Derivatives: Futures Contract Essay

Derivatives notes
Chapter 3 - Hedging strategies using futures

Learning outcomes
Basic principles of hedging using futures
Pros and cos of hedging
Concept of basis risk
Concept of cross hedging
Stock index futures in the US and Australia
Rolling the hedge forward
3.1 Hedging
Short hedges: Hedging short position in futures contracts, the asset is already owned by the hedger and is expected to sell some time in the future at a locked price.
Basic short hedge example:
‘Example: I’m selling 1 million barrels of crude oil. The spot price for a barrel is $19 per barrel and the 3-month futures price is $18.75 per barrel.’
– Spot price in three months proves to be $17.50: I gain $18.75-$17.50=$1.25 per barrel from the futures but I’m selling the oil for $1.25 less per barrel. I end up getting $18.75 per barrel.
– Spot price in three months proves to be $19.50: I lose $19.50-$18.75=$0.75 per barrel from the futures but I’m selling the oil for $0.75 more per barrel. I end up getting $18.75 per barrel.
Long hedges: Hedging long positions in futures contract, the asset is not owned but will be purchased in the future by the hedger at a locked price. If a long position is not taken it will incur both interest and storage costs.
3.2 Arguments against hedging
Arguments against hedging:
Hedging and shareholders: Shareholders can hedge themselves, they do not need the company to do it for them. However they do not have as much information and the argument ignores commissions and other transaction costs.
Hedging and competitors: If hedging is uncommon in a certain industry, it is recommended not to hedge. Hedging in this case can cause profit margins to fluctuate.

Hedging can lead to a worse outcome: Treasurers make decisions based on forecasting to hedge or not. If prices go up, the company is in a worse position then it would have been in with no hedging. Treasurers are often reluctant to hedge as although it reduces risk for the company, it increases risk for the treasurer.

3.3 Basis risk
Basis risk: In practice, hedging is different as:
The asset whose price is to be hedged may not be exactly the same as the asset underlying the futures contract
The hedger may not be certain of the exact date the asset will be bought or sold.
The hedge may require the futures contract to be closed out before its delivery month.
Basis = Spot price of asset to be hedged – Futures price of contract used
Basis risk increases: as the time difference between the hedge expiration and the delivery month increases
Variation of basis overtime

To examine the nature of basis risks the following notations are used:
S1 = Spot price at t1
S2 = Spot price at t2
F1 = Futures price at time t1
F2 = Futures price at time t2 b1 = Basis at time t1 b2 = Basis at time t2

Useful formulas
Definition of basis: b1 = S1 – F1 and b2 = S2 – F2
Effective price obtained for the asset with hedging: S2 + (F1 - F2) = F1 + b2
Effective price paid with hedging:
S2 - (F2 – F1) = F1 + b2
By hedging a company ensure the price will be paid for the asset:
S2 + F1 – F2
This can be written as:
F1 + (S2* - F2) + (S2 - S2)
(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 two assets

Factors affect basis risk if the choice of the futures contract to be used for hedging, these include:
The choice of the asset underlying the futures contract
The choice of the delivery month

3.4 Cross hedging
Cross hedging: Occurs when the two asses are different. A cross hedge is performed when an investor who holds a long or short position in an asset takes an opposite (not necessarily equal) position in a separate security, in order to limit both up- and down-side exposure related to the initial holding.
Hedge ratio: ratio of the size of the position taken in futures contract to the size of the exposure,

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