Differentiate between Long Futures hedge and Short Futures hedge
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Added on 2022-01-22
Differentiate between Long Futures hedge and Short Futures hedge
Added on 2022-01-22
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BFW2751 - Derivatives 1
S1, 2021
Lecture Week 2
Hedging Strategies using Futures Contracts
Chapter 3 in text book
S1, 2021
Lecture Week 2
Hedging Strategies using Futures Contracts
Chapter 3 in text book
Lecture 2: Learning objectives
▪ Understand the concept of “hedging”.
▪ Differentiate between “Long Futures hedge” and “Short Futures hedge”.
▪ Be able to perform hedging strategies using Futures contracts
▪ Appreciate that real world hedge is typically “imperfect”, leading to the
need for an optimal hedge strategy.
3/16/2021 BFW2751 S2 2020 AP Jothee 2
▪ Understand the concept of “hedging”.
▪ Differentiate between “Long Futures hedge” and “Short Futures hedge”.
▪ Be able to perform hedging strategies using Futures contracts
▪ Appreciate that real world hedge is typically “imperfect”, leading to the
need for an optimal hedge strategy.
3/16/2021 BFW2751 S2 2020 AP Jothee 2
Learning structure
▪ Issues in hedging using futures
▪ Types of hedge
▪ Basis risk
▪ The optimal hedge ratio (OHR), optimal number of hedging contracts and
hedging effectiveness
3/16/2021 BFW2751 S2 2020 AP Jothee 3
▪ Issues in hedging using futures
▪ Types of hedge
▪ Basis risk
▪ The optimal hedge ratio (OHR), optimal number of hedging contracts and
hedging effectiveness
3/16/2021 BFW2751 S2 2020 AP Jothee 3
What is hedging ?
▪ Hedging is about reducing the volatility (risk) of future cash flows associated with
commitments in cash/physical market.
▪ Commitments in cash/physical market means existing positions in some instruments /
commodities or equities or planning to buy or sell any of these in the future time in physical
market.
▪ The concept is to take some position in derivative contracts that neutralizes the risk as much
as possible. (if you lose in cash market, you will gain in derivative market, and vis a vis)
▪ In most of the cases, hedging involves the use of some financial derivatives like Futures or
Options contracts.
▪ Hedgers identify the risk factor and take a position in a derivative such as to benefits from the
adverse movements in the underlying asset prices.
3/16/2021 BFW2751 S2 2020 AP Jothee 4
▪ Hedging is about reducing the volatility (risk) of future cash flows associated with
commitments in cash/physical market.
▪ Commitments in cash/physical market means existing positions in some instruments /
commodities or equities or planning to buy or sell any of these in the future time in physical
market.
▪ The concept is to take some position in derivative contracts that neutralizes the risk as much
as possible. (if you lose in cash market, you will gain in derivative market, and vis a vis)
▪ In most of the cases, hedging involves the use of some financial derivatives like Futures or
Options contracts.
▪ Hedgers identify the risk factor and take a position in a derivative such as to benefits from the
adverse movements in the underlying asset prices.
3/16/2021 BFW2751 S2 2020 AP Jothee 4
Examples of Hedging
Farmers want to lock-in the price they can sell their future crops. Producers of goods
will hedge their future product delivery prices by going into short hedge (i.e. to short sell
in Futures contracts to gain in the Futures market if their product / crop prices fall by the
time it could be delivered in the physical market.
Gold producers want to ensure the sale price they’ll get from their gold will not fall below
a certain level in the future supply.
Jewellery makers want to lock in the price of gold they’re going to buy as raw materials
for their business in future dates.
Importers of products wish to fix the price they pay for the next shipment.
A bank just sold a forward contract and wishes to hedge against that risk of its underlying
falling.
3/16/2021 BFW2751 S2 2020 AP Jothee 5
Farmers want to lock-in the price they can sell their future crops. Producers of goods
will hedge their future product delivery prices by going into short hedge (i.e. to short sell
in Futures contracts to gain in the Futures market if their product / crop prices fall by the
time it could be delivered in the physical market.
Gold producers want to ensure the sale price they’ll get from their gold will not fall below
a certain level in the future supply.
Jewellery makers want to lock in the price of gold they’re going to buy as raw materials
for their business in future dates.
Importers of products wish to fix the price they pay for the next shipment.
A bank just sold a forward contract and wishes to hedge against that risk of its underlying
falling.
3/16/2021 BFW2751 S2 2020 AP Jothee 5
Long & Short Futures hedges
▪ A Long Futures hedge is appropriate when you want to purchase an asset
in the future date and intend to neutralize the risk of increase in price of the
asset by taking a long position in the Futures market. (Long Futures hedge
when asset price may rise at future time).
▪ A Short Futures hedge is appropriate when you want to sell an asset in the
future date and intend to neutralize the risk of fall in price of the asset by
taking a short position in the Futures market. (Short Futures hedge when
asset price may fall in future time).
3/16/2021 BFW2751 S2 2020 AP Jothee 6
▪ A Long Futures hedge is appropriate when you want to purchase an asset
in the future date and intend to neutralize the risk of increase in price of the
asset by taking a long position in the Futures market. (Long Futures hedge
when asset price may rise at future time).
▪ A Short Futures hedge is appropriate when you want to sell an asset in the
future date and intend to neutralize the risk of fall in price of the asset by
taking a short position in the Futures market. (Short Futures hedge when
asset price may fall in future time).
3/16/2021 BFW2751 S2 2020 AP Jothee 6
An Example of Long Futures Hedge
Assuming it is March 2020 now, and a gold-bullion manufacturer anticipates a need for 10,000 grams. of raw gold in
September 2020. His downside risk is that the gold price may increase by September 2020.
Currently Gold is priced at $990 / gram in cash market, and the September Gold Futures are priced at $1000 / gram.
Each Gold Futures contract for all delivery months is 1000 grams.
The gold-bullion manufacturer can hedge the possible increase in price of raw gold by going long in Gold futures
Contracts:
Case 1: Gold Price in September is $900 / gram Case 2: Gold Price in September is $1200/ grams
Net cost of purchasing gold in September is $10 million in either case.
Net cash flow = 10, 000F =$10M a certainty amount, so hedge is "perfect." Why certain?
3/16/2021 BFW2751 S2 2020 AP Jothee 7
CASH/PHYSICAL MARKET GOLD FUTURES MARKET
Now in March 2020 Now in March 2020
Do nothing
Long 10 September Gold Futures Contracts
@ $1 million /contract
Total Contract Value $10 million
In September 2020 In September 2020
Buy 10,000 grams of gold at $900/ gram
Total purchase value $9 million
Short the 10 September Gold Futures Contract
@ $0.9 million/ contract
Total Sales value $9 million
Cash outflow = $ 9 mill
Offset Futures Loss $ 1 mill
Cash Flow in Futures 9 – 10 = - $1mil
Total cost $10 mill
CASH/PHYSICAL MARKET GOLD FUTURES MARKET
Now in March 2020 Now in March 2020
Do nothing Long 10 September Gold Futures Contracts @
$1 million /contract
Total Contract Value $10 million
In September 2020 In September 2020
Buy 10,000 grams of gold at $1200/
gram
Total purchase value $12 million
Short the 10 September Gold Futures Contract
@ $1.2 million/ contract
Total Sales value $12 million
Cash outflow = $ 12 mill
Offset Futures gain - $ 2 mill
Cash Flow in Futures 12 – 10 = $2 mil
Total cost $10 mill
Assuming it is March 2020 now, and a gold-bullion manufacturer anticipates a need for 10,000 grams. of raw gold in
September 2020. His downside risk is that the gold price may increase by September 2020.
Currently Gold is priced at $990 / gram in cash market, and the September Gold Futures are priced at $1000 / gram.
Each Gold Futures contract for all delivery months is 1000 grams.
The gold-bullion manufacturer can hedge the possible increase in price of raw gold by going long in Gold futures
Contracts:
Case 1: Gold Price in September is $900 / gram Case 2: Gold Price in September is $1200/ grams
Net cost of purchasing gold in September is $10 million in either case.
Net cash flow = 10, 000F =$10M a certainty amount, so hedge is "perfect." Why certain?
3/16/2021 BFW2751 S2 2020 AP Jothee 7
CASH/PHYSICAL MARKET GOLD FUTURES MARKET
Now in March 2020 Now in March 2020
Do nothing
Long 10 September Gold Futures Contracts
@ $1 million /contract
Total Contract Value $10 million
In September 2020 In September 2020
Buy 10,000 grams of gold at $900/ gram
Total purchase value $9 million
Short the 10 September Gold Futures Contract
@ $0.9 million/ contract
Total Sales value $9 million
Cash outflow = $ 9 mill
Offset Futures Loss $ 1 mill
Cash Flow in Futures 9 – 10 = - $1mil
Total cost $10 mill
CASH/PHYSICAL MARKET GOLD FUTURES MARKET
Now in March 2020 Now in March 2020
Do nothing Long 10 September Gold Futures Contracts @
$1 million /contract
Total Contract Value $10 million
In September 2020 In September 2020
Buy 10,000 grams of gold at $1200/
gram
Total purchase value $12 million
Short the 10 September Gold Futures Contract
@ $1.2 million/ contract
Total Sales value $12 million
Cash outflow = $ 12 mill
Offset Futures gain - $ 2 mill
Cash Flow in Futures 12 – 10 = $2 mil
Total cost $10 mill
• A Motivating Example (Outcome)
Alternative explanation: consider the outcomes from 2 different scenarios in September
2020
Try again with any ST value, you always get 10M.
Why?
Well, any gain (loss) from the spot transaction is exactly matched by loss (gain) from the
futures transaction, as long as ST=FT. This “exactness” makes the hedge perfect.
Scenario 1: ST=FT =900 Scenario 2: ST=FT =1200
Price paid for gold on
the spot market in Sept.
10,000 x 900 = 9M 10,000x1200=12M
Less payoff from futures
(You go short in
September 2020.)
10,000(FT -F)
=10,000 (900-1000)
=-1M
10,000(FT -F)
=10,000(1200-1000)
=+2M
Net price paid for gold
By offsetting the
gain/loss in futures
9M + 1M = 10M 12M – 2M = 10M
3/16/2021 BFW2751 S2 2020 AP Jothee 8
Alternative explanation: consider the outcomes from 2 different scenarios in September
2020
Try again with any ST value, you always get 10M.
Why?
Well, any gain (loss) from the spot transaction is exactly matched by loss (gain) from the
futures transaction, as long as ST=FT. This “exactness” makes the hedge perfect.
Scenario 1: ST=FT =900 Scenario 2: ST=FT =1200
Price paid for gold on
the spot market in Sept.
10,000 x 900 = 9M 10,000x1200=12M
Less payoff from futures
(You go short in
September 2020.)
10,000(FT -F)
=10,000 (900-1000)
=-1M
10,000(FT -F)
=10,000(1200-1000)
=+2M
Net price paid for gold
By offsetting the
gain/loss in futures
9M + 1M = 10M 12M – 2M = 10M
3/16/2021 BFW2751 S2 2020 AP Jothee 8
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