C.3 Hedging Strategies Using Futures

Question 1

Perfect hedge

Answer 1

One that completely eliminates risk

Question 2

Long hedge

Answer 2

Hedges that take a long position in a futures contract

Question 3

Basis

Answer 3

Basis = Spot price of asset to be hedged - Futures price of contract used

Question 4

Cross hedging

Answer 4

When hedging and the asset underlying the futures contract is different than the asset being hedged

Question 5

Hedge ratio

Answer 5

The ratio of the size of the position taken in futures contracts to the size of the exposure

Question 6

Hedge ratio of 1

Answer 6

WHen the asset underlying the futures contract is the same as the asset being hedged

Question 7

How to choose a hedge ratio

Answer 7

The hedger should choose a value for the hedge ratio that minimizes the variance of the value of the hedged position

Question 8

Hedge effectiveness

Answer 8

The proportion of the variance that is eliminated by hedging. Aka R^2 from the regression of delta(S) against delta(F) and equals p^2

Question 9

Hedge ratio eq’n

Answer 9

h* = p*(sd_S/sd_F)