Effective Hedging Strategies for Risk Management

1. Chapter 11: Forward and Futures Hedging Strategies Hedging is the tai chi of trading. Jim Kharouf Futures, October, 1996, p. 90 An Introduction to Derivatives and Risk Management, 8th ed.

2. Important Concepts in Chapter 11 • Why firms hedge • Hedging concepts • Factors involved when constructing a hedge An Introduction to Derivatives and Risk Management, 8th ed.

3. Why Hedge? (Reasons to Hedge) • The value of the firm may not be independent of financial decisions because • Shareholders might be unaware of the firm’s risks. • Shareholders might not be able to identify the correct number of futures contracts necessary to hedge. • Shareholders might have higher transaction costs of hedging than the firm. • Desired by shareholders simply to find a more acceptable combination of expected return and risk. An Introduction to Derivatives and Risk Management, 8th ed.

4. Why Hedge? (continued) • Corporate hedging is motivated by a desire to ensure lower cost financing internally when attractive investment opportunities are available. • There may be tax advantages to a firm hedging. • Hedging reduces bankruptcy costs. An Introduction to Derivatives and Risk Management, 8th ed.

5. Why Hedge? (continued) • Managers may be reducing their own risk. • Managers’ livelihoods may be heavily tied to the performance of the firm. • Hedging may send a positive signal to creditors. • That the firm is making concerted effort to protect the value of the underlying assets. • This can result in more favorable credit terms and less costly, restrictive covenants (Any type of agreement that requires the buyer to either take or abstain from a specific action). An Introduction to Derivatives and Risk Management, 8th ed.

6. Why Hedge? (continued) • Reasons not to hedge • If everyone hedged, it’s simply end up with an economy in which no one takes risks? This would surely lead to economy stagnancy. Moreover, we must wonder whether hedging can actually increase shareholder wealth. • Hedging can give a misleading impression of the amount of risk reduced An Introduction to Derivatives and Risk Management, 8th ed.

7. Why Hedge? (continued) • Hedging eliminates the opportunity to take advantage of favorable market conditions • There is no such thing as a hedge. Any hedge is an act of taking a position that an adverse market movement will occur. This, itself, is a form of speculation. An Introduction to Derivatives and Risk Management, 8th ed.

8. Hedging Concepts • Short Hedge and Long Hedge • Short (long) hedge implies a short (long) position in futures • Short hedges can occur because the hedger owns an asset and plans to sell it later. • Long hedges can occur because the hedger plans to purchase an asset later. • An anticipatory hedge is a hedge of a transaction that is expected to occur in the future. • See Table 11.1, p. 358 for hedging situations. Note: Short hedge means long spot, short futures Long hedge means short spot, long futures An Introduction to Derivatives and Risk Management, 7th ed.

9. Hedging and the Basis • T = time point of expiration (month, day, and year) • t = time point prior to expiration • S0 = spot price today • F0 = future price today • ST = spot price at expiration • fT = future price at expiration • St = spot price at time t prior to expiration • ft = future price at time t prior to expiration • ∏ = profit from a given strategy An Introduction to Derivatives and Risk Management, 8th ed.

10. Hedging Concepts (continued) • The Basis • Basis = Spot price - Futures price. • Hedging and the Basis (the profit from a hedge held to expiration): • π(short hedge) = (ST - S0) (from spot market) + (f0 -fT) (from futures market). • π (long hedge) = (S0 - ST) (from spot market) + (fT - f0) (from futures market). An Introduction to Derivatives and Risk Management, 8th ed.

11. Hedging Concepts (continued) • The Basis • Basis = spot price - futures price. • Hedging and the Basis (the profit from a hedge if hedge is closed prior to expiration) : • π (short hedge) = (St - S0) + (f0 - ft) • π (long hedge) = (S0 - St) + (ft - f0) An Introduction to Derivatives and Risk Management, 8th ed.

12. Hedging Concepts (continued) • The Basis (continued) • Hedging and the Basis (continued) • Example: Suppose you buy an asset for $100, sell a futures contract on the asset at $103. Therefore, you have a short hedge (Short hedge means long spot, short futures) At expiration, the spot and futures prices are both $96. • Basis definition: ST = 96, fT = 96, S0 = 100, f0 = 103 • π(short hedge) = (ST - S0) + (f0 -fT) = (96 - 100) + (103 -96) = (- 4) + (7) = 3 An Introduction to Derivatives and Risk Management, 8th ed.

13. Hedging Concepts (continued) • The Basis (continued) • Hedging and the Basis (continued) • Example: Suppose you sell an asset for $100, buy a futures contract for $103. Therefore, you have a long hedge (Long hedge means short spot, long futures). At expiration, the spot and futures prices are both $96. • Basis definition: ST = 96, fT = 96, S0 = 100, f0 = 103 • π(long hedge) = (S0 - ST) + (fT - f0) = (100 - 96) + (96 -103) = (4) + (-7) = -3 (net loss) An Introduction to Derivatives and Risk Management, 8th ed.

14. Hedging Concepts (continued) • The Basis (continued) • The profit of the hedges is simply the change in the basis. • The uncertainty on how the basis will change is called basis risk. • Hedging attempts to lock in the future price of an asset today, which will be f0 + (St - ft). • A perfect hedge is practically non-existent. • Short hedges benefit from a strengthening basis. • All of this reverses for a long hedge. • See Table 11.2, p. 361 for hedging profitability and the basis. An Introduction to Derivatives and Risk Management, 8th ed.

15. Hedging Concepts (continued) • Basis : • b0 = S0 – f0 (initial basis) • bT = ST – fT (basisat expiration) • bt = St – ft (basisat time t) prior to expiration An Introduction to Derivatives and Risk Management, 8th ed.

16. Hedging Concepts (continued) • The Basis (continued) • Example using gold: On March 30. the price of gold futures expiring in June was $388.60 per troy ounces. Spot gold price was $387.15. Buy spot, sell futures (short hedge). Gold dealer held 100 troy ounces of gold worth 100 (387.15) = 38,715. To protect against a decrease in the price of gold, the dealer might sell one futures contract on 100 troy ounces, hence he might entered a short hedge. • Notation: S0 = 387.15, f0 = 388.60 • b0 = S0 – f0 (initial basis) • b0 = 387.15 - 388.60 = -1.45. If held to expiration, profit should be change in basis (-1)(b0)(no. of ounces): • π= -1 (-1.45)(100) = 145 An Introduction to Derivatives and Risk Management, 8th ed.

17. Hedging Concepts (continued) • Supposed at expiration, spot price ST = $408.50. Sell gold in spot for $408.50, a profit of 21.35 ($408.50 - $387.15). Buy back futures at $408.50, a profit of -19.90 ($388.60 - $408.50). Net gain =1.45 or $145 on 100 oz. of gold. • bT = ST – fT(basisat expiration) • bT = $408.50 – $408.50 = 0 • b0 = 387.15 - 388.60 = -1.45 • Note that change in basis was bT - b0 or 0 - (-1.45) = 1.45. • π(short hedge) = (ST - S0) + (f0 -fT) = (408.50 – 387.15) + (388.60 – 408.50) = (21.35) + (-19.90) = 1.45 or $145 on 100 oz. of gold. An Introduction to Derivatives and Risk Management, 8th ed.

18. Hedging Concepts (continued) • The Basis (continued) • Example: (continued) • Instead, close out prior to expiration when St = $377.52 and ft = $378.63. • (S0 = 387.15, f0 = 388.60)~ previous data • St = $377.52 and ft = $378.63 • Bt = St - ft = $377.52 - $378.63 = - 1.11 • b0 = 387.15 - 388.60 = -1.45 • Note that change in basis was : • bt - b0 or -1.11 - (-1.45) = 0.34. • π (short hedge) = (St - S0) + (f0–ft) = (377.52 – 387.15) + (388.60 – 378.63) = (-9.63) + (9.97) = 0.34 or $34 on 100 oz. of gold. • Behavior of the basis, see Figure 11.1, p. 362. • In forward markets, the hedge is customized so there is no basis risk. An Introduction to Derivatives and Risk Management, 8th ed.

19. Hedging Concepts (continued) • Some Risks of Hedging • cross hedging • spot and futures prices occasionally move opposite • quantity risk An Introduction to Derivatives and Risk Management, 8th ed.

20. Hedging Concepts (continued) • Contract Choice (continued) • Long or short? • A critical decision! No room for mistakes. • Three methods to answer the question. See Table 11.4, p. 365. • worst case scenario method • current spot position method • anticipated future spot transaction method An Introduction to Derivatives and Risk Management, 8th ed.

21. Hedging Concepts (continued) • Margin Requirements (MRs) and Marking to Market (M2M) • MRs : funds kept in a margin account for the purpose of covering losses. • low MRs on futures & virtually insignificant in relation to the size of the position being hedged. Moreover, MRs for hedges are even smaller than speculate margin. • M2M (daily settlement) : the process in a futures market in which the daily price changes are paid by the parties incurring losses to the parties making profits. An Introduction to Derivatives and Risk Management, 8th ed.

22. Hedging Concepts (continued) • The effect of M2M & the potential for margin calls (A demand for additional funds because of adverse price movement) are somehow important (cash will be required for margin calls). • Remember that the profit on a futures transaction is supposed to offset the loss on the spot asset. At least part of the time, there will be profits on the spot asset & losses on the futures contract. • When the futures contract generates a loss, the hedger must deposit additional margin money to cover the loss. An Introduction to Derivatives and Risk Management, 8th ed.

23. Hedging Concepts (continued) • Even if the spot position has generated profit in excess of the loss on the futures contract, it may be impossible, or at least inconvenient to withdraw the profit on the spot position to cover the loss on the futures. • This is the major obstacles to more widespread use of futures as futures profits & losses are realized immediately & spot profits and losses do not occur until hedge is terminated. • Because of this, many potential hedgers tend to weigh/consider the losses on the futures position more heavily than the gains on the spot. An Introduction to Derivatives and Risk Management, 8th ed.

24. Hedging Concepts (continued) • Forward contracts do not entail/involve MRs and M2M, but they are subject to credit risk. Indeed, MRs & M2M are primarily used by futures markets to reduce, if not effectively eliminate, credit risk. An Introduction to Derivatives and Risk Management, 8th ed.

25. Summary • Table 11.17, p. 401 recaps the types of hedge situations, the nature of the risk and how to hedge the risk An Introduction to Derivatives and Risk Management, 8th ed.

26. Appendix 11: Taxation of Hedging • Hedges used by businesses to protect inventory and in standard business transactions are taxed as ordinary income. • Transactions must be shown to be legitimate hedges and not just speculation outside of the norm of ordinary business activities. This is called the business motive test. An Introduction to Derivatives and Risk Management, 8th ed.

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