Hedging Strategies Using Futures Lecture 12 3 1

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Hedging Strategies Using Futures Lecture #12 3. 1

Hedging Strategies Using Futures Lecture #12 3. 1

Long Hedge l l l Suppose that F 1 : Initial Futures Price F

Long Hedge l l l Suppose that F 1 : Initial Futures Price F 2 : Final Futures Price S 2 : Final Asset Price You hedge the future purchase of an asset by entering into a long futures contract Cost of Asset=S 2 – (F 2 – F 1) = F 1 + Basis 3. 2

Short Hedge l l l Suppose that F 1 : Initial Futures Price F

Short Hedge l l l Suppose that F 1 : Initial Futures Price F 2 : Final Futures Price S 2 : Final Asset Price You hedge the future sale of an asset by entering into a short futures contract Price Realized=S 2+ (F 1 – F 2) = F 1 + Basis 3. 3

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Choice of Contract l l Choose a delivery month that is as close as

Choice of Contract l l 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. 3. 5

Optimal Hedge Ratio Proportion of the exposure that should optimally be hedged is where

Optimal Hedge Ratio Proportion of the exposure that should optimally be hedged is where s. S is the standard deviation of DS, the change in the spot price during the hedging period, s. F is the standard deviation of DF, the change in the futures price during the hedging period r is the coefficient of correlation between DS and DF. 3. 6

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Hedging Using Index Futures (Page 63) To hedge the risk in a portfolio the

Hedging Using Index Futures (Page 63) To hedge the risk in a portfolio the number of contracts that should be shorted is where P is the value of the portfolio, b is its beta, and A is the value of the assets underlying one futures contract 3. 8

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l Source: Options, Futures, and Other Derivatives 6 th Edition, Copyright © John C.

l Source: Options, Futures, and Other Derivatives 6 th Edition, Copyright © John C. Hull 2005 3. 14