Hedging Strategy

using Futures
Kumar Bijoy
9810452266
kumarbijoy@sscbsdu.ac.in
Hedges…
• Short Hedges
• A short hedge is a hedge involves a short position in futures contracts.
• It is appropriate when the hedger already owns an asset and expects to sell it
at some time in the future.
• Long Hedges
• Hedges that involve taking a long position in a futures contract
• A long hedge is appropriate when one has to purchase certain asset in the
future and wants to lock in a price now.
Basis Risk…
• Hedging is often not straightforward. Reasons are as follows:
• 1. The asset whose price is to be hedged may not be exactly the same as the
asset underlying the futures contract.
• 2. The hedger may be uncertain as to the exact date when the asset will be
bought or sold.
• 3. The hedge may require the futures contract to be closed out before its
delivery month.

These problems give rise to what is termed basis risk.

The Basis:
Basis = Spot price of asset to be hedged - Futures price of contract used
• As time passes, the spot price and the futures price for a particular
month do not necessarily change by the same amount. As a result,
the basis changes.
• An increase in the basis is referred to as a strengthening of the basis;
• A decrease in the basis is referred to as a weakening of the basis.
Basis Risk…
• To examine the nature of basis risk, we will use the following
notation:
• S1 : Spot price at time t1
• S2 : Spot price at time t2
• F1 : Futures price at time t1
• F2 : Futures price at time t2
• b1 : Basis at time t1
• b2 : Basis at time t2.
• Assume that a hedge is put in place at time t1 and closed out at time t2
• From the definition of the basis
b1 = S1 - F1 and b2 = S2 - F2
• Consider first the situation of a hedger who knows that the asset
will be sold at time t2 and takes a short futures position at time t1.
• Price realized for the asset is S2 and profit on the futures position is
F1 - F2.
• The Effective price that is obtained for the asset with hedging is
therefore
S2 + F1 - F2 = F1 + b2
As an example
• Consider the case where the spot and futures prices at the time the
hedge is initiated are $2.50 and $2.20, respectively, and that at the
time the hedge is closed out they are $2.00 and $1.90, respectively.
• This means that
• S1 = 2.50,
• F1 = 2.20,
• S2 = 2.00, and
• F2 = 1.90.
Since, b1 = S1 - F1 and b2 = S2 - F2
So, b1 = 0.30 and b2 = 0.10.
Calculate the Effective Price:
 Effective price = S2 + F1 - F2 = F1 + b2 = $2.30
• The value of F1 is known at time t1.
• If b2 were also known at this time, a perfect hedge would result.
• Hedging risk is the uncertainty associated with b2 and is known as basis risk
Consider a company that uses a short hedge because it plans to sell the
underlying asset:
If the basis strengthens (i.e., increases) unexpectedly, the company’s
position improves because it will get a higher price for the asset after futures
gains or losses are considered;
If the basis weakens (i.e., decreases) unexpectedly, the company’s
position worsens.
For a company using a long hedge because it plans to buy the asset, the reverse
holds.
Note: basis changes lead to an improvement or worsening of a hedger’s position.
Cross hedging…
• Hedging through different underlying
• It leads to an increase in basis risk.
• If S2* is the price of the asset underlying the futures contract and S2 is
the price of the asset being hedged at time t2. By hedging, a company
ensures that the price that will be paid (or received) for the asset is
S2 + F1- F2
This can be written as
F1 + (S2*- F2)+ (S2 - S2*)
• The terms (S2* - F2) and (S2 - S2*) represent the two components of
the basis.
• The (S2* - F2) term is the basis that would exist if the asset being hedged were
the same as the asset underlying the futures contract.
• The (S2 - S2*) term is the basis arising from the difference between the two
assets.
Example..
• It is March 1. A US company expects to receive 50 million Japanese
yen at the end of July. Yen futures contracts on the CME Group have
delivery months of March, June, September, and December. One
contract is for the delivery of 12.5 million yen. The company therefore
shorts four September yen futures contracts on March 1. When the
yen are received at the end of July, the company closes out its
position. We suppose that the futures price on March 1 in cents per
yen is 0.9800 and that the spot and futures prices when the contract
is closed out are 0.9200 and 0.9250, respectively.
What is the total amount received by the company?
Solution..
• Gain on the futures contract: 0.9800 – 0.9250 = 0.0550 cents per yen.
• The basis is 0.9200 - 0.9250 = -0.0050 cents per yen when the
contract is closed out.
• The effective price obtained in cents per yen is the final spot price
plus the gain on the futures: 0.9200 + 0.0550 = 0.9750
• This can also be written as the initial futures price plus the final basis:
0.9800 + (-0.0050) = 0.9750
The total amount received by the company for the 50 million yen is
50 x 0.00975 million dollars, or $487,500.
The hedge ratio…
• The hedge ratio is the ratio of the size of the position taken in futures
contracts to the size of the exposure.
• The minimum variance hedge ratio (h*)depends on the relationship
between changes in the spot price and changes in the futures price.
ΔS: Change in spot price, S, during a period of time equal to the life of
the hedge
ΔF: Change in futures price, F, during a period of time equal to the life of
the hedge
Optimal Number of Contracts…
Optimal Number of Contracts…Example
• An airline expects to purchase 2 million gallons of jet fuel in 1 month
and decides to use heating oil futures for hedging. Data on the ΔS in
the jet fuel price per gallon and the corresponding ΔF for the contract
on heating oil for 15 successive months is given in next table, that
would be used for hedging price changes during the month.
• In this case, the usual formulas for calculating standard deviations
and correlations give σF = 0.0313, σS = 0.0263, and ρ= 0.928:
Data to calculate minimum variance hedge ratio when heating oil
futures contract is used to hedge purchase of jet fuel.
Interest Rates….
• Nominal Interest rate
• Real Interest rate
• Inflation
• Fischer Equation: (1+ i) = (1+r)(1+π) or
i=r+π+rπ
• Yield Curve
• Term Structure
• zero rates
• Bootstrap
• Treasury rates
• LIBOR
• Continuous Compounding: 𝑒 𝑟𝑡
Bootstrapping Solution
• Bootstrapping is a method for constructing a zero-coupon yield curve
from the prices of a set of coupon-bearing products
• The bootstrapping method uses interpolation to determine the yields
for Treasury zero-coupon securities with various maturities.
Determining Treasury zero rates
• The first three bonds pay no coupons, the zero rates corresponding to
the maturities of these bonds can easily be calculated.
• The 3-month bond has the effect of turning an investment of 97.5
into 100 in 3 months. The continuously compounded 3-month rate R
is therefore given by solving
Price Quotations of Treasury Bills
• The prices of money market instruments are sometimes quoted using
a discount rate.
• This is the interest earned as a percentage of the final face value
rather than as a percentage of the initial price paid for the
instrument.
• If the price of a 91-day Treasury bill is quoted as 8, this means that
the rate of interest earned is 8% of the face value per 360 days.
Suppose that the face value is 100.
• Interest of 2.0222 (=100 x 0.08 x 91/360) is earned over 91-day life.
• This corresponds to a true rate of interest of 2.0222/(100-2.0222)=
2.064% for the 91-day period.
quoted price of a Treasury bill
• In general, the relationship between the cash price per 100 of face
value and the quoted price of a Treasury bill
360
𝑃= (100-y)
𝑛
Where
P is the quoted price,
Y is the cash price, and
n is the remaining life of the Treasury bill measured in calendar
days.
• For example, when the cash price of a 90-day Treasury bill is 99, the
quoted price is 4.
Price Quotations of US Treasury Bonds
• Treasury bond prices in the United States are quoted
in dollars and thirty-seconds of a dollar.
• The quoted price is for a bond with a face value of
$100.
5
• Thus, a quote of 90-05 or90 indicates that the
32
quoted price for a bond with a face value of $100,000
is $90,156.25
Cash price
• The quoted price, which traders refer to as the clean price, is not the
same as the cash price paid by the purchaser of the bond, which is
referred to by traders as the dirty price.
• In general,
Cash price = Quoted price + Accrued interest since last coupon date
Example… Cash Price
• Suppose on March 5, 2015, the bond under consideration is an 11%
coupon bond maturing on July 10, 2038, with a quoted price of 95-16
or $95.50.
• Because coupons are paid semi-annually on government bonds (and
the final coupon is at maturity), the most recent coupon date is
January 10, 2015, and the next coupon date is July 10, 2015.
Calculate the Cash Price?
• Actual no of days between Jan 10, 2015 and March 5, 2015 = 54,
• Actual no of days between Jan 10, 2015 and July 10, 2015 = 181.
• On a bond with $100 face value, the coupon payment is $5.50 on
January 10 and July 10.
• The accrued interest on March 5, 2015 is the share of the July 10
coupon accruing to the bondholder on March 5, 2015.
• Because actual/actual in period is used for Treasury bonds in the
United States, this is
54
x $ 5.5 = $ 1.64
181
The cash price per $100 face value for the bond
= $95.50 + $1:64 = $97.14
Thus, the cash price of a $100,000 bond is $97,140.
Conversion Factors
• Treasury bond futures contract allows the party with the short position
to choose to deliver any bond that has a maturity between 15 and 25
years.
• When a particular bond is delivered, a parameter known as its
conversion factor defines the price received for the bond by the party
with the short position.
• The applicable quoted price for the bond delivered is the product of the
conversion factor and the most recent settlement price for the futures
contract.
• Taking accrued interest into account, the cash received for each $100
face value of the bond delivered is
(Most recent settlement price x Conversion factor) + Accrued interest
• Each contract is for the delivery of $100,000 face value of bonds.
• Suppose that the most recent settlement price is 90-00, the
conversion factor for the bond delivered is 1.3800, and the accrued
interest on this bond at the time of delivery is $3 per $100 face value.
• The cash received by the party with the short position (and paid by
the party with the long position) is then
(1.3800 x 90.00) + 3.00 = $127.20 per $100 face value.
A party with the short position in one contract would deliver bonds
with a face value of $100,000 and receive $127,200.
Cheapest-to-Deliver Bond…
• The party with the short position has decided to deliver and is trying
to choose between the three bonds in the table below. Assume the
most recent settlement price is 93-08, or 93.25.
The cost of delivering each of the bonds is as
follows:
• Bond 1: 99.50 – (93.25 x 1.0382) = $2.69

• Bond 2: 143:50 – (93.25 x 1.5188) = $1.87

• Bond 3: 119.75- (93.25 x 1.2615) = $2.12

The cheapest-to-deliver bond is Bond 2.

Factors determine the cheapest-to-deliver bond
• When bond yields are in excess of 6%, the conversion factor system
tends to favor the delivery of low-coupon long-maturity bonds.
• When yields are less than 6%, the system tends to favor the delivery
of high-coupon short-maturity bonds.
• When the yield curve is upward sloping, there is a tendency for
bonds with a long time to maturity to be favored, whereas
• When it is downward-sloping, there is a tendency for bonds with a
short time to maturity to be delivered