Ch03 hullfundamentals7thed
Download as PPT, PDF1 like1,022 views
The document discusses various hedging strategies using futures contracts. It describes long and short hedges to lock in future prices when purchasing or selling an asset. It also discusses arguments for and against hedging, basis risk, optimal hedge ratios, tailing hedges over time, and hedging equity portfolios using stock index futures.
Ch03 hullfundamentals7thed
- 1. Hedging Strategies Using Futures Chapter 3 (All Pages) Fundamentals of Futures and Options Markets, 7th Ed, Ch3, Copyright © John C. Hull 2010
- 2. 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 Fundamentals of Futures and Options Markets, 7th Ed, Ch3, Copyright © John C. Hull 2010
- 3. 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 Fundamentals of Futures and Options Markets, 7th Ed, Ch3, Copyright © John C. Hull 2010
- 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 (Airline Example) Explaining a situation where there is a loss on the hedge and a gain on the underlying can be difficult (Page 52 example) Fundamentals of Futures and Options Markets, 7th Ed, Ch3, Copyright © John C. Hull 2010
- 5. Convergence of Futures to Spot (Hedge initiated at time t 1 and closed out at time t 2 ) Fundamentals of Futures and Options Markets, 7th Ed, Ch3, Copyright © John C. Hull 2010 Time Spot Price Futures Price t 1 t 2
- 6. 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 Fundamentals of Futures and Options Markets, 7th Ed, Ch3, Copyright © John C. Hull 2010
- 7. Long Hedge 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 Fundamentals of Futures and Options Markets, 7th Ed, Ch3, Copyright © John C. Hull 2010
- 8. Short Hedge 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 Fundamentals of Futures and Options Markets, 7th Ed, Ch3, Copyright © John C. Hull 2010
- 9. Choice of Contract 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. There are then 2 components to basis Fundamentals of Futures and Options Markets, 7th Ed, Ch3, Copyright © John C. Hull 2010
- 10. Optimal Hedge Ratio Proportion of the exposure that should optimally be hedged is where S is the standard deviation of S , the change in the spot price during the hedging period, F is the standard deviation of F , the change in the futures price during the hedging period is the coefficient of correlation between S and F . Fundamentals of Futures and Options Markets, 7th Ed, Ch3, Copyright © John C. Hull 2010
- 11. Tailing the Hedge Two way of determining the number of contracts to use for hedging are Compare the exposure to be hedged with the value of the assets underlying one futures contract Compare the exposure to be hedged with the value of one futures contract (=futures price time size of futures contract The second approach incorporates an adjustment for the daily settlement of futures Fundamentals of Futures and Options Markets, 7th Ed, Ch3, Copyright © John C. Hull 2010
- 12. Hedging Using Index Futures (Page 63) To hedge the risk in a portfolio the number of contracts that should be shorted is where V A is the current value of the portfolio, is its beta, and V F is the current value of one futures (=futures price times contract size) Fundamentals of Futures and Options Markets, 7th Ed, Ch3, Copyright © John C. Hull 2010
- 13. Reasons for Hedging an Equity Portfolio Desire to be out of the market for a short period of time. (Hedging may be cheaper than selling the portfolio and buying it back.) (Why Cheaper?) Desire to hedge systematic risk (Appropriate when you feel that you have picked stocks that will outperform the market.) (Market Neutral Trading) Fundamentals of Futures and Options Markets, 7th Ed, Ch3, Copyright © John C. Hull 2010
- 14. Example – Page 64 Futures price of S&P 500 is 1,010 Size of portfolio is $5.05 million Beta of portfolio is 1.5 One contract is on $250 times the index S&P 500 Index is 1,000 Dividend Yield on index = 1% What position in futures contracts on the S&P 500 is necessary to hedge the portfolio? Fundamentals of Futures and Options Markets, 7th Ed, Ch3, Copyright © John C. Hull 2010
- 15. Changing Beta What position is necessary to reduce the beta of the portfolio to 0.75? What position is necessary to increase the beta of the portfolio to 2.0? Fundamentals of Futures and Options Markets, 7th Ed, Ch3, Copyright © John C. Hull 2010
- 16. Stock Picking If you think you can pick stocks that will outperform the market, futures contract can be used to hedge the market risk If you are right, you will make money whether the market goes up or down Fundamentals of Futures and Options Markets, 7th Ed, Ch3, Copyright © John C. Hull 2010
- 17. Rolling The Hedge Forward We can use a series of futures contracts to increase the life of a hedge Each time we switch from 1 futures contract to another we incur a type of basis risk Fundamentals of Futures and Options Markets, 7th Ed, Ch3, Copyright © John C. Hull 2010
- 18. Practice Problems: All Quiz Questions Problem 3.10 Problem 3.17 Problem 3.24 Fundamentals of Futures and Options Markets , 6 th Edition, Copyright © John C. Hull 2007
Editor's Notes
- #4: Small businesses or corporations with little knowledge or exposure to factors affecting underlying asset prices. Example: Starbucks hedging its energy exposure.
- #5: Airline Example – Jet Fuel Hedging when competitors don’t… Discuss example of power utility or Oil producer. The decision to hedge and if so how much (%) and how far forward (Yrs) Are there any natural hedges for these examples? Exelon & Sunoco for example.
- #6: Discuss Contango vs. Backwardation nearby vs. forward futures In graph above, futures may actually fall below spot between t1 & t2 – basis can be volatile What factors could affect this? 1) Shortage of physical commodity (inverts) 2) interest rates rising (widens)
- #7: Note: Storage may not be available – what typically happens to basis then? – basis increases – futures move higher than spot Other reason for basis – expected quality difference of product likely to be delivered to exchange – Oil with sulfur content
- #10: Can there be basis at futures expiration? Discuss how – Quality difference at settlement – delivery costs – because contracts typically require seller to have product delivered to exchange approved location.
- #13: This also works for hedging individual stock positions, but the hedges performance is considerably worse because overall market risk is a much smaller proportional factor influencing the individual stock’s price. =B*Va/Vf, where Va = Market value of portfolio
- #15: N = B*Va/Vf = 1.5*$5.05mm/($250*1010) = 30 contracts (pg. 64) Therefore the gain on futures only is: 30 x (1010-902) x 250 = $810,000 (Pg. 64)
- #16: (B-B*) Va/Vf = (1.5-.75) 5.05M/252,500 = sell 15 contracts (B*-B) Va/Vf = (2.0 – 1.5) 5.05M/252500 = buy 10 contracts Formulas on Page 66
- #18: Example top page 68 – Table 3.5