TAILIEUCHUNG - Lecture Financial derivatives - Lecture 12: Hedging strategies using futures

Companies should focus on the main business they are in and take steps to minimize risks arising from interest rates, exchange rates, and other market variables. Shareholders are usually well diversified and can make their own hedging decisions. It may increase risk to hedge when competitors do not. Explaining a situation where there is a loss on the hedge and a gain on the underlying can be difficult. | 3. Hedging Strategies Using Futures Lecture #12 3. Long Hedge Suppose that F1 : Initial Futures Price F2 : Final Futures Price S2 : Final Asset Price You hedge the future purchase of an asset by entering into a long futures contract Cost of Asset=S2 – (F2 – F1) = F1 + Basis 3. Short Hedge Suppose that F1 : Initial Futures Price F2 : Final Futures Price S2 : Final Asset Price You hedge the future sale of an asset by entering into a short futures contract Price Realized=S2+ (F1 – F2) = F1 + Basis 3. 3. Choice of Contract Choose a delivery month that is as close as possible to, but later than, the end of the life of the hedge When there is no futures contract on the asset being hedged, choose the contract whose futures price is most highly correlated with the asset price. This is known as cross hedging. 3. Optimal Hedge Ratio Proportion of the exposure that should optimally be hedged is where sS is the standard deviation of DS, the change in the spot price during the hedging period, sF is the standard deviation of DF, the change in the futures price during the hedging period r is the coefficient of correlation between DS and DF. 3. 3. Hedging Using Index Futures (Page 63) To hedge the risk in a portfolio the number of contracts that should be shorted is where P is the value of the portfolio, b is its beta, and A is the value of the assets underlying one futures contract 3. 3. 3. 3. 3. Source: Options, Futures, and Other Derivatives 6th Edition, Copyright © John C. Hull 2005 3.

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