Rkm chapter 06 hedging strategies using futures
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This chapter discusses different hedging strategies using futures. It explains that a perfect hedge fully eliminates price uncertainty while an imperfect hedge only reduces it. A long hedge is used when prices are expected to rise, while a short hedge hedges against falling prices. Basis risk exists when the asset and futures contract do not match in terms of underlying asset, timing or quantity. The hedge ratio determines the optimal number of futures contracts to use based on the volatility of the asset and futures contract prices.
Rkm chapter 06 hedging strategies using futures
- 1. Chapter 6 Hedging Strategies Using Futures
- 2. Perfect and Imperfect Hedges A perfect hedge is achieved when price uncertainty is fully eliminated and the hedger knows for certain what the future cash flow will be An imperfect hedge is a partial hedge in which the price uncertainty is reduced but not fully eliminated
- 3. When to Hedge? A long hedge is appropriate only if the price is expected to increase (hedge downside risk) A short hedge is appropriate only if the price is expected to decrease (hedge downside risk) Decision to hedge is based on expectations of price movement
- 4. Risks in Hedging Price movement is opposite to what was expected (upside risk), which can result in losses One does not get perfect hedges if any of the following conditions hold: Asset to be hedged is different from the underlying f asset in the futures The quantity to be hedged is different from the futures size The end of exposure date of the asset is different from the maturity date of the futures
- 5. Basis and Basis Risk Basist = spot price of asset to be hedged (St) – futures price of contract used (Ft) Final basis (ST – FT) is basis on the maturity date Final basis should be zero if the asset to be hedged is the same as the asset underlying the futures If the final basis is not zero, basis risk exists
- 6. Factors Affecting Basis Risk a. Asset being hedged is different from the futures underlying the asset b. The day on which the hedge is closed out is different from the futures maturity date c. The quantity of the asset being hedged is not fully covered by an integer multiple of futures contracts
- 7. Example of Basis Risk An exporter expects to receive AUD 546, 288 on Oct 14. Futures are not available on AUD and hence will use USD futures. The final basis need not have to be zero as ST = spot price of AUD, whereas FT = spot price of USD USD futures are available with maturities of Sep 30 and Oct 31. Mismatch of timing of hedge being closed out and futures maturity date. The USD futures contract size is USD 1000. Since a complete hedge requires 546.288 contracts, there is a mismatch of quantity to be hedged and contract size
- 8. Hedge Ratio Size of exposure Hedge ratio Size of position in futures Size of exposure = quantity of asset * spot price of asset Size of position in futures = contract size * number of contracts Optimal hedge ratio : h* * s f 2 Hedging effectiveness : h 2* * F 2 s
- 9. Example of Using Hedge Ratio A company requires 20 tonnes of wheat on March 20. On March 1, wheat sells at INR 1200/quintal, and March futures are at INR 1240. The contract size for futures is 10 tonnes. σS = 100, σF = 70, s s= 0.98 Optimal hedge ratio: h* = r * sf Hedge Ratio (h) = 0.98 * (100/70) = 1.4
- 10. Example-6.12 σS = 6, σF = 4, = 0.9 ss Optimal hedge ratio: h* = r * sf Hedge Ratio (h) = 0.9 * (6/4) = 1.35 No. of contracts (optimal) = (h * size of position/contract size) = 1.35 * 20,000/100 = 270 contracts Hedging effectiveness = (1.35)2 x (4/6)2 = 81% of ATF price volatility is hedged