CHAPTER 3

Hedging Strategies Using Futures

Problem 3.2.
Explain what is meant by basis risk when futures contracts are used for hedging.

Basis risk arises from the hedger’s uncertainty as to the difference between the spot price and
futures price at the expiration of the hedge.

Problem 3.4.
Under what circumstances does a minimum-variance hedge portfolio lead to no hedging at all?

A minimum variance hedge leads to no hedging when the coefficient of correlation between the
futures price changes and changes in the price of the asset being hedged is zero.

Problem 3.5.
Give three reasons why the treasurer of a company might not hedge the company’s exposure to a
particular risk. Explain your answer.

(a) If the company’s competitors are not hedging, the treasurer might feel that the company will
experience less risk if it does not hedge. (See Table 3.1.) (b) The shareholders might not want
the company to hedge because the risks are hedged within their portfolios. (c) If there is a loss on
the hedge and a gain from the company’s exposure to the underlying asset, the treasurer might
feel that he or she will have difficulty justifying the hedging to other executives within the
organization.

Problem 3.6.
Suppose that the standard deviation of quarterly changes (measurement interval for returns) in
the prices of a commodity is $0.65, the standard deviation of quarterly changes in a futures price
on the commodity is $0.81, and the coefficient of correlation between the two changes is 0.8.
What is the optimal hedge ratio for a three-month contract? What does it mean?

Note that for hedging issues, metrics on futures is always use in the denominator. Since
correlations is bounded by unity (+1 or -1), if SD of asset return is less than that of futures
return, then the hedge ratio must be below unity

The optimal hedge ratio is (asset or portfolio beta with respect to the futures price change)
This means that the size of the futures position should be 64.2% of the size of the company’s
exposure in a three-month hedge.

Problem 3.7.
A company has a $20 million portfolio with a beta (hedge ratio) of 1.2. It would like to use
futures contracts on the S&P 500 to hedge its risk. The index futures is currently standing at
1080, and each contract is for delivery of $250 (contract multiplier=$250 per index point) times
the index (notional value per futures is 1080 (250). What is the hedge that minimizes
(NEUTREALIZE) MARKET risk? What should the company do if it wants to reduce the beta of
the portfolio to 0.6?

STEP 1: 20 m / 1080 ($250) = size of the portfolio in number of futures contracts = 74.0740
S&P500

STEP 2: optimal number of futures contract to be sold = 1.2 (74.0740) = 88.9 round up to 89
contracts

DOLLAR VALUE OF PORTFOLIO / NOTATION VALUE OF A FUTURES

Multiply that by the hedge ratio give you the number of contract to neutral the portfolio market
risk
The formula for the number of contracts that should be shorted gives

Rounding to the nearest whole number, 89 contracts should be shorted. To reduce the beta to 0.6,
half of this position, or a short position in 44 contracts, is required.

(beta* - beta) size of portfolio in futures contract

0.6-1.2 (74.0740) = short 44 contracts

First question beta* = 0

(0-1.2) 74.0740 = -1.2 74.0740 = -88.9 (this implies that the total delta of the portfolio is 88.9),
after round up short 89 contracts

Second question beta* = 0.6

(0.6 – 1.2) 74.0740 = -0.6 74.0740 = - 44.45

Remark: the total risk of the portfolio is 89 futures contract, to eliminate the market risk of the
portfolio, need to sell 89 S&P500 futures; to reduce the beta of the portfolio to 0.6 (i.e., half of
the initial risk) then short 44 or 45 contract.

To increase the beta of the portfolio, then need to buy futures

Problem 3.13.
“If the minimum-variance hedge ratio is calculated as 1.0, the hedge must be perfect." Is this
statement true? Explain your answer.

The statement is not true. The minimum variance hedge ratio is

It is 1.0 when and . Since the hedge is clearly not perfect.

If correlation between X & Y = 1, then X and Y has a perfect linear relationship. In the absence
of a perfect linear relationship, there is a random element in their relationship.

However, if rho = 0, it does not imply that X and Y are unrelated. Y = (-X)^2

X=1Y1

X=2 Y=4

X = -1 Y = 1

X = -2 Y = 4

To capture the non-linear relationship

Y = a0 + a1 X + a2 X^2 + a3 X^3

Problem 3.14.
“If there is no basis risk, the minimum variance hedge ratio is always 1.0." Is this statement
true? Explain your answer.

The statement is true. Using the notation in the text, if the hedge ratio is 1.0, the hedger locks in a
price of . Since both and are known this has a variance of zero and must be the best
hedge.

Problem 3.15
“For an asset where futures prices are usually less than spot prices, long hedges are likely to be
particularly attractive." Explain this statement.

A company that knows it will purchase a commodity in the future is able to lock in a price close
to the futures price. This is likely to be particularly attractive when the futures price is less than
the spot price. (consider a crude oil futures contract)

Problem 3.16.
The standard deviation of monthly changes in the spot price of live cattle is (in cents per pound)
1.2. The standard deviation of monthly changes in the futures price of live cattle for the closest
contract is 1.4. The correlation between the futures price changes and the spot price changes is
0.7. It is now October 15. A beef producer is committed to purchasing 200,000 pounds of live
cattle on November 15. The producer wants to use the December live-cattle futures contracts to
hedge its risk. Each contract is for the delivery of 40,000 pounds of cattle. What strategy should
the beef producer follow?

The optimal hedge ratio is

The beef producer requires a long position in lbs of cattle. The beef
producer should therefore take a long position in 3 December contracts closing out the position
on November 15.

Problem 3.17.
A corn farmer argues “I do not use futures contracts for hedging. My real risk is not the price of
corn. It is that my whole crop gets wiped out by the weather.”Discuss this viewpoint. Should the
farmer estimate his or her expected production of corn and hedge to try to lock in a price for
expected production?

If weather creates a significant uncertainty about the volume of corn that will be harvested, the
farmer should not enter into short forward contracts to hedge the price risk on his or her expected
production. The reason is as follows. Suppose that the weather is bad and the farmer’s
production is lower than expected. Other farmers are likely to have been affected similarly. Corn
production overall will be low and as a consequence the price of corn will be relatively high. The
farmer’s problems arising from the bad harvest will be made worse by losses on the short futures
position. This problem emphasizes the importance of looking at the big picture when hedging.
The farmer is correct to question whether hedging price risk while ignoring other risks is a good
strategy.

Problem 3.18.
On July 1, an investor holds 50,000 shares of a certain stock. The market price is $30 per share.
The investor is interested in hedging (how much? Beta*?) against movements in the market over
the next month and decides to use the September Mini S&P 500 futures contract. The index
(more properly the futures price) is currently 1,500 and one contract is for delivery of $50 times
the index (mini is 1/5 of the regular size). The beta of the stock is 1.3. What strategy should the
investor follow? Under what circumstances will it be profitable? Neutralize beta beta*=0

A short position in

contracts is required. It will be profitable if the stock outperforms the market in the sense that its
return is greater than that predicted by the capital asset pricing model.

An important use of hedging: bet on an idiosyncratic information of the stock

Problem 3.20.
A futures contract is used for hedging. Explain why the daily settlement of the contract can give
rise to cash flow problems.

Suppose that you enter into a short futures contract to hedge the sale of an asset in six months. If
the price of the asset rises sharply during the six months, the futures price will also rise and you
may get margin calls. The margin calls will lead to cash outflows. Eventually the cash outflows
will be offset by the extra amount you get when you sell the asset, but there is a mismatch in the
timing of the cash outflows and inflows. Your cash outflows occur earlier than your cash
inflows. A similar situation could arise if you used a long position in a futures contract to hedge
the purchase of an asset at a future time and the asset’s price fell sharply. An extreme example of
what we are talking about here is provided by Metallgesellschaft (see Business Snapshot 3.2).
Problem 3.23.
The expected return on the S&P 500 is 12% and the risk-free rate is 5%. What is the expected
return on the investment with a beta of (a) 0.2, (b) 0.5, and (c) 1.4?
a) or 6.4%
b) or 8.5%
c) or 14.8%

Problem 3.26. (a review of rudimentary statistics)

The following table gives data on monthly changes in the spot price and the futures price for a
certain commodity. Use the data to calculate a minimum variance hedge ratio.

Spot Price Change +0.50 +0.61 −0.22 −0.35 +0.79

Futures Price Change +0.56 +0.63 −0.12 −0.44 +0.60

Spot Price Change +0.04 +0.15 +0.70 −0.51 −0.41

Futures Price Change −0.06 +0.01 +0.80 −0.56 −0.46

Denote and by the -th observation on the change in the futures price and the change in the
spot price respectively.

An estimate of is

An estimate of is

An estimate of is
The minimum variance hedge ratio is

Problem 3.27.
It is July 16. A company has a portfolio of stocks worth $100 million. The beta of the portfolio is
1.2. The company would like to use the CME December futures contract on the S&P 500 to
change the beta of the portfolio to 0.5 during the period July 16 to November 16. The index is
currently 1,000, and each contract is on $250 times the index.
a) What position should the company take?
b) Suppose that the company changes its mind and decides to increase the beta of the
portfolio from 1.2 to 1.5. What position in futures contracts should it take?

a) The company should short

or 280 contracts.

b) The company should take a long position in

or 120 contracts.