LO 32.a:
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.
Explanation: Hedging involves using financial instruments like futures contracts to offset the risk of price movements in an underlying asset. If an investor expects the price of the asset to decrease, they can enter a short position in futures (sell futures) to protect themselves from potential losses. Conversely, if the investor expects the price to increase, they can buy futures to hedge against potential price rises.
Example: Let's say an oil producer expects the price of oil to decrease in the next few months. To protect against this price decline, they sell (short) oil futures contracts. If the price of oil falls, the profit from the short futures position can help offset the losses in the spot (physical) market.
LO 32.b:
Investors hedge with futures contracts to reduce or eliminate the price risk of an asset or a portfolio. The key advantage of hedging is that it leads to less uncertainty regarding future profitability. The key disadvantage of hedging (assuming a short hedge) is that it can lead to less profitability if the asset being hedged ends up increasing in value.
Explanation: Hedging aims to mitigate the risk associated with price fluctuations. By using futures contracts, investors can lock in a certain price for their assets and reduce uncertainty. The advantage of hedging is the increased predictability of future returns. However, if the hedged asset increases in value, the investor may miss out on potential profits due to the short position taken in the futures contract.
Example: An investor holds a portfolio of technology stocks and decides to hedge the portfolio's value using S&P 500 index futures. If the market experiences a significant downturn, the value of the futures contract is expected to increase, offsetting the losses in the stock portfolio. However, if the technology sector outperforms the market and the portfolio value rises, the short position in the futures contract could lead to missed gains.
LO 32.c:
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.
Explanation: Basis risk arises from the potential mismatch between the spot price of the asset being hedged and the futures price of the contract used for hedging. It can occur due to differences in the underlying asset, maturity dates, or other contract specifications. Basis risk is minimized when there is an exact match between the underlying asset and the futures contract.
Example: An airline company wants to hedge its exposure to jet fuel prices and decides to use crude oil futures contracts as a proxy for hedging. However, jet fuel and crude oil are not perfect substitutes, and their prices may not move in tandem. This introduces basis risk as the hedging effectiveness is dependent on the correlation between crude oil prices and jet fuel prices.
LO 32.d:
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.
Explanation: Cross hedging involves using futures contracts based on an asset that is related to, but not identical with, the asset being hedged. The hedge ratio specifies the number of futures contracts needed to effectively hedge a given exposure in the spot market.
Example: A wheat farmer in a particular region might want to hedge against price fluctuations in wheat, but there are no wheat futures contracts available for that specific region. In this case, the farmer could use corn futures contracts (a related asset) to cross hedge their wheat exposure. The hedge ratio would determine how many corn futures contracts the farmer needs to achieve the desired level of protection for their wheat crops.
LO 32.e:
By using either a short or long hedge, an investor can lock in a price equal to the current futures price.
Explanation: Both short and long hedges can lock in a specific price for the underlying asset. A short hedge involves selling futures contracts to protect against a price decline, while a long hedge involves buying futures contracts to protect against a price increase. In both cases, the investor can establish a known future price for the asset based on the current futures price.
Example: A company plans to purchase a large quantity of copper six months from now but is concerned about potential price increases. To lock in the current copper price, they enter into a long hedge by buying copper futures contracts at the current futures price. This way, they can ensure they will pay the same price for copper in six months, regardless of any price fluctuations during that period.
LO 32.f:
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:
# of contracts = portfolio value / (futures price x contract multiplier)
To correct for the possibility of overhedging, a hedger can implement a tailing the hedge strategy by multiplying the hedge ratio by the daily spot-price-to-futures-price ratio.
Explanation: This section discusses hedging equity portfolios using stock index futures. The number of futures contracts needed for hedging is calculated by dividing the value of the portfolio by the product of the futures price and the contract multiplier.
The "tailing the hedge" strategy involves adjusting the hedge ratio based on the daily spot-price-to-futures-price ratio. This helps avoid overhedging or underhedging as the spot price and futures price change over time.
Example: An investor holds an equity portfolio worth $1,000,000 and wants to hedge it using S&P 500 index futures. If the futures price is $4,000, and the contract multiplier is 250 (meaning each contract controls $250,000 worth of the index), the number of contracts required for a complete hedge would be:
# of contracts = $1,000,000 / ($4,000 x 250) = 5 contracts
If the investor decides to implement the tailing the hedge strategy and the spot-price-to-futures-price ratio indicates a 10% difference, the adjusted hedge ratio would be 5 contracts x (1 + 0.10) = 5.5 contracts.
LO 32.g:
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:
number of contracts = (6 - 8) x portfolio value / (value of futures contract)
Explanation: Beta measures the sensitivity of a portfolio's returns to movements in the overall market. By shorting stock index futures, an investor can reduce the portfolio's beta, making it less sensitive to market fluctuations.
Example: An investor holds a stock portfolio valued at $500,000, and each stock index futures contract has a value of $50,000. To reduce the portfolio's beta, the investor decides to short sell stock index futures. The number of contracts required to achieve the desired beta adjustment would be:
number of contracts = (6 - 8) x $500,000 / $50,000 = -
40 to -53 contracts
Note: The negative sign indicates that the investor is shorting (selling) the contracts.
LO 32.h:
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 reestablished.
Explanation: If the maturity of the futures contract used for hedging is shorter than the desired hedging period, the hedger will need to roll the hedge forward by closing out the expiring futures position and entering a new one with a later expiration date. This introduces rollover risk, which refers to the potential for unfavorable price movements during the rollover process. Additionally, basis risk may arise when the new futures contract is different from the original one, leading to potential mismatches between spot and futures prices.
Example: An investor wants to hedge their soybean exposure for the next six months. However, the available soybean futures contracts expire every three months. To maintain the hedge, the investor must roll the futures position every three months by selling the expiring contract and buying a new one with a later expiration date. The risk lies in the possibility of adverse price movements during these rollover transactions, impacting the effectiveness of the hedge.
Here are some multiple-choice questions related to hedging and futures contracts, along with their possible answers:
Question 1:
Which of the following is a key advantage of hedging using futures contracts?
a) Guaranteed profitability
b) Elimination of all market risk
c) Reduced uncertainty regarding future profitability
d) Guaranteed protection against price increases
Answer: c) Reduced uncertainty regarding future profitability
Question 2:
Basis risk refers to:
a) The risk of holding a position without hedging
b) The risk of price fluctuations in the futures market
c) The risk of a difference between the spot price and futures price of the hedged asset
d) The risk associated with cross hedging using unrelated assets
Answer: c) The risk of a difference between the spot price and futures price of the hedged asset
Question 3:
Which hedging strategy involves selling futures contracts to protect against price declines?
a) Long hedge
b) Cross hedge
c) Short hedge
d) Tailing the hedge
Answer: c) Short hedge
Question 4:
A company wants to hedge its exposure to foreign exchange rate fluctuations. However, there are no futures contracts available for the specific currency it needs to hedge. What strategy can the company use to hedge this risk?
a) Tail the hedge strategy
b) Cross hedge using a related currency futures contract
c) Use options contracts instead of futures contracts
d) Use a forward contract with a financial institution
Answer: b) Cross hedge using a related currency futures contract
Question 5:
Which formula can be used to determine the number of futures contracts needed to hedge an equity portfolio using stock index futures?
a) # of contracts = portfolio value x futures price x contract multiplier
b) # of contracts = portfolio value / (futures price x contract multiplier)
c) # of contracts = portfolio value + (futures price x contract multiplier)
d) # of contracts = portfolio value - (futures price x contract multiplier)
Answer: b) # of contracts = portfolio value / (futures price x contract multiplier)
Question 6:
What risk is associated with rolling over futures contracts when the hedging horizon is longer than the maturity of the futures?
a) Rollover risk
b) Market risk
c) Basis risk
d) Counterparty risk
Answer: a) Rollover risk
Question 7:
How can an investor reduce the beta of their stock portfolio using stock index futures?
a) Buying stock index futures
b) Selling stock index futures
c) Buying individual stocks
d) Selling individual stocks
Answer: b) Selling stock index futures
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