Chapter 3

Hedging Strategies Using

Futures

Options, Futures, and Other Derivatives, 9th Edition,

Copyright © John C. Hull 2014 1
Long & Short Hedges
! A long futures hedge is appropriate when
you know you will purchase an asset in
the future and want to lock in the price
! A short futures hedge is appropriate
when you know you will sell an asset in
the future and want to lock in the price

Options, Futures, and Other Derivatives, 9th Edition,

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Arguments in Favor of Hedging
! 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

Options, Futures, and Other Derivatives, 9th Edition,

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Arguments against Hedging
! 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

Options, Futures, and Other Derivatives, 9th Edition,

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Basis Risk
! Basis is usually defined as the spot
price minus the futures price
! Basis risk arises because of the
uncertainty about the basis when
the hedge is closed out

Options, Futures, and Other Derivatives, 9th Edition,

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Long Hedge for Purchase of an Asset
! Define
F1 : Futures price at time hedge is set up
F2 : Futures price at time asset is purchased
S2 : Asset price at time of purchase
b2 : Basis at time of purchase

Cost of asset S2
Gain on Futures F2 −F1
Net amount paid S2 − (F2 −F1) =F1 + b2

Options, Futures, and Other Derivatives, 9th Edition,

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Short Hedge for Sale of an Asset
! Define
F1 : Futures price at time hedge is set up
F2 : Futures price at time asset is sold
S2 : Asset price at time of sale
b2 : Basis at time of sale

Price of asset S2
Gain on Futures F1 −F2
Net amount received S2 + (F1 −F2) =F1 + b2

Options, Futures, and Other Derivatives, 9th Edition,

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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.

Options, Futures, and Other Derivatives, 9th Edition,

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Optimal Hedge Ratio (page 59)
Proportion of the exposure that should optimally be
hedged is * σS
h =ρ
σF
where

σS is the standard deviation of ΔS, the change in the
spot price during the hedging period,
σF is the standard deviation of ΔF, the change in the
futures price during the hedging period
ρ is the coefficient of correlation between ΔS and ΔF.

Options, Futures, and Other Derivatives, 9th Edition,

Copyright © John C. Hull 2014 9
Example (Page 61)
! Airline will purchase 2 million gallons of jet
fuel in one month and hedges using heating
oil futures
! From historical data σF =0.0313, σS =0.0263,
and ρ= 0.928
* 0.0263
h = 0.928 × = 0.78
0.0313

Options, Futures, and Other Derivatives, 9th Edition,

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Example continued
! The size of one heating oil contract is 42,000 gallons
! The spot price is 1.94 and the futures price is 1.99
(both dollars per gallon) so that
V A = 1.94 × 2,000,000 = 3,880,000
V F = 1.99 × 42,000 = 83 ,580
! Optimal number of contracts is
= 0.78 × 2,000,000 42,000
which rounds to 37

Options, Futures, and Other Derivatives, 9th Edition,

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Alternative Definition of Optimal
Hedge Ratio
! Optimal hedge ratio is
ˆ σˆ S
h = ρˆ
σˆ F
where variables are defined as follows
Correlation between percentage daily changes for
ρ̂ spot and futures
σˆ S SD of percentage daily changes in spot

σˆ F SD of percentage daily changes in futures

Options, Futures, and Other Derivatives, 9th Edition,

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Optimal Number of Contracts
QA Size of position being hedged (units)
QF Size of one futures contract (units)
VA Value of position being hedged (=spot price time QA)
VF Value of one futures contract (=futures price times QF)

Optimal number of contracts

Optimal number of contracts if after “tailing adjustment” to
adjustment for daily settlement allow or daily settlement of
futures
h *Q A ˆ
= hV
QF = A
VF
Options, Futures, and Other Derivatives, 9th Edition,
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Hedging Using Index Futures
(Page 64)

To hedge the risk in a portfolio the

number of contracts that should be
shorted is V A
β
VF
where VA is the value of the portfolio, β is
its beta, and VF is the value of one
futures contract

Options, Futures, and Other Derivatives, 9th Edition,

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Example
S&P 500 futures price is 1,000
Value of Portfolio is $5 million
Beta of portfolio is 1.5

What position in futures contracts on the S&P

500 is necessary to hedge the portfolio?

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Changing Beta
! What position is necessary to reduce
the beta of the portfolio to 0.75?
! What position is necessary to increase
the beta of the portfolio to 2.0?

Options, Futures, and Other Derivatives, 9th Edition,

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Why Hedge Equity Returns
! May want to be out of the market for a while.
Hedging avoids the costs of selling and
repurchasing the portfolio
! Suppose stocks in your portfolio have an
average beta of 1.0, but you feel they have
been chosen well and will outperform the
market in both good and bad times. Hedging
ensures that the return you earn is the risk-
free return plus the excess return of your
portfolio over the market.
Options, Futures, and Other Derivatives, 9th Edition,
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Stack and Roll (page 68-69)

! We can roll futures contracts forward to

hedge future exposures
! Initially we enter into futures contracts to
hedge exposures up to a time horizon
! Just before maturity we close them out an
replace them with new contract reflect the
new exposure
! etc
Options, Futures, and Other Derivatives, 9th Edition,
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Liquidity Issues (See Business Snapshot 3.2)
! In any hedging situation there is a danger that
losses will be realized on the hedge while the
gains on the underlying exposure are
unrealized
! This can create liquidity problems
! One example is Metallgesellschaft which sold
long term fixed-price contracts on heating oil
and gasoline and hedged using stack and roll
! The price of oil fell.....
Options, Futures, and Other Derivatives, 9th Edition,
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