Reading 36 : HEDGING STRATEGIES USING FUTURES

Hedging

        Hedging may be achieved by shorting futures to protect an underlying position against price deterioration or by buying futures to hedge against unanticipated price increases in an underlying asset.

Advantages and Disadvantages of Hedging

        Investors hedge with futures contracts to reduce or eliminate the price risk of an asset or a portfolio. The advantage of hedging is that it leads to less uncertainty regarding future profitability. The disadvantage of hedging is that it can lead to less profitability if the asset being hedged ends up increasing in value.

Basis Risk

        Basis risk is the risk that a difference may occur between the spot price of a hedged asset and the futures price of the contract used to implement the hedge. Basis risk is zero only when there is a perfect match between the hedged asset and the contract’s underlying instrument in terms of maturity and asset type.
Three sources of basis risk are:

• (1) interruption in the convergence of the futures and spot prices,
• (2) changes in the cost of carry, and
• (3) imperfect matching between the cash asset and the hedge asset.

Cross Hedging

        Sometimes it may be more efficient to cross hedge or hedge a cash position with a hedge asset that is closely related but different from the cash asset.
         A hedge ratio is the ratio of the size of the futures position relative to the spot position necessary to provide a desired level of protection.

         The effectiveness of the hedge measures the variance that is reduced by implementing the optimal hedge.

Hedging With Stock Index Futures

        A common hedging application is the hedging of equity portfolios using futures contracts on stock indices (index futures). The number of futures contracts required to completely hedge an equity position is determined as follows:

Adjusting the Portfolio Beta

        When hedging an equity portfolio with a short position in stock index futures, the beta of the portfolio is reduced. To change a stock portfolio’s beta, use the following formula:

Benefiting From Stock Selection

        A manager can lock in the benefits of stock selection by shorting index futures contracts by an amount equal to (beta × portfolio value) / value of futures contract.

Rolling a Hedge Forward

        When the hedging horizon is longer than the maturity of the futures, the hedge must be rolled forward to retain the hedge. This exposes the hedger to rollover risk, the basis risk when the hedge is re-established.