Hedging Long and Short Long futures hedge appropriate

Hedging: Long and Short è Long futures hedge appropriate when you will purchase an asset in the future and fear a rise in prices – If you have liabilities now, what do you fear? è Short futures hedge appropriate when you will sell an asset in the future and fear a fall in price – If you expect to issue liabilities, what do you fear? 1

Arguments For Hedging è Companies should focus on their main business and minimize risks arising from interest rates, exchange rates, and other market variables – Non-intrusive risk management tool è Hedging may help smooth income and minimize tax liabilities è Hedging may help smooth income and reduce managerial salaries 2

Arguments Against Hedging è Well-diversified shareholders can make their own risk management decisions è It may increase business risk to hedge when competitors do not è Explaining a loss on the hedge and a gain on the underlying can be difficult 3

Basis Risk è Basis is the difference between spot and futures prices è Basis risk arises because of uncertainty about the price difference when the hedge is closed out è Basis risk usually less than the risk of price or rate level changes è Basis risk depends on futures pricing forces 4

Choice of Hedging Contract è Delivery month should be as close as possible to, but later than, the end of the life of the hedge è If no futures contract hedged position, choose the contract whose futures price is most highly correlated with the asset price – Called cross-hedging – Additional basis risk 5

Naive Hedge Ratio è Divide the face value of the cash position by the face value of one futures contract è Problems: – Market values should be focus – Ignores differences between the cash and futures instruments è Variation: divide the market value of the cash position by the market value of one futures contract 6

Minimum Variance Hedge Ratio è Proportion of the exposure that should optimally be hedged is hedge per dollar of cash market value è Hedge ratio estimated from: 7

Hedging Stock Portfolios è If hedging a well-diversified stock portfolio with a well-diversified stock index futures contract, what are implications? – No diversifiable risk in the cash stock portfolio and futures hedge removes systematic risk – Since no risk, systematic or unsystematic, what can an investor expect to earn by hedging a well-diversified stock portfolio? 8

Hedging Stock Portfolios è But has all risk been eliminated? è Problems: – Stock portfolio being hedged may have a different price volatility than the stock -index futures – Hedging goal is not to reduce all systematic risk è Price sensitivity to market movements determined by beta 9

Hedging Stock Portfolios è Optimal number of contracts to hedge a portfolio is è Future contracts can be used to change the beta of a portfolio – If b* >(<) b. S, hedging implies a long (short) stock index futures position 10

Rolling The Hedge Forward è What if hedging further in the future than available delivery dates? è Series of futures contracts used to increase the life of a hedge è Each time a futures contract matures, switch position into another, later contract – Basis risk, cash flow problems possible 11