hedging using futures

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Hedging Strategies
Using Futures
Chapter 3

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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
& want to lock in the price
• A short hedge is also appropriate if you currently own the asset and want to be protected against price fluctuations

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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 4

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

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Convergence of Futures to Spot

Futures
Price

Spot Price
Futures
Price

Spot Price

Time

(a)

Time

(b)

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Basis Risk
• Basis is the difference between spot & futures
• Basis risk arises because of the uncertainty about the basis when the hedge is closed out

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Long Hedge
• Suppose that
F1 : Initial Futures Price
F2 : Final Futures Price
S2 : Final Asset Price
• You hedge the future purchase of an asset by entering into a long futures contract • Exposed to basis risk if hedging period does not match maturity date of futures

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Long Hedge
• Cost of Asset = Future Spot Price - Gain on Futures

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Gain on Futures = F2 - F1
Future Spot Price = S2
Cost of Asset= S2 - (F2 - F1)
Cost of Asset = F1 + Basis2
Basis2 = S2 - F2
Future basis is uncertain
Therefore, effective cost of asset hedged is uncertain 9

Short Hedge
• Suppose that
F1 : Initial Futures Price
F2 : Final Futures Price
S2 : Final Asset Price
• You hedge the future sale of an asset