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Unit 3

Unit 3. Hedging Strategies Using Futures Dr Noura Ben Mbarek. What is Hedging?. Hedging against investment risk means using instruments in the market to offset the risk of any adverse price movements. In other words, investors hedge one investment by making another. Long Hedges.

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Unit 3

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  1. Unit 3 Hedging Strategies Using Futures Dr Noura Ben Mbarek

  2. What is Hedging? Hedging against investment risk means using instruments in the market to offset the risk of any adverse price movements. In other words, investors hedge one investment by making another.

  3. Long Hedges A long hedge Involve taking a long position in future contract. It is appropriate when you know you will purchase an asset in the future and want to lock in the price

  4. Short Hedges A short hedge involves a short position in future contracts. It is appropriate when you know you will sell an asset in the future and want to lock in the price It can also be used when an asset is not owned right now but will be owned at some time in the future.

  5. Hedging… It is important to realize that a hedge using futures contracts can result in a decrease or an increase in a company’s profits relative to the position it would be in with no hedging. In practice hedging is used to reduce risk and rarely leads to eliminating it totally Hedging is rarely perfect

  6. Basis Risk Basis is usually defined as the spot price minus the futures price Basis = Spot price of asset to be hedged - Futures price of contract used Basis risk arises because of the uncertainty about the basis when the hedge is closed out

  7. Why hedging is not always perfect? 1.The asset whose price is to be hedged may not be exactly the same as the asset underlying the futures contract. 2. The hedger may be uncertain as to the exact date when the asset will be bought or sold. 3. The hedge may require the futures contract to be closed out before its delivery month.

  8. Long Hedge for Purchase of an Asset Let: F1: Futures price at time hedge is set up F2: Futures price at time asset is purchased S2: Asset price at time of purchase b2: Basis at time of purchase

  9. Short Hedge for Sale of an Asset • Define F1: Futures price at time hedge is set up F2: Futures price at time asset is sold S2: Asset price at time of sale b2 : Basis at time of sale

  10. Example 1 It is March 1. A US company expects to receive 50 million Japanese yen at the end of July. Yen futures contracts on the CME Group have delivery months of March, June, September, and December. One contract is for the delivery of 12.5 million yen. The company therefore shorts four September yen futures contracts on March 1. When the yen are received at the end of July, the company closes out its position. We suppose that the futures price on March 1 in cents per yen is 0.9800 and that the spot and futures prices when the contract is closed out are 0.9200 and 0.9250, respectively.

  11. Example1 continued… 1- Calculate the gain on the future contracts 2- Calculate the basis 3- How much will the company effectively obtain in cents? 4- what is the total amount received by the company in USD?

  12. Example 1. Solution 1- The gain on the futures contract is F1- F2 0.9800 - 0.9250 = 0.0550 cents per yen. 2- The basis is S2- F2 0.9200 - 0.9250 = 0.0050 cents per yen when the contract is closed out. 3- The effective price obtained in cents per yen is the final spot price plus the gain on the futures F1 + b2 : 0.9200 + 0.0550 = 0.9750 4- The total amount received by the company: 50 000 000 x 0.00975 = 487 500 $

  13. Example 2 It is June 8 and a company knows that it will need to purchase 20,000 barrels of crude oil at some time in October or November. Oil futures contracts are currently traded for delivery every month on the NYMEX division of the CME Group and the contract size is 1,000 barrels. The company therefore decides to use the December contract for hedging and takes a long position in 20 December contracts. The futures price on June 8 is $88.00 per barrel. The company finds that it is ready to purchase the crude oil on November 10. It therefore closes out its futures contract on that date. The spot price and futures price on November 10 are $90.00 per barrel and $89.10 per barrel.

  14. Example 2 continued… 1- Calculate the gain on the future contracts 2- Calculate the basis when the contract is closed out 3- How much will the company effectively pay (dollars per barrel)? 4- what is the total paid by the company in USD?

  15. Example2. Solution 1- The gain on the futures contract is F2- F1 89.10- 88.00 = 1.10 $. 2- The basis is: S2- F2 90.00 - 89.10= 0.090 $ when the contract is closed out. 3- The effective price paid in dollar per barrel is the final spot price less the gain on the futures:S2- (F2 – F1) 90.00 – 1.10 = 88.90 This can also be calculated as the initial futures price plus the final basis F1 + b2 : 88.00 + 0.90 = 88.90 4- The total price paid by the company is: 20 000 x 88.90 = 1778000$

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