HEDGING STRATEGIES USING FUTURES

GROUP WORK
August /2021
 Contents
 1. Concepts of hedging
 2. Types of hedging
 3. Basis risk and price risk
 4. Hedging strategy
 5. Hedge ratio
 6. Management of hedge position
 1. Concepts of hedging
 Hedging, in finance, is a risk management
strategy. It deals with reducing or eliminating
the risk of uncertainty. The aim of this strategy
is to restrict the losses that may arise due to
unknown fluctuations in the investment prices
and to lock the profits therein.
 cont..

 Hedging in finance refers to protecting

investments. A hedge is an investment status,
which aims at decreasing the possible losses
suffered by an associated investment. Hedging
is used by those investors investing in market-
linked instruments.
 Where Hedging is employed
 Hedging is employed in the following areas:
  Securities Market
  Commodities Market
  Interest Rate
  Currencies:
Advantages of Hedging
 Hedging limits the losses to a great extent.
 Hedging increases liquidity as it facilitates investors to invest in
various asset classes.
 Hedging requires lower margin outlay and thereby offers a flexible
price mechanism.
 Types of hedging
The types of hedges have increased greatly:-
 Forward exchange contract for currencies
 Commodity future contracts for hedging physical positions
 Currency future contracts
 Money Market Operations for currencies
 Forward Exchange Contract for interest
 Money Market Operations for interest
 Future contracts for interest
 Basis risk and price risk

 Basis risk
 Basis risk is the potential risk that arises from
mismatches in a hedged position. Basis risk
occurs when a hedge is imperfect, so that losses
in an investment are not exactly offset by the
hedge. Certain investments do not have good
hedging instruments, making basis risk more of
a concern than with others assets.
 Price risk

 Price risk is the risk that the value of a security

or investment will decrease. Factors that affect
price risk include earnings volatility, poor
business management, and price changes.
Diversification is the most common and
effective tool to mitigate price risk.
 Hedging strategy

 Hedging strategies are broadly classified as follows:

 Forward Contract: It is a contract between two parties for
buying or selling assets on a specified date, at a particular
price. This covers contracts such as forwarding exchange
contracts for commodities and currencies.
 Futures Contract: This is a standard contract between
two parties for buying or selling assets at an agreed price
and quantity on a specified date. This covers various
contracts such as a currency futures contract.
 Money Markets: These are the markets where short-term
buying, selling, lending, and borrowing happen with
maturities of less than a year. This includes various
contracts such as covered calls on equities, money market
operations for interest, and currencies.
  
 Financial Futures ContractsFutures
Contract
 Financial futures contracts are highly
standardized forward contracts traded on
organized exchanges subject to specific rules.
 A financial futures contract is similar to an
interest-rate forward contract in that it specifies
that a financial instrument must be delivered
by one party to another on a stated future date
 However, it differs from an interest-rate forward
contract in several ways that overcome some of the
liquidity and default problem of forward markets
 Cont….

 Financial Futures Contracts Specify

• Type of security to be traded
1. Delivery Location
2. Amount to be Delivered
3. Date
4. Price
 Success of FFC
1. FFC are more liquid: standardized contracts that can be traded
2. Delivery of range of securities reduces the chance of corner.
3. Mark to market daily: avoids default risk
4. Don't have to deliver: cash netting of positions
 Cont…

 Trading
 Your broker contacts floor trader who executes
purchase or sale of futures contract
 Trades are effectively with the exchange's
clearinghouse acting as a counterparty in each trade.
There must be a short position for each long position.
 All trades require a Margin Deposit.
 Initial Margin is set by the exchange for each contract type
 End of trading day settlement price on contract is
determined
 Each open account is marked to market. If P , long
position profits and short position loses.
 Count..
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 Financial Futures Contracts: Example
 On February 1, you sell one $100,000 June
contract at a price of 115 (that is $115,000)
 By selling this contract, you agree to deliver
$100,000 face value of the long-term Treasury
bonds to the contract’s counterparty at the end
of June for $115,000
 By buying the contract at a price of 115, the
buyer has agreed to pay $115,000 for the
$100,000 face value of bonds when you deliver
the bond, at the end of June
 Count…
 If interest rates on long-term bonds rise so that
when the contract mature at the end of June the
price of these bonds has fallen to 110 ($110,000
per $100,000 of face value), the buyer of the
contract will have lost $5,000 because he paid
$115,000 for the bonds but he can sell them only
for the market price of $110,000
 But you the seller of the contract, will have gained
$5,000 because you can now sell the bonds to the
buyer for $115,000 but have to pay only $110,000
for them in the market
 How do Investors Hedge

The following hedging strategies to mitigate losses:

 Asset Allocations: This is done by diversifying an
investor’s portfolio with various classes of assets. For
instance, you can invest 40% in the equities market and the
rest in stable asset classes. This balances your investments.
 Structure: This is done by investing a certain portion of the
portfolio in debt instruments and the rest in derivatives.
Investing in debt provides stability to the portfolio while
investing in derivatives protects you from various risks.
 Through Options: This strategy includes options of calls
and puts of assets. This facilitates you to secure your
portfolio directly.
 Hedge ratio

 Hedge ratio compares the value of a position protected

through the use of a hedge with the size of the entire
position itself. A hedge ratio may also be a comparison of
the value of futures contracts purchased or sold to the
value of the cash commodity being hedged.
 Hedge ratio is the comparative value of an open position's
hedge to the overall position. A hedge ratio of 1, or 100%,
means that the open position has been fully hedged. By
contrast, a hedge ratio of 0, or 0%, means that the open
position hasn't been hedged in any way. Understanding
the hedge ratio can be immensely beneficial for risk
management, as it helps you understand the extent to
which changes to the value of your asset or liability will
be offset by movement in your hedging instrument.
  
 Calculating the hedge ratio

 Hedge Ratio = Hedge Value / Total Position Value

 Mr. X is a resident of the United States and is

working there only. He has the surplus amount and
wants to invest the same outside the United States
as he is already having a good amount of
investment in his home country. For the new
investment, he conducted some study of the
different foreign markets, and after studying, he
found that the economy of country India is growing
currently at a faster pace, which is even more than
that of the United States.
 Cont..
 So, Mr. X decides that he would participate in the
Indian market, which is having higher than
domestic growth, by constructing a portfolio of the
equities having the Indian companies in that
amounting $ 100,000. But due to this investment in
a foreign country, the currency risk will arise as
there is a currency risk involved whenever
investment is made in non-domestic companies.
So there is a concern of the investor over the
devaluation of rupees against the U.S. dollar.
 Now in order to foreign exchange risk, the
investor decides to hedge $ 50,000 of its equity
position. Calculate the hedge ratio.
 Cont…

Here,
Value of the Hedge Position = $ 50,000
Value of the total Exposure = $ 100,000
So the calculation is as follows –
= $ 50,000 / $100,000
= 0.
Thus the hedge ratio is 0.5
 Management of hedge position
 Hedging is a risk management strategy employed to offset losses in
investments by taking an opposite position in a related asset
 Hedging involves engaging in a financial transaction to offset an
existing position to reduces or eliminate risk
 Long Positions:-If a financial institution has bought an asset, it is
said to have taken a long position
 And this exposes the institution to risk if the returns on the asset are uncertain
 On the other hand, if it sold an asset that it has agreed to deliver to
another party at a future date, it is said to have taken a short position

 Example :-Say, Mr. X decided to buy 1000 shares of stock in Adidas

as he researched for the company’s strong fundamentals and growth.
 Mr. X purchases 1000 shares at a closing price of $80 per share, which
means 1000 * 80 = 80000.
 One year later, the price of the stock is $85 per share, a hike of $5 per
share. The value of Mr. X’s investment would be: 1000 * 85 = $85000
 The gain of $5000 will be booked by the long position by Mr. X
End of Presentation