F INANCIAL R ISK M ANAGEMENT

F UTURES AND F ORWARDS :

H EDGING
L ECTURE 3
Angelo Luisi — [email protected]
OVERVIEW

1 I NTRODUCTION TO D ERIVATIVES

2 F ORWARD CONTRACTS

3 F UTURES

4 H EDGING S TRATEGIES USING F ORWARDS

5 Q UESTIONS ?

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I NTRODUCTION TO D ERIVATIVES
W HAT IS A D ERIVATIVE

A derivative is an instrument whose value depends on (or is derived from) the value of
another asset
Examples: futures, forwards, swaps, options...

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W HY D ERIVATIVES ARE IMPORTANT

Derivatives play a key role in transferring risks in the economy.

The underlying assets include stocks, currencies, interest rates, commodities, debt
instruments, electricity prices, the weather...
Many financial transactions have embedded derivatives
Real option approach to assessing capital investment decisions has become widely accepted

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H OW D ERIVATIVES ARE TRADED

On exchanges such as the Chicago Board Options Exchange (CBOE)

Initially, to bring farmers and merchants together
Main task was to standardize the quantities of the grains that were traded
Once two traders agree to trade a product, the exchange clearing house handles
Advantage, traders do not worry about credit risk
The clearing house takes care of the credit risk by requiring each of the two traders to deposit
funds (margin)
In the Over-the-Counter (OTC) market where traders working for banks, fund managers and
corporate treasurers contact each other directly

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T HE OTC MARKET
Main participants: banks, other large financial institutions, fund managers and corporations
Once an OTC trade has been agreed, the two parties can either
present it to a central counterparty (CCP) or
clear the trade bilaterally
Large banks often act as market makers for the more commonly traded instruments
They always prepared to quote a bid price (at which they are ready to buy) and an ask price (at
which they are prepared to sell)
Prior to 2008
Largely unregulated
Following 2008
1 OTC market has become regulated. Objectives:
Reduce systemic risk
Increase transparency
2 Standardized OTC products must be traded on swap execution facilities (SEFs). They are
electronic platforms similar to exchanges
3 CCPs must be used to clear standardized transactions between financial institutions in most
countries
4 All trades must be reported to a central repository 8 / 57
M ARKET S IZE

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F ORWARD CONTRACTS
F ORWARD CONTRACTS

It is the agreement to buy or sell an asset at a certain future time for a certain price
Inversely, the spot contract is to buy or sell immediately
Long position: agreeing to buy the underlying asset
Short position: agreeing to sell the underlying asset

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E XAMPLE OF U SAGE OF A F ORWARD CONTRACT
To hedge foreign currency risk.

Bid Ask

Spot 1.2217 1.2220

1-month forward 1.2218 1.2222
3-month forward 1.2220 1.2225
6-month forward 1.2224 1.2230

Table: Foreign Exchange Quotes for GBP, May 21st , 2020

Suppose that a U.S. corporation knows that it will pay £ 1 million

To hedge against exchange rate moves in 6 months.
1 Long 6-month forward contract at 1.2230
The counterpart will have a short position

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PAYOFFS FROM F ORWARDS

What are the possible outcomes?

If the spot exchange rate rises to (for example) 1.3000
→ The forward contract would be worth 77, 000(= 1, 300, 000 − 1, 223, 000)
What if the spot rate fell to 1.2000?
In general the payoff from a long position in a forward contract on one unit of an asset is

ST − K (1)

K is the delivery price

ST is the spot price of the asset at maturity
What about a short position?

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L ONG PAYOFF

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S HORT PAYOFF

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F ORWARD P RICES AND S POT P RICES
Consider a stock that pays no dividend with market price 60 C
Suppose you can borrow/lend money at 5% for 1 year.
What should the forward price of the stock be?
Answer, 60(1 + 0.05) = 63 C
What if the forward price is 67 C ?
1 Borrow 60 C
2 buy one share
3 sell it forward for 67 C
4 Profit, 4 C in 1 year
What if the forward price is 58 C ?
1 Sell the stock for 60
2 enter a forward contract to buy it back for 58
3 invest the proceeds at 5% to earn 3
4 Profit, 5 C in 1 year

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F UTURES
F UTURES CONTRACT

Like a forward contract

Agreement between two parties to buy or sell an asset at a certain time in the future for a
certain price
Unlike forwards
Traded on exchange
Standardized features

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C LOSING OUT P OSITIONS

Vast majority of future contracts does not lead to delivery

How?
Close out the position prior to the delivery period
Closing out the position means entering into the opposite trade to the original

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S PECIFICATION OF F UTURE C ONTRACTS

1 The asset
2 The contract size (how much of the asset will be delivered under one contract)
3 Where the delivery can be made
4 When the delivery can be made

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T HE ASSET

Commodity
Possible quality variations: specify the grade or grades of the commodity that are acceptable
(the price will depend on it)
Financial Asset
Usually well defined and unambiguous

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C ONTRACT S IZE

The amount of the asset that has to be delivered under one contract
If too large, traders who wish to hedge small exposures unable to use the exchange
If too small, trading my be expensive
Some times, mini contract available to attract smaller traders

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D ELIVERY A RRANGEMENTS

The place where delivery will be made must be specified

Particularly important for commodities because of transportation costs
Price higher the further from the main source of the commodity

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D ELIVERY M ONTHS

Specify the precise period during the month when delivery can be made
Chosen by the exchange to meet the needs of market participants

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P RICE Q UOTES

The exchange specifies how prices will be quoted

For example, crude oil futures prices in dollars and cents

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P RICE L IMITS AND P OSITION L IMITS

Daily price limits are specified by the exchange

Trading ceases for the day once the contract is limit up or limit down
To prevent large price movements because of speculative excesses

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C ONVERGENCE OF F UTURES TO S POT P RICES

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C ONVERGENCE OF F UTURES TO S POT P RICES

Imagine that the futures price is above the spot price

1 Sell (i.e., short) a futures contract
2 Buy the asset
3 Make delivery
Profit equal to the amount by which the futures price exceeds the spot price
As traders exploit this arbitrage, the futures price will fall

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M ARGINS

A margin is cash or marketable securities deposited by and investor with the broker
The balance in the margin account is adjusted to reflect daily settlement
Margins minimize the possibility of a loss through a default on a contract

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M ARGIN C ASH F LOWS

A retail trader has to bring the balance in the margin account up to the initial margin when it
falls below the maintenance margin level
A member of the exchange clearing house only has an initial margin and is required to
maintain the balance in its account at that level every day
These daily margin cash flows are referred to as variation margin
A member of the exchange is also required to contribute to a default fund

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E XAMPLE OF A F UTURES T RADE

A retail trader takes a long position in 2 December gold futures contracts on June 5th
Contract size is 100 oz.
Futures price is US$ 1,750 per ounce
Initial margin requirement is US$ 6,000/contract
Maintenance margin is US$4,500/contract

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A POSSIBLE OUTCOME

Day Trade Price Settle Price Daily Gain Cumulative gain Margin Balance Margin call

1 1,750.00 12,000
1 1,741.00 -1,800 -1,800 10,200
2 1,738.30 -540 -2,340 9,660
...
6 1,736.20 -780 -2,760 9,240
7 1,729.90 -1,260 -4,020 7,980 4,020
8 1,730.80 180 -3,840 12,180
...
16 1,726.90 -780 -4,620 15,180

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T HE CLEARING HOUSE
It is an intermediary in futures transactions
It guarantees the performance of the parties to each transaction
The main task is to keep track of all transactions during a day to calculate the net position
The clearing house member is required to provide to the clearing hosue
The initial margin
At the end of the day, if the transactions have lost money, the member provides the variation
margin
At the end of the day, if the transactions have gained money, the member receives the variation
margin
Net basis more than gross basis (hence, clearing)
Guarantee fund for eventual defaults of members
Very successful system to minimize credit risk

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C ASH FLOW WHEN F UTURES P RICE I NCREASES

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C ASH FLOW WHEN F UTURES P RICE D ECREASES

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F UTURES VS F ORWARDS
Futures Forwards

Trade On exchange Private contract

Settlement Daily End of the contract
Default risk borne By Clearing House By Counterparts
What Standardized Negotiable
Price Marked to market Payment at maturity
Where Standardized Negotiable
When Standardized Negotiable
Liquidity Risk Avoided by Clearing House Difficult to exit a contract
How much Standardized Negotiable
Margin Required Collateral negotiable
Typical Offset prior to delivery Delivery takes place

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H EDGING S TRATEGIES USING F ORWARDS
L ONG AND S HORT H EDGES

A long future hedge is appropriate when

you know you will purchase an asset in the future
you want to lock in the price
A short futures hedge is appropriate when
you know you will sell an asset in the future
you want to lock in the price

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P LUS SIDES OF H EDGING

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

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D OWN SIDES OF H EDGING

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

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B ASIS R ISK

Hedging is not that straightforward

1 The asset whose price is to be hedged may not be exactly the same as the asset underlying the
futures contract
2 There may be uncertainty as to the exact date when the asset will be bought or sold
3 The hedge may require the futures contract to be closed out before its delivery month

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B ASIS RISK

Basis = Spot price of asset to be hedged - Futures price of contract used

Notation:
S1 spot price at time t1
S2 spot price at time t2
F1 futures price at time t1
F2 futures price at time t2
b1 Basis at time t1
b2 Basis at time t2

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E XAMPLE INVOLVING B ASIS R ISK
Assume that a hedge is put in place at time t1 and closed at time t2
Consider the case where the spot and futures price at the time the hedge is initiated are $
2.50 and $ 2.20
Consider the case where the spot and futures at the time the hedge is closed out they are $
2.00 and $ 1.90
Using the notation outlined before
S1 = 2.50
S2 = 2.00
F1 = 2.20
F2 = 1.90
b1 = S1 − F1 = 0.30
b2 = S2 − F2 = 0.10

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E XAMPLE INVOLVING B ASIS RISK
Consider first the situation of a hedger who knows that the asset will be sold at time t2 and
takes a short futures position at time t1
The price realized for the asset is S2 and the profit on the futures position is F1 − F2
The effective price that is obtained for the asset with hedging is therefore

S2 + F1 − F2 = F1 + b2 (2)

In the example, it is $ 2.30

NOTICE:
The value of F1 is known at time t1
If b2 were also known at time t1 a perfect hedge would result
The hedging risk is the uncertainty associated with b2

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E XAMPLE INVOLVING B ASIS RISK
Consider next the situation of a hedger who knows that the asset will be bought at time t2
and takes a long futures position at time t1
The price paid for the asset is S2 and the loss on the futures position is F1 − F2
The effective price that is paid for the asset with hedging is therefore

S2 + F1 − F2 = F1 + b2 (3)

In the example, it is $ 2.30

NOTICE:
The value of F1 is known at time t1
If b2 were also known at time t1 a perfect hedge would result
The hedging risk is the uncertainty associated with b2

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L ONG H EDGE FOR P URCHASE OF AN A SSET

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

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S HORT H EDGE FOR S ALE OF AN A SSET

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

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C HOICE OF C ONTRACT

Choose a delivery month that is as close as possible to, but later than, the end of the life of
the hedge
In general, basis risk increases as the time difference between the hedge expiration and the
delivery month increases
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 (cross hedging)

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E XAMPLE OF C ROSS H EDGING WITH BASIS RISK
The asset that gives rise to the hedger’s exposure is sometimes different from the asset
underlying the futures contract used for hedging
This leads to an increase in basis risk
Define
S2∗ the price of the asset being hedged at time t2
As before S2 the price of the asset being hedged at time t2
By hedging, a company ensures that the price that will be paid (or received) for the asset is
S2 + F 1 − F 2 (4)
that can be written as
F1 + (S2∗ − F2 ) + (S2 − S2∗ ) (5)
The terms (S2∗ − F2 ) and (S2 − S2∗ ) represent the components of the basis risk, specifically,
(S2∗ − F2 ) is the basis that would exist if the asset being hedged were the same as the asset
underlying the futures contract
(S2 − S2∗ ) is the basis arising from the difference between the two assets

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O PTIMAL H EDGE R ATIO
Assume no daily settlement of futures contracts
The minimum variance hedge ratio depends on the relationship between changes in the spot
price ∆S and changes in the futures price ∆F
Assume their relationship is approximately linear

∆S = a + b ∆F + ϵ (6)

with a and b constants and ϵ an error term.

Suppose that the hedge ratio is h (i.e., a percentage h of the exposure to S is hedged with
futures
Then, the change in the value of the position per unit of exposure to S is

∆S − h∆F = a + (b − h)∆F + ϵ (7)

⇒ The standard deviation of this is minimized when h = b (so that the second term on the
right-hand side disappears)

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O PTIMAL H EDGE R ATIO
Then, the change in the value of the position per unit of exposure to S is

∆S − h∆F = a + (b − h)∆F + ϵ (8)

⇒ The standard deviation of this is minimized when h = b (so that the second term on the
right-hand side disappears)
Recap on b in a regression
Y = a + bX + ϵ
b = Cov (Y , X )/Var (X ) = σx,y /σX2
We can re-express b as
σx,y 1
b= × (9)
σX σX
By multiplying and dividing by σY
σx,y σY
b= × (10)
σX σY σX
Remember that ρ = σx,y /σX σY

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O PTIMAL H EDGE R ATIO

Ignore daily settlements of futures (or assume forwards are used)

the proportion of the exposure that should optimally be hedged is

σS
h∗ = ρ (11)
σF
where
σs is the standard deviation of ∆S, the change in the spot price during the hedging period
σF is the standard deviation of ∆F , the change in the futures price during the hedging period
ρ is the correlation coefficient between ∆S and ∆F

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O PTIMAL N UMBER OF C ONTRACTS

h∗ QA
N∗ = (12)
QF

Where
QA is the size of the position being hedged (units)
QF is the size of the futures contract (units)

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O PTIMAL N UMBER OF C ONTRACTS WHEN THE CONTRACT IS
SETTLED DAILY

σ̂S SQA
N ∗ = ρ̂ (13)
σ̂F FQF

where
ρ̂ is the correlation between percentage daily changes for spot and futures
σ̂S is the standard deviation of percentage daily changes in spot
σ̂F is the standard deviation of percentage daily changes in futures

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S TACK AND R OLL

When the expiration date of the hedge is later than the delivery dates of all the future
contracts that can be used
1 Enter into futures contracts to hedge exposure up to a time horizon
2 Just before maturity close them out and replace them with new contracts reflecting the new
exposure

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Q UESTIONS ?
F INANCIAL R ISK M ANAGEMENT

F UTURES AND F ORWARDS :

H EDGING
L ECTURE 3
Angelo Luisi — [email protected]