FMP8 - Using Futures for Hedging

Question 1

Define and differentiate between long and short hedges and identify their appropriate uses

Answer 1

Long hedge locks a price for a company to buy an asset at, want actual price to be higher than the futures price at maturity. Appropriate when company knows they have to buy an asset at future time.

Short hedge locks a price for a company to sell an asset at, want price at maturity to be less than futures price. Appropriate when company knows they have to sell an asset at a future time.

Question 2

Describe the arguments for and against hedging and potential impact of hedging on firm profitability

Answer 2

• Shareholders tend to diversify portfolio so often no need to hedge, but often less informed so hedging could be beneficial
• Hedging may not be appropriate due to size of exposure, could actually increase risk
• Hedging reduces profit variability, but because of this can reduce profits in cases

Question 3

Define and calculate the basis, discuss various sources of basis risk, and explain how basis risks arise when hedging futures

Answer 3

• Basis risk is from closing out a futures contract before maturity
• Basis = spot price of hedged asset - futures price of asset underlying futures contract

Question 4

Define cross hedging and compute and interpret hedge ratio and hedge effectiveness

Answer 4

Cross hedging is hedging an exposure to the price of one asset with a futures contract in another asset.

Hedge ratio h* = rho * σ_S / σ_F
where rho is cofficient of correlation between change in spot price and change in futures price during period equal to the life of the hedge, σ_S is standard deviation of change in spot, σ_F is standard deviation of change in futures

Hedge effectiveness = rho^2 and is proportion of variance of change in spot price (S) that is eliminated by hedging

Question 5

Calculate the profit and loss on a short or long hedge

Question 6

Compute the optimal number of futures contracts needed to hedge an exposure and calculate the “tailing the hedge” adjustment

Answer 6

Optimal number of futures N* = h* * Qa / Qf, where Qa is the size of position being hedged, and Qf is the number of units underlying one futures contract

This is correct for forwards but adjustment needed for futures as futures settled daily, this is “tailing the hedge”

N* = rho * (σ_S * S * Qa) / (σ_F * F * Qf)
where σ,rho are the standard deviation / correlation of one day returns of S/F

Question 7

Explain how to use stock index futures contracts to change a stock portfolios beta

Answer 7

Beta is sensitivity of return compared to the rest of the market, treat like finding optimal number of futures with B = h* and value of portfolio in the numerator

Question 8

Explain how to create a long-term hedge using a stack and roll strategy and describe some of the risks that arise from this strategy

Answer 8

Stack and roll implemented by creating a short term futures hedge. Close the short term hedge out just before delivery period and replace with another short term hedge, repeat.

Risk comes as uncertainty as to the difference in the futures price every time an old contract is closed and a new one opened.