Hedging: Long and Short

1. Hedging: Long and Short • Long futures hedge appropriate when you will purchase an asset in the future and fear a rise in prices • If you have liabilities now, what do you fear? • Short futures hedge appropriate when you will sell an asset in the future and fear a fall in price • If you expect to issue liabilities, what do you fear?

2. Arguments For Hedging • Companies should focus on their main business and minimize risks arising from interest rates, exchange rates, and other market variables • Non-intrusive risk management tool • Hedging may help smooth income and minimize tax liabilities • Hedging may help smooth income and reduce managerial salaries

3. Arguments Against Hedging • Well-diversified shareholders can make their own risk management decisions • It may increase business risk to hedge when competitors do not • Explaining a loss on the hedge and a gain on the underlying can be difficult

4. Basis Risk • Basis is the difference between spot and futures prices • Basis risk arises because of uncertainty about the price difference when the hedge is closed out • Basis risk usually less than the risk of price or rate level changes • Basis risk depends on futures pricing forces

5. Choice of Hedging Contract • Delivery month should be as close as possible to, but later than, the end of the life of the hedge • If no futures contract hedged position, choose the contract whose futures price is most highly correlated with the asset price • Called cross-hedging • Additional basis risk

6. Naive Hedge Ratio • Divide the face value of the cash position by the face value of one futures contract • Problems: • Market values should be focus • Ignores differences between the cash and futures instruments • Variation: divide the market value of the cash position by the market value of one futures contract

7. Minimum Variance Hedge Ratio • Proportion of the exposure that should optimally be hedged is hedge per dollar of cash market value • Hedge ratio estimated from:

8. Hedging Stock Portfolios • If hedging a well-diversified stock portfolio with a well-diversified stock index futures contract, what are implications? • No diversifiable risk in the cash stock portfolio and futures hedge removes systematic risk • Since no risk, systematic or unsystematic, what can an investor expect to earn by hedging a well-diversified stock portfolio?

9. Hedging Stock Portfolios • But has all risk been eliminated? • Problems: • Stock portfolio being hedged may have a different price volatility than the stock-index futures • Hedging goal is not to reduce all systematic risk • Price sensitivity to market movements determined by beta

10. Hedging Stock Portfolios • Optimal number of contracts to hedge a portfolio is • Future contracts can be used to change the beta of a portfolio • If b* >(<) bS, hedging implies a long (short) stock index futures position

11. Rolling The Hedge Forward • What if hedging further in the future than available delivery dates? • Series of futures contracts used to increase the life of a hedge • Each time a futures contract matures, switch position into another, later contract • Basis risk, cash flow problems possible