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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

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hedging long and short
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?
arguments for hedging
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
arguments against hedging
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
basis risk
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
choice of hedging contract
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
naive hedge ratio
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
minimum variance hedge ratio
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:
hedging stock portfolios
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?
hedging stock portfolios9
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
hedging stock portfolios10
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
rolling the hedge forward
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
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