Chapter 3: Hedging Strategies Using Futures

If short-term demand is strong and the available supply is small, spot prices could rise relative to futures prices, causing the basis to strengthen. If the demand is weak and a large supply is available, spot prices could fall relative to the futures price, causing the basis to weaken.

-As the factors affecting spot and futures markets change, the basis also changes. -Two terms used to describe a changing basis are (1)Strengthening and (2)Weakening. -The basis is said to be strengthening if it becomes more positive or less negative; whereas the basis is said to be weakening if it becomes less positive or more negative. A strengthening basis happens when the spot prices increase relative to the futures prices. Meanwhile, a weakening basis occurs when the spot prices decrease relative to the futures prices over time.

If a hedge ratio is 0.70, it means that 70% of the investment is protected from risk, while 30% remains exposed to risk.

-Hedge ratio is a ratio of the size (value) of the position taken in futures contracts to the size (value) of the entire exposure. -It shows how exposed an investment to a risk. Imagine a scenario where you are holding $50,000 in foreign equity, which exposes you to a currency risk. You could enter into a hedge to protect against losses in this position, which can be constructed through a variety of positions to take an offsetting position to the foreign equity investment. If you hedge $30,000 worth of the equity with a currency position, your hedge ratio would be $30,000/$50,000, which is 0.6. -This means that 60% of your foreign equity investment is protected from currency risk, while the remaining 40% remains exposed to the risk.

The minimum variance hedge ratio (MVHR)

-The minimum variance hedge ratio (MVHR) also known as optimal hedge ratio (OHR). -It depends on the relationship between changes in the spot price and changes in the futures price.

Stock Index Futures are commonly used for speculating, hedging, and spread trading.

1) When the investors use stock index futures to speculate the directions and the movement of the market in the future as well as planning to hedge their position against potential future losses. 2) Index futures can also be used for hedging purposes. Investors usually bought many stocks at once where they also position themselves into uncertain risks. Hence, they used stock index futures to reduce risk and the volatility of their investment. 3) Index futures are used as a spread or relative value trading tool where the investment focuses on the development and differences within the prices on the related securities. That means, there will be no changes as a whole on the index, instead, the trade will obtain the profit by enlargement and shrinking of those prices.

Beta (β) is used to determine the appropriate hedge ratio.

=> Used in the capital asset pricing model (CAPM). => The slope of the best-fit line obtained when excess return on the portfolio over the risk-free rate is regressed against the excess return of the index over the risk-free rate. => A measure of the volatility of a security compared to the market as a whole. - portrays the movement of the market in terms of dimension but not their direction where the security relative to neutral level. [Generally] The market itself has its own beta which is 1.0. In comparison to 1.0, beta illustrated that the higher the beta, the sensitive the investment will be. Meanwhile, if the beta is lower, the movement might be very small and very slow.

Delivery of stock index futures is made by a cash settlement based on the index value.

>> Equity Index futures are purely cash-settled on a daily basis which means that the investors and traders pay or collect the difference in value daily. >> In the stock index futures market, the delivery of underlying assets at the expiration date will never happen due to all open transactions being automatically closed out on the settlement date.

The difference between the spot price of a commodity (the underlying) and the price of a specified futures contract of the same commodity (related commodity) at any given point in time is known as basis and the risk associated with it is called the basis risk.

Basis = Spot price of asset to be hedge - Futures price of contract used Example of basis: The current spot price of gold is $1170 and the price of gold in the August gold futures contract is $1175. Basis= $1170 - $1175 = -$5. -This is called a negative basis and is said to be "under" as the spot price is lower than the futures price. -The basis can be positive if the spot price is higher than the futures price, and it is said to be "over". -Basis risk is the risk that the futures price might not move in normal, steady correlation with the price of the underlying asset, and this fluctuation in the basis may deny the effectiveness of a hedging strategy used to minimize a trader's exposure to a potential loss.

Cross Hedging occurs when the two assets underlying futures contracts are different.

Cross hedging refers to the practice of hedging risk using two distinct assets with positively correlated price movements. Example of cross hedging: If there is no futures contract actively traded for jet fuel, the airliner might choose to use heating oil futures to hedge its exposures of jet fuel risk.

When a company already owns an asset and expects to sell it in the future, or not owned right now but will be owned at some time in the future, short hedge is appropriate.

Hedge: - can be understood as insurance to protect a company's finances from risky situations. - reduce the impact of negative events like losses on a company's finances and also potentially earn a profit in the future. Short hedge: - appropriate when the company is in either one of the two circumstances: 1) already own an asset and expects to sell it in the future. 2) did not own the asset right now but will be owned in the future. - protect from risk of a decreasing asset price in the future A company can short the asset and secure it against potential losses by locking the selling price when the price is high. By locking the selling price today, the company will not have to worry about the future price fluctuations anymore.

Treasurers are reluctant to hedge when the executives within the organization do not understand the hedging strategy as it may lead to a worse outcome.

Hedging can lead in increase or decrease in a company's profits relative to the position it would be in with no hedging. The company's management and the shareholders might not appreciate the contribution made by the treasurer even when the hedging decision made by the treasurer is perfectly logical. Even though hedging can protect the company from risk, treasurers might be the one that are exposed to risks if the company's management do not fully understand the hedging decision that is being made. Treasurers should clearly communicate the hedging strategies to both the company's management and the shareholders to avoid misunderstanding.

There are 3 basic inputs required to calculate the number of stock index futures contracts needed to hedge an equity portfolio.

In order to establish a short hedge using stock index futures, the portfolio must be hedged. To form an effective hedge, the amount of future contracts are required. Thus, to calculate the number of stock index futures contracts, there must be 3 basic inputs : a) the current value of the stock portfolio, V(A). b) the beta of the stock portfolio, (β) or the hedge ratio, (h*). c) the current value of one futures contract, V(F).

When hedging is not the norm in the industry, the company should be against using hedging strategy.

It does not make sense for only one company to practice hedging when other companies do not do hedging and it is not the norm in the certain industry. It is important to look at the big picture when hedging. All the implications of price changes on a company's profitability should be considered in the design of a hedging strategy to protect against the price changes. Since hedging also has costs associated with it, a company that decides to hedge must consider carefully whether the potential benefits from hedge can justify the expense. The company also has to understand first that the goal of hedging is just to protect the company from financial risks, not to gain money.

If a company is lacking in predicting variables such as interest rates, exchange rates, and commodity prices, it is favorable for the company to hedge, to avoid increase in risk.

It makes sense for most nonfinancial companies such as companies in the business of manufacturing, or retailing or wholesaling, to practice hedging as they are lacking expertise in predicting variables that can cause fluctuations in market price. The variables are interest rates, exchange rates, and commodity prices. Hedging can help the companies to reduce risks by locking prices to limit losses to an extent. With hedging, companies can also save time by not having to monitor and worry about the daily market volatility and price fluctuations.

When a company knows that it will have to purchase a certain asset in the future and wants to lock in the price now, a long hedge is appropriate.

Long hedge: - appropriate when a company knows that it will have to purchase a certain asset in the future and wants to lock in the price now. - long futures position that is entered into for the purpose of price stability on a purchase. The company suspects that the price of the asset will rise in the future, thus long hedge helps to offset the greater cost of the asset.

There are 2 reasons for hedging an equity portfolio based on two events.

[a] Hedging can be justified if the hedger feels that the stocks in the portfolio have been chosen well. >> SIF protects the portfolio of the investment by hedging the risk. >> Considered as insurance for the investment because the traders may face uncertainty to lose certain things. >> Investors can't control the market and the movement of the market itself but they can control their mechanism on selecting the stock. >> Prevent the investment from the arising risk on the market move as a whole but merely exposing it to certain relative markets. [b] The hedger is planning to hold a portfolio for a long period of time and requires short-term protection in an uncertain market situation as the hedger may want to be out of the market for a while. >> Inhibits the investment from any drastic and extreme loss when the hedger leaves out from the market just for a small interval of time.