FNAN 406: Ch. 3

Reasons why companies do not hedge:

(1) Shareholders, by holding well-diversified portfolios, can eliminate many of the risks faced by a company; therefore, they do not require the company to hedge these risks. (2) A company may find that it is increasing rather than decreasing risk by hedging if none of its competitors does so. (3) A treasurer may fear criticism from other executives if the company makes a gain from movements in the price of the underlying asset and a loss on the hedge.

2 ways in which a company can take a position in futures contracts to offset an exposure to the price of an asset:

(1) Short hedge - appropriate if the exposure is such that the company gains when the price of the asset increases and loses when the price of the asset decreases. (2) Long hedge - appropriate if the exposure is such that the company gains when the prices of the asset decreases and loses when the price of the asset increases.

2 key choices when selecting futures contract for hedging purposes:

(1) choice of the asset underlying the futures contract (2) choice of the delivery month

2 uses of stock index futures:

(1) used to hedge the systematic risk in an equity portfolio (2) used to change the beta of a portfolio without changing the stocks comprising the portfolio # of futures contracts required = (beta of portfolio) * (ratio of the value of the portfolio to the value of one futures contract)

3 problems that give rise to basis risk

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 not be certain of the exact date the asset will be bought or sold. 3. The hedge may require the futures contract to be closed out before its delivery month.

Short hedge

A hedge that involves a short position in a futures contract; appropriate when the hedger already owns an asset and expects to sell it at some time in the future, also when an asset is not owned right now but will be in the future.

Long hedge

A hedge that involves taking a long position in a futures contract; appropriate when a company knows it will have to purchase a certain asset in the future and wants to lock in a price now.

Hedge

A trade designed to reduce risk.

Perfect hedge

A trade that completely eliminates risk.

Stock index

An index that tracks the changes in the value of a hypothetical portfolio of stocks. The weight of a stock portfolio at a particular time = the proportion of the hypothetical portfolio invested in the stock at that time. The percentage increase in the stock index over a small interval of time is set = to the percentage increase in the value of the hypothetical portfolio. Dividends are not included, so the index tracks the capital gain/loss from investing in the portfolio.

S&P 500 index futures

Are based on a portfolio of 500 different stock: 400 industrials, 40 utilities, 20 transportation companies, and 40 financial institutions. The weights of the stocks in the portfolio at any given time are proportional to their market capitalizations. The stocks are those of large publicly held companies that trade on NYSE Euronext or NASDAQ OMX. The CME trades two futures contracts: one that is $250 times the index, the other is $50 times the index.

What happens to basis risk in relation to the hedge expiration date and the delivery month?

Basis risk increases as the time difference between the hedge expiration and the delivery month increases. Therefore, you should chose a delivery month that is as close as possible to, but later than, the expiration of the hedge.

What happens to the basis if the asset to be hedged and the asset underlying the futures contract are the same?

If the asset to be hedged and the asset underlying the futures contract are the same, the basis at the contracts expiration should = 0.

What happens if the stock index of a hypothetical portfolio remains fixed?

If the hypothetical portfolio of stocks remains fixed, the weights assigned to the individual stocks in the portfolio do not remain fixed. When the price of one particular stock in the portfolio rises more sharply than others, more weight is automatically given to that stock.

Optimal hedge ratio

Is the slope of the best-fit line obtained when changes in the spot price are regressed against changes in the futures price.

What happens to a trader's long futures position if the basis rises/falls?

Long hedge = plans to buy asset -if the basis strengthens (increases), the company's position worsens bc it will pay a higher price for the asset after future gain and losses are considered. -if the basis weakens (decreases), the company's position improves.

Cross hedging

Occurs when the asset underlying the futures contract is different from the asset whose price is being hedged; hedging an exposure to the price of one asset with a contract on another asset.

What happens to a trader's short futures position if basis rises/falls?

Short-hedge basis = plans to sell asset -if the basis strengthens (increases), the company's position improves bc it will get a higher price for the asset after future gains or losses are considered. -if the basis weakens (decreases), the company's position worsens.

Strengthening of the basis

Strengthening of the basis = an increase in the basis

Basis

The difference between the spot price and the futures price of a commodity; (spot price of asset being hedged) - (futures price of contract used).

Hedge ratio

The ratio of the size of the position taken in futures contracts to the size of the exposure. When the asset underlying the futures contract is the same as the asset being hedged, the ratio = 1.0. When cross hedging is used, the hedger should choose a value for the hedge ratio that minimizes the variance of the value of the hedged position.

Basis risk

The risk to a hedger arising from uncertainty about the basis at a future time.

What happens when stock index are constructed from a hypothetical portfolio consisting of one of each of a number of stock?

The weights assigned to the stocks are proportional to their market prices, with adjustments being made when there are stock splits. Others are constructed so that weights are proportional to their market capitalization.

Weakening of the basis

Weakening of the basis = a decrease in the basis