Transcript Financial Futures Hedging
Hedging: Long and Short
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Long futures hedge appropriate when you will purchase an asset in the future and fear a rise in prices
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If you have liabilities now, what do you fear?
Short futures hedge appropriate when you will sell an asset in the future and fear a fall in price
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If you expect to issue liabilities, what do you fear?
Arguments For Hedging
Companies should focus on their main business and minimize risks arising from interest rates, exchange rates, and other market variables
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Non-intrusive risk management tool
Hedging may help smooth income and minimize tax liabilities
Hedging may help smooth income and reduce managerial salaries
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Arguments Against Hedging
Well-diversified shareholders can make their own risk management decisions
It may increase business risk to hedge when competitors do not
Explaining a loss on the hedge and a gain on the underlying can be difficult
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Basis Risk
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Basis is the difference between spot and futures prices
Basis risk arises because of uncertainty about the price difference when the hedge is closed out
Basis risk usually less than the risk of price or rate level changes
Basis risk depends on futures pricing forces
Choice of Hedging Contract
Delivery month should be as close as possible to, but later than, the end of the life of the hedge
If no futures contract hedged position, choose the contract whose futures price is most highly correlated with the asset price
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Called cross-hedging
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Additional basis risk
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Naive Hedge Ratio
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Divide the face value of the cash position by the face value of one futures contract
Problems:
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Market values should be focus
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Ignores differences between the cash and futures instruments
Variation: divide the market value of the cash position by the market value of one futures contract
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Minimum Variance Hedge Ratio
Proportion of the exposure that should optimally be hedged is h
S F
S , F 2 F hedge per dollar of cash market value
Hedge ratio estimated from:
CP t
FP t
Hedging Stock Portfolios
If hedging a well-diversified stock portfolio with a well-diversified stock index futures contract, what are implications?
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No diversifiable risk in the cash stock portfolio and futures hedge removes systematic risk
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Since no risk, systematic or unsystematic, what can an investor expect to earn by hedging a well-diversified stock portfolio?
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Hedging Stock Portfolios
But has all risk been eliminated?
Problems:
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Stock portfolio being hedged may have a different price volatility than the stock-index futures
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Hedging goal is not to reduce all systematic risk
Price sensitivity to market movements determined by beta
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Hedging Stock Portfolios
Optimal number of contracts to hedge a portfolio is (
S
F
* )
MV of spot portfolio MV of one futures contract
Future contracts can be used to change the beta of a portfolio
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If
* >(<)
S , hedging implies a long (short) stock index futures position
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Rolling The Hedge Forward
What if hedging further in the future than available delivery dates?
Series of futures contracts used to increase the life of a hedge
Each time a futures contract matures, switch position into another, later contract
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Basis risk, cash flow problems possible
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