has in the cash market, or
 A futures cash obligation that one has or will incur
 There are two basic types of hedges: Short hedge and long hedge
 Short Hedge: A short hedge occurs when a firm which owns or
plans to produce a cash commodity, sells forwards/futures to hedge
the cash position.
 Cash price risk is declining cash prices
 Long Hedge: A long hedge occurs when a firm which plans to
purchase a cash commodity in either cash or forward market,
purchase futures to hedge the future cash position.
 Cash price risk is increasing cash prices
 Hedging Fundamentals
Short Hedge (with Zero Basis Risk)
 Suppose it is June 01. A cotton farmer in Lubbock planted cotton in
April, and expects to harvest 100,000 lbs of cotton in October.
 On June 01, the cash price for cotton is 55 cents/lb in the local
market and
 October NYBOT Cotton futures settled at 57 cents/lb.
 The farmer is worried that cash price of cotton at harvest (in
October) may decline significantly.
 The farmer may hedge against the declining price risk by short
hedging.
 To fully cover his expected cash position at harvest, the cotton
farmer needs to short 2 NYBOT Cotton futures (because the size of
NYBOT cotton futures is 50,000 lbs.)
 Perfect Hedging
Short Hedge (with Zero Basis Risk)
Date Cash Transaction Futures Transaction Basis

June 01 Local cash price = ¢/lb Fut. Price = ¢/lb − 2 ¢/lb

Exp. cash position =
100,000 lbs
Oct. 19 Harvest = 100,000 lbs Fut. Price = ¢/lb − 2 ¢/lb
Cash price = ¢/lb
Sell cash cotton at ¢/lb
Gain/Loss
Rev./Profit

Net Return (Cash Revenue + profit/loss from futures transaction)

Net realized price = Net Return /Cash position

 Perfect Hedging
Short Hedge (with Zero Basis Risk)
Date Cash Transaction Futures Transaction Basis

June 01 Local cash price = 55 ¢/lb Fut. Price = 57 ¢/lb − 2 ¢/lb

Exp. cash position =
100,000 lbs
Oct. 19 Harvest = 100,000 lbs
Cash price = 50 ¢/lb
Sell cash cotton at 50 ¢/lb
Gain/Loss Loss = (50−55=) −5 ¢/lb
Short 2 NYBOT cotton
futures at 57 ¢/lb
Fut. Price = 52 ¢/lb − 2 ¢/lb
Long 2 NYBOT cotton
futures at 52 ¢/lb
Gain = (57−52=) 5 ¢/lb 0

Revenue/Profit Rev. = $0.50×100,000 Profit = $0.05× 2×50,000

= $50,000 = $5,000
Net Return (Cash Revenue + profit/loss from futures transaction) $55,000

Net realized price = Net Return /Cash position (= $55,000/100,000) 55 ¢/lb

 Perfect Hedging
Long Hedge (with Zero Basis Risk)
 Suppose that a beef packer in Amarillo has a plant-capacity of
slaughtering 1,000 fed cattle per month. Each fed cattle weight
approximately 1,200 lbs.
 It is Oct 19. The cash price for live cattle is 75 cents/lb in the local
market, and Feb CME Live Cattle futures settled at 85 cents/lb.
 The beef packer plans to purchase live cattle in February from the
local market, but is worried that cash price for live cattle may
increase significantly in February.
 The beef packer may hedge against the increasing price risk by long
hedging.
 To fully cover her expected cash position in February, the beef
packer needs to long 30 CME Live Cattle futures (because the size
of CME Live Cattle futures is 40,000 lbs.)
 Perfect Hedging
Long Hedge (with Zero Basis Risk)
Date Cash Transaction Futures Transaction Basis

Oct 22 Local cash price = ¢/lb Futures Price = ¢/lb

Exp. cash position =
1,200,000 lbs
Feb 01 Local cash price = 80 ¢/lb Futures Price = ¢/lb
Purchase 1,000 cattle
@ 50 ¢/lb
Gain/Loss Loss = ¢/lb Gain = ¢/lb

Payment/Profit Payment = Profit =

= =
Net Payment (Cash payment - profit/loss from futures transaction)

Net price paid = Net Payment /Cash position (= ) ¢/lb

 Perfect Hedging
Long Hedge (with Zero Basis Risk)
Date Cash Transaction Futures Transaction Basis

Oct 22 Local cash price = 75 ¢/lb Fut. Price = 85 ¢/lb − 10 ¢/lb

Exp. cash position = Long 30 CME LC futures
1,200,000 lbs cont. @ 85 ¢/lb

Feb 01 Local cash price = 80 ¢/lb Fut. Price = 90 ¢ − 10 ¢/lb

Purchase 1,000 cattle Short 30 CME LC fut.
@ 50 ¢/lb contracts @ 90 ¢/lb
Gain/Loss Loss = (75−80=) −5 ¢/lb Gain = (90−85=) 5 ¢/lb 0

Payment/Profit Payment = $0.80×1,200,000 Profit=$0.05×30×40,000

= $960,000 = $60,000
Net Payment (Cash payment - profit/loss from futures transaction) $900,000
Net price paid = Net Payment /Cash position (= 900,000/1,200,000) 75 ¢/lb
 Hedging with Basis Risk
 When the basis remains unchanged, it is simple to construct
predictable, no-risk hedge.
 Unfortunately, perfect hedging is not usual in reality
 Like cash and futures prices, basis may change as well
 Basis may expand (absolute basis becomes larger) or shrink (absolute
basis becomes smaller)
 However, a change in the basis can affect the results of hedging
 Short Hedge
 Basis expands – net realized price is lower than the initial cash price
 Basis shrinks – net realized price is higher than the initial cash price
 Long Hedge
 Basis expands – net price paid is lower than the initial cash price
 Basis shrinks – net price paid is higher than the initial cash price
 Short Hedge (with Basis Risk)
Basis Expands
Change in Basis = Long Basis – Short Basis
Date Cash Transaction Futures Transaction Basis

June 01 Local cash price = 55 ¢/lb Fut. Price = 57 ¢/lb − 2 ¢/lb

Exp. cash position =
100,000 lbs
Oct. 22 Harvest = 100,000 lbs Fut. Price = ¢/lb ¢/lb
Cash price = 50 ¢/lb
Sell cash cotton at 50 ¢/lb
Gain/Loss

Revenue/Profit

Net Return (Cash Revenue + profit/loss from futures transaction)

Net realized price = Net Return /Cash position

 Short Hedge (with Basis Risk)
Basis Expands
Change in Basis = Long Basis – Short Basis
Date Cash Transaction Futures Transaction Basis

June 01 Local cash price = 55 ¢/lb Fut. Price = 57 ¢/lb − 2 ¢/lb

Exp. cash position =
100,000 lbs
Oct. 22 Harvest = 100,000 lbs
Cash price = 50 ¢/lb
Sell cash cotton at 50 ¢/lb
Gain/Loss Loss = (50−55=) −5 ¢/lb
Short 2 NYBOT cotton
futures at 57 ¢/lb
Fut. Price = 54 ¢/lb − 4 ¢/lb
Long 2 NYBOT cotton
futures at 54 ¢/lb
Gain = (57−54=) 3 ¢/lb − 2 ¢/lb

Revenue/Profit Rev. = $0.50×100,000 Profit = $0.03× 2×50,000

= $50,000 = $3,000
Net Return (Cash Revenue + profit/loss from futures transaction) $53,000

Net realized price = Net Return /Cash position (= $53,000/100,000) 53 ¢/lb

 Short Hedge (with Basis Risk)
Basis Shrinks
Change in Basis = Long Basis – Short Basis
Date Cash Transaction Futures Transaction Basis

June 01 Local cash price = 55 ¢/lb Fut. Price = 57 ¢/lb − 2 ¢/lb

Exp. cash position =
100,000 lbs
Oct. 22 Harvest = 100,000 lbs Fut. Price = ¢/lb ¢/lb
Cash price = 50 ¢/lb
Sell cash cotton at 50 ¢/lb
Gain/Loss

Revenue/Profit

Net Return (Cash Revenue + profit/loss from futures transaction)

Net realized price = Net Return /Cash position

 Short Hedge (with Basis Risk)
Basis Shrinks
Change in Basis = Long Basis – Short Basis
Date Cash Transaction Futures Transaction Basis

June 01 Local cash price = 55 ¢/lb Fut. Price = 57 ¢/lb − 2 ¢/lb

Exp. cash position =
100,000 lbs
Oct. 22 Harvest = 100,000 lbs
Cash price = 50 ¢/lb
Sell cash cotton at 50 ¢/lb
Gain/Loss Loss = (50−55=) −5 ¢/lb
Short 2 NYBOT cotton
futures at 57 ¢/lb
Fut. Price = 51 ¢/lb − 1 ¢/lb
Long 2 NYBOT cotton
futures at 51 ¢/lb
Gain = (57−51=) 6 ¢/lb + 1 ¢/lb

Revenue/Profit Rev. = $0.50×100,000 Profit = $0.06× 2×50,000

= $50,000 = $6,000
Net Return (Cash Revenue + profit/loss from futures transaction) $56,000

Net realized price = Net Return /Cash position (= $56,000/100,000) 56 ¢/lb

 Long Hedge (with Basis Risk)
Basis Expands
Change in Basis = Short Basis – Long Basis
Date Cash Transaction Futures Transaction Basis

Oct 22 Local cash price = 75 ¢/lb Fut. Price = 85 ¢/lb

Exp. cash position =
1,200,000 lbs
Feb 01 Local cash price = 80 ¢/lb Fut. Price = ¢/lb
Purchase 1,000 cattle
@ 50 ¢/lb
Gain/Loss Loss = ¢/lb Gain = ¢/lb

Payment/Profit Payment =0.80×1,200,000 Profit = $ × 30×40,000

= $960,000 =$
Net Payment (Cash payment - profit/loss from futures transaction)

Net price paid = Net Payment /Cash position (= ) ¢/lb

 Long Hedge (with Basis Risk)
Basis Expands
Date Change in Basis = Short Basis
Cash Transaction – Long
Futures Basis
Transaction Basis

Oct 22 Local cash price = 75 ¢/lb Fut. Price = 85 ¢/lb − 10 ¢/lb

Exp. cash position = Long 30 CME LC
1,200,000 lbs futures cont. @ 85 ¢/lb

Feb 01 Local cash price = 80 ¢/lb Fut. Price = 92 ¢ − 12 ¢/lb

Purchase 1,000 cattle Short 30 CME LC fut.
@ 50 ¢/lb contracts @ 90 ¢/lb
Gain/Loss Loss = (75−80=) −5 ¢/lb Gain = (92−85=) 7 ¢/lb − 2 ¢/lb

Payment/Profit Payment = $0.80×1,200,000 Profit=$0.07×30×40,000

= $960,000 = $84,000
Net Payment (Cash payment - profit/loss from futures transaction) $876,000

Net price paid = Net Payment /Cash position (= 876,000/1,200,000) 73 ¢/lb

 Long Hedge (with Basis Risk)
Basis Shrinks
Change in Basis = Short Basis – Long Basis
Date Cash Transaction Futures Transaction Basis

Oct 22 Local cash price = 75 ¢/lb Fut. Price = 85 ¢/lb

Exp. cash position =
1,200,000 lbs
Feb 01 Local cash price = 80 ¢/lb Fut. Price = ¢/lb
Purchase 1,000 cattle
@ 50 ¢/lb
Gain/Loss Loss = ¢/lb Gain = ¢/lb

Payment/Profit Payment =0.80×1,200,000 Profit = $ × 30×40,000

= $960,000 =$
Net Payment (Cash payment - profit/loss from futures transaction)
Net price paid = Net Payment /Cash position (= ) ¢/lb
 Long Hedge (with Basis Risk)
Basis Shrinks
Change in Basis = Short Basis – Long Basis
Date Cash Transaction Futures Transaction Basis

Oct 22 Local cash price = 75 ¢/lb Fut. Price = 85 ¢/lb − 10 ¢/lb

Exp. cash position = Long 30 CME LC futures
1,200,000 lbs cont. @ 85 ¢/lb

Feb 01 Local cash price = 80 ¢/lb Fut. Price = 87 ¢ − 7 ¢/lb

Purchase 1,000 cattle Short 30 CME LC fut.
@ 50 ¢/lb contracts @ 90 ¢/lb
Gain/Loss Loss = (75−80=) −5 ¢/lb Gain = (87−85=) 2 ¢/lb + 3 ¢/lb

Payment/Profit Payment = $0.80×1,200,000 Profit=$0.02×30×40,000

= $960,000 = $24,000
Net Payment (Cash payment - profit/loss from futures transaction) $936,000
Net price paid = Net Payment /Cash position (= 936,000/1,200,000) 78 ¢/lb
 Hedging Fundamentals
Price Risk versus Basis Risk
 While the objective of hedging is to reduce exposure to price risk,
hedgers trade price risk for basis risk (assumes basis risk).
 Hedging => reduces exposure to cash price risk, but increases
exposure to basis risk
 Cash Price Risk => the magnitude by which the cash price may
deviate from the mean (cash price)
 Typically measured by the variance (or by standard deviation)
 Basis risk => the magnitude by which the basis deviates from the
mean (basis)
 Typically measured by the variance (or by standard deviation)
 Basis: Bt, T = CPt − FPt, T
 Change in the basis: ∆Bt, T = ∆CPt − ∆FPt, T
 Hedging Fundamentals
Price Risk versus Basis Risk

 If the cash and futures prices always change by exactly the same amount,
there is no basis risk because the change in the basis is zero. When changes
in the cash and futures prices are not equal, there is basis risk.
 Basis risk is defined as the variance of the basis.
 B2   CP
2
  FP
2
 2  CP FP
 Where  B2 = Var(B ) = E[B2] – (E[B])2
= Var(CP − FP )
= Var(CP) + Var(FP ) – 2Cov(CP , FP)
  CP
2
= Var(CP ) = E[CP2] – (E[CP])2
  FP
2
= Var(FP) = E[FP2] – (E[FP])2
Cov(CP, FP)
 ρ = Correlation coefficient between CP and FP =
 CP FP
 Cov(CP, FP ) = E[CP×FP] – E[CP]× E[FP]
 Hedging Fundamentals
Price Risk versus Basis Risk

 Basis risk is defined as the variance of the basis.

 B2   CP
2
  FP
2
 2  CP FP
 Var (CP)  Var ( FP)  2Cov(CP, FP)
 = 0, if and ρ = 1

2
B > 0, if
 CP
2
  FP
2

2  CP
2
  FP
2
 TheBmagnitude of the basis risk depends mainly on the degree of correlation
between cash and futures prices
 Higher ρ => Lower basis risk
 Lower ρ => Higher basis risk
 For a hedge to be attractive, the basis risk should be significantly less than the
hedger’s cash price risk.
 Hedging Fundamentals
Anticipated Hedging Effectiveness

 One measure of anticipated hedging effectiveness is to compare the

basis risk that the hedgers expect to assume with the price risk they
expect to eliminate.
 The smaller the anticipated basis risk is compared to the anticipated
price risk, the more effective is the hedge. This measure of
effectiveness can be stated formally as
Var ( B)  B2
HE  1   1 2
Var (CP)  CP
 The closer HE is to 1, the more effective is the hedge.
 The higher the cash price risk relative to the basis risk (i.e., higher
variance of cash price relative to lower variance of the basis), the
more effective is the hedge.
 Hedging Fundamentals
Anticipated Hedging Effectiveness
Var ( B)2

HE  1   1  2B
Var (CP)  CP
  B2   CP
2
=> HE = 0 => no potential benefit from hedging

 B   CP => HE > 0 => hedging may be beneficial
2 2

  B2   CP
2
=> HE < 0 => hedging incurs a potential loss

 Anticipated hedging effectiveness is higher the lower is the basis

risk.
 The basis risk is lower the higher the correlation between the
cash and futures prices.
ρ↑ => σ2B ↓ => HE ↑
 Devising a Hedging Strategy

 A hedger faces three initial decisions:

 What kind of futures to use,
 Which contract month of that futures to use, and
 How many contracts to hedge with
 Which Futures Contract
 A hedger wants to maximize hedging effectiveness
 ρ↑ => σ2B ↓ => HE ↑
 The hedger chooses a futures contract the price of which is highly
correlated with the cash prices of the commodity (or asset) to be hedged
 Futures and cash prices of the same commodity are generally highly
correlated.
 When hedging a commodity on which no futures contract is traded, a
closely related commodity is used on which futures contract is traded –
cross-hedging
 Devising a Hedging Strategy

 Which Contract Month

 Typically, the prices of the nearest month futures contract are the
most highly correlated with cash prices. Thus, using the near
month futures contract reduces the basis risk the most.
 When hedging a continuous cash obligation for a long period of
time, hedgers have to decide between two alternatives:
 hedging with a nearby futures contract and rolling the hedge
forward
 Rolling the hedge often entails greater brokerage and execution costs.
 hedging with a more distant futures contract and rolling the hedge
less frequently.
 Using a more distant futures contract usually increases basis risk, since
its price would be less correlated with cash prices.
 Devising a Hedging Strategy
 How Many Futures Contracts
 Decide about the optimal futures position to assume - the number of futures
contract times the quantity represented by each contract
 In general, the number is determined by the hedge ratio – the ratio of the
size of the futures position to the size of the cash position.

Qf NFC  Q fc Qc
HR 
Qc = the quantity  ; NFC  being
HR hedged.
Qc of the Q
cash
c
commodity that
Q is
fc
Qf = the size (quantity) of the futures position = NFC×Qfc
Qfc = the size of the futures contract
NFC = Number of futures contracts
 The hedge ratio that minimizes risk is defined as
Q *f
HR * 
 Where, Q*f Qc risk
= the quantity of the commodity futures that minimize
 Devising a Hedging Strategy

∆VH = ∆CP× Qc − ∆FP× Qf

 ∆VH = the change in value of the total hedged position
 ∆CP = The change in the cash price
 ∆FP = the change in the futures price
 If the change in the value of the hedged position is set equal to zero
(making variability equal to zero), then
CP Q f CP
*

  Q*f   Qc  Q*f  HR *  Qc
FP Qc FP
 But, Q*f  NFC*  Q fc
 Where, NFC* = the number of contracts that minimize risk
Qfc = the size of the futures contract
 Devising a Hedging Strategy

 The number of futures contract with which to hedge in order to

achieve the minimum variance hedge is given by
NFC*  Q fc  HR*  Qc
Qc
NFC*   HR *
Q fc

 Estimating the Hedge Ratio

 There are two general techniques to estimate the hedge ratio:
 the naïve method and
 the regression analysis.
 Both procedures use historical price data to estimate the hedge ratio.
 Devising a Hedging Strategy

Estimating the Hedge Ratio  CP 

HR*  Mean 
 The naïve method:  FP 
 The regression analysis: HR   , where CPt     FPt  
*

 Another way of obtaining the estimate of the (regression analysis) hedge

ratio is to use the following formula
 CP
HR    
*

 FP

 σ∆CP = standard deviation of the changes in cash price (∆CP)

 σ∆FP = standard deviation of the changes in futures price (∆FP)
 ρ∆ = Correlation coefficient between ∆CP and ∆FP
Calculating Hedge Ratio from Cash and Futures Prices

CP FP Basis ∆CP ∆FP ∆CP/∆FP

March 61.40 68.98 -7.59
April 64.17 69.32 -5.15 2.77 0.34 8.25
May 64.99 67.88 -2.90 0.82 -1.44 -0.57
June 63.49 65.11 -1.63 -1.50 -2.77 0.54
July 60.32 62.80 -2.48 -3.17 -2.31 1.37
Aug 59.03 60.12 -1.09 -1.29 -2.68 0.48
Sep 58.05 60.31 -2.26 -0.98 0.19 -5.27

Mean 61.63 64.93 -0.56 -1.45 0.80

Variance 7.08 15.58 5.23 4.28 1.97
Std. Dev. 2.66 3.95 2.07 1.40
Covariance 7.47 1.61
Corr. Coeff. 0.71 0.56

HE 0.26
HR (Naïve) 0.80
HR (Regression) 0.82