Chapter 11: Forward and Futures Hedging,
Spread, and Target Strategies
The beauty of finance and speculation was that they could
be different things to different men. To some: poetry or
high drama; to others, physics, scientific and immutable;
to still others, politics or philosophy. And to still others,
war.
Michael M. Thomas
Hanover Place, 1990, p. 37
Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 11: 1
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Important Concepts in Chapter 11
Why firms hedge
Hedging concepts
Factors involved when constructing a hedge
Hedge ratios
Examples of foreign currency hedges, intermediate- and
long-term interest rate hedges, and stock index futures
hedges
Examples of spread and target strategies
Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 11: 2
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Why Hedge?
The value of the firm may not be independent of financial
decisions because
Shareholders might be unaware of the firm’s risks.
Shareholders might not be able to identify the correct
number of futures contracts necessary to hedge.
Shareholders might have higher transaction costs of
hedging than the firm.
There may be tax advantages to a firm hedging.
Hedging reduces bankruptcy costs.
Managers may be reducing their own risk.
Hedging may send a positive signal to creditors.
Dealers hedge their market-making activities in
derivatives.
Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 11: 3
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Why Hedge? (continued)
Reasons not to hedge
Hedging can give a misleading impression of the
amount of risk reduced
Hedging eliminates the opportunity to take advantage
of favorable market conditions
There is no such thing as a hedge. Any hedge is an act
of taking a position that an adverse market movement
will occur. This, itself, is a form of speculation.
Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 11: 4
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Hedging Concepts
Short Hedge and Long Hedge
Short (long) hedge implies a short (long) position in
futures
Short hedges can occur because the hedger owns an
asset and plans to sell it later.
Long hedges can occur because the hedger plans to
purchase an asset later.
An anticipatory hedge is a hedge of a transaction that is
expected to occur in the future.
See Table 11.1 for hedging situations.
Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 11: 5
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Hedging Concepts (continued)
The Basis
Basis = spot price - futures price.
Hedging and the Basis
(short hedge) = S - S (from spot market)
T 0
- (fT - f0) (from futures market)
(long hedge) = -S + S (from spot market)
T 0
+ (fT - f0) (from futures market)
If hedge is closed prior to expiration,
(short hedge) = St - S0 - (ft - f0)
If hedge is held to expiration, S = S = f = f .
t T T t
Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 11: 6
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Hedging Concepts (continued)
The Basis (continued)
Hedging and the Basis (continued)
Example: Buy asset for $100, sell futures for $103. Hold
until expiration. Sell asset for $97, close futures at $97. Or
deliver asset and receive $103. Make $3 for sure.
Basis definition
initial basis: b = S - f
0 0 0
basis at time t: b = S - f
t t t
basis at expiration: bT = ST - fT = 0
For a position closed at t:
(short hedge) = S - f - (S - f ) = -b + b
t t 0 0 0 t
Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 11: 7
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Hedging Concepts (continued)
The Basis (continued)
This is the change in the basis and illustrates the
principle of basis risk.
Hedging attempts to lock in the future price of an asset
today, which will be f0 + (St - ft).
A perfect hedge is practically non-existent.
Short hedges benefit from a strengthening basis.
All of this reverses for a long hedge.
See Table 11.2 for hedging profitability and the basis.
Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 11: 8
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Hedging Concepts (continued)
The Basis (continued)
Example: March 30. Spot gold $1,387.15. June
futures $1,388.60. Buy spot, sell futures. Note:
b0 = 1,387.15 − 1,388.60 = −1.45. If held to expiration,
profit should be change in basis or 1.45.
At expiration, let S = $1,408.50. Sell gold in spot
T
for $1,408.50, a profit of 21.35. Buy back futures at
$1,408.50, a profit of −19.90. Net gain =1.45 or
$145 on 100 oz. of gold.
Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 11: 9
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Hedging Concepts (continued)
The Basis (continued)
Example: (continued)
Instead, close out prior to expiration when
St = $1,377.52 and ft = $1,378.63.
Profit on spot = −9.63. Profit on futures = 9.97.
Net gain = 0.34 or $34 on 100 oz.
Note that change in basis was b − b or
t 0
−1.11 − (−1.45) = 0.34.
Behavior of the basis, see Figure 11.1.
In forward markets, the hedge is customized so there is no basis
risk.
Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 11: 10
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Hedging Concepts (continued)
Some Risks of Hedging
cross hedging
spot and futures prices occasionally move opposite
quantity risk
Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 11: 11
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Hedging Concepts (continued)
Contract Choice
Which futures underlying asset?
High correlation with spot
Favorably priced
Which expiration?
The futures with maturity closest to but after the
hedge termination date subject to the suggestion not
to be in a contract in its expiration month
See Table 11.3 for example of recommended
contracts for T-bond hedge
Concept of rolling the hedge forward
Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 11: 12
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Hedging Concepts (continued)
Contract Choice (continued)
Long or short?
A critical decision! No room for mistakes.
Three methods to answer the question.
See Table 11.4.
• worst case scenario method
• current spot position method
• anticipated future spot transaction method
Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 11: 13
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Hedging Concepts (continued)
Margin Requirements and Marking to Market
low margin requirements on futures, but
cash will be required for margin calls
Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 11: 14
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Determination of the Hedge Ratio
Hedge ratio: The number of futures contracts to hedge a
particular exposure
Naïve hedge ratio
Appropriate hedge ratio should be
N = −S/f
−
f
Note that this ratio must be estimated.
Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 11: 15
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Determination of the Hedge Ratio (continued)
Minimum Variance Hedge Ratio
Profit from short hedge:
= S + fN
f
Variance of profit from short hedge:
2 + 2N 2 + 2
S f f SfNf
The optimal (variance minimizing) hedge ratio is
N = −
S f / f
2
f
This is the beta from a regression of spot price
change on futures price change.
Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 11: 16
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Determination of the Hedge Ratio (continued)
Minimum Variance Hedge Ratio (continued)
Hedging effectiveness is
e* = (risk of unhedged position − risk of hedged
position)/risk of unhedged position
This is coefficient of determination from regression.
Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 11: 17
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Determination of the Hedge Ratio (continued)
Price Sensitivity Hedge Ratio
This applies to hedges of interest sensitive securities.
First we introduce the concept of duration. We start
with a bond priced at B:
T
CPt
B t 1 (1 y B ) t
where CPt is the cash payment at time t and yB is the
yield, or discount rate.
Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 11: 18
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Determination of the Hedge Ratio (continued)
Price Sensitivity Hedge Ratio (continuation)
An approximation to the change in price for a yield change is
DUR B (y)
B B
1 yB
with DURB being the bond’s duration, which is a weighted-average
of the times to each cash payment date on the bond, and
represents the change in the bond price or yield.
Duration has many weaknesses but is widely used as a measure of
the sensitivity of a bond’s price to its yield.
Modified duration (MD) measures the bond percentage price
change for a given change in yield.
Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 11: 19
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Determination of the Hedge Ratio (continued)
Price Sensitivity Hedge Ratio (continuation)
The hedge ratio is as follows:
MD B B
N *f
MD
f
f
Where MDB −(/B) /yB and
MDf −(f/f) /yf
Note the concepts of implied yield and implied duration
of a futures. Also, technically, the hedge ratio will
change continuously like an option’s delta and, like
delta, it will not capture the risk of large moves.
Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 11: 20
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Determination of the Hedge Ratio (continued)
Price Sensitivity Hedge Ratio (continued)
Alternatively,
N = −(Yield beta)PVBP /PVBP
f B f
• where Yield beta is the beta from a regression of
spot bond yield on futures yield and
• PVBPB, PVBPf is the present value of a basis
point change in the bond and futures prices.
Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 11: 21
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Determination of the Hedge Ratio (continued)
Stock Index Futures Hedging
Appropriate hedge ratio is
N = −(
−( S/f)(S/f)
f
where is the beta from the CAPM and is the
S f
beta of the futures, often assumed to be 1.
Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 11: 22
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Hedging Strategies
Long Hedge With Foreign Currency Futures
American firm planning to buy foreign inventory and
will pay in foreign currency.
See Table 11.5.
Short Hedge With Foreign Currency Forwards
British subsidiary of American firm will convert
pounds to dollars.
See Table 11.6.
Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 11: 23
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Hedging Strategies (continued)
Intermediate and Long-Term Interest Rate Hedges
First let us look at the CBOT T-note and bond contracts
T-bonds: must be a T-bond with at least 15 years to
maturity or first call date
T-note: three contracts (2-, 5-, and 10-year)
A bond of any coupon can be delivered but the
standard is a 6% coupon. Adjustments, explained in
Chapter 10, are made to reflect other coupons.
Price is quoted in units and 32nds, relative to $100
par, e.g., 93 14/32 is $93.4375.
Contract size is $100,000 face value so price is
$93,437.50
Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 11: 24
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Hedging Strategies (continued)
Intermediate and Long-Term Interest Rate Hedges
(continued)
Hedging a Long Position in a Government Bond
See Table 11.7 for example.
Anticipatory Hedge of a Future Purchase of a Treasury
Note
See Table 11.8 for example.
Hedging a Corporate Bond Issue
See Table 11.9 for example.
Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 11: 25
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Hedging Strategies (continued)
Stock Market Hedges
First look at the contracts
We primarily shall use the S&P 500 futures. Its
price is determined by multiplying the quoted price
by $250, e.g., if the futures is at 1300, the price is
1300($250) = $325,000
Stock Portfolio Hedge
See Table 11.10 for example.
Anticipatory Hedge of a Takeover
See Table 11.11 for example.
Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 11: 26
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Spread Strategies
Intramarket Spreads
Based on changes in the difference in carry costs
See Figure 11.2 for illustration.
Treasury Bond Futures Spreads
See Figure 11.3 and Figure 11.4 for illustration the
relationship between changes in spreads and interest
rates.
See Table 11.12 for calculation of Tbond futures spread
profits.
See Figure 11.5 for illustration of stock index spreads
Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 11: 27
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Intermarket Spread Strategies
Intermarket spread strategies involve two futures contracts
on different underlying instruments
Intermarket spread strategies tend to be more risky than
intramarket spreads because there is both the change in
spreads and the change in underlying instruments
NOB denotes notes over bonds
Intermarket spread strategies could also involve various
equity markets
Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 11: 28
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Target Strategies: Bonds
Target Duration with Bond Futures
Number of futures needed to change modified duration
MD T - MD B B
N *f
f
MD f
Goal is to move the modified duration from its current
value to a new target value
See Table 11.13 for illustration.
Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 11: 29
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Target Strategies: Equities
Alpha Capture
Number of futures to hedge systematic risk
S
N *f S
f
Goal is to move the eliminate systematic risk
See Table 11.14 for illustration.
Target Beta (see Table 11.15 for illustration.)
S
N *f T S
f
Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 11: 30
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Target Strategies: Equities (continued)
Tactical Asset Allocation
Strategic asset allocation – long run target weights for
each asset class
Tactical asset allocation – short run deviations in
weights for each asset class
See Table 11.16 for illustration.
Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 11: 31
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Summary
Table 11.17 recaps the types of hedge situations, the nature
of the risk and how to hedge the risk
Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 11: 32
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Appendix 11: Taxation of Hedging
Hedges used by businesses to protect inventory and in
standard business transactions are taxed as ordinary
income.
Transactions must be shown to be legitimate hedges and
not just speculation outside of the norm of ordinary
business activities. This is called the business motive test.
Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 11: 33
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