Hedging ConceptsHedging Concepts

Short HedgeShort Hedge

A short hedge means to hedge by going short in the futures market. A hedger who holds an asset and is concerned about a decrease in price might consider hedging it with a short position in futures.

If the spot price and futures price move together, the hedge will reduce some of the risk.

Long HedgeLong Hedge

When a party plans to purchase an asset at a later date, there exists a fear on increase in the asset’s price.

Here the party might buy the futures contract.

Then, if the price of the asset increases, the futures price also will increase and produce a profit on the futures position that will atleast partially offset the higher cost of purchasing the asset.

As it involves an anticipated transaction, it is sometimes called an anticipatory hedge.

BasisBasis

Defined as the spot price minus the futures price.

Hedging entails the assumption of basis risk, the uncertainty of the basis over the hedge period.

The hedge profit is the change in the basis.

Hedging profitability and the riskHedging profitability and the risk

Type of Hedge Benefits From Which occurs if

Short Hedge (long spot, shot futures)

Strengthening basis Spot price rises more than futures price rises or spot price falls less than futures price falls

Long Hedge (short spot, long futures)

Weakening basis Spot price rises less than futures price rises or Spot price falls more than futures price falls or Spot price falls and futures price rises

Some risks of hedgingSome risks of hedging

Cross Hedging – Involves an additional source of basis risk arising from the fact that the asset being hedged is not the same as the asset underlying the futures (example – Hedging of a corporate bond with Treasury bond futures contract)

Quantity risk – Uncertainty over the size of the future cash flows

Also, when the hedger does not know the horizon date, it will be more difficult to align the expiration date of the futures contract as a result of which the effectiveness of the hedge will be lower

Hedge RatioHedge Ratio

Hedge ratio is the number of futures contract one should use to hedge a particular exposure in the spot market.

The hedge ratio should be the one in which the futures profit or loss matches spot profit or loss.

Though there is no exact method of determining the hedge ratio before performing the hedge, there are several ways to estimate it.

Minimum variance hedge ratioMinimum variance hedge ratio

This gives the optimal number of futures when the objective is to minimize risk.

Formula – Nf = -σΔSΔf / σ2 Δf The negative sign means that the hedger should

sell futures. If the problem were formulated as a long hedge, the sign would be positive.

We can estimate Nf by running a regression with ΔS as the dependent variable and Δf as the independent variable. (provided we know the actual values for the future)

Hedging strategiesHedging strategies

1. Foreign currency hedging2. Intermediate and long-term interest rate

risk hedging3. Stock hedging

Hedge situations – Foreign Hedge situations – Foreign currencycurrency

The Scenario The Risk The Appropriate Action

Plan to purchase a foreign currency with domestic currency

The foreign currency will increase in value

Buy forwards or futures

Plan to convert a foreign currency into domestic currency

The foreign currency will decrease in value

Sell forwards or futures

Hedge Situations - BondsHedge Situations - Bonds

The Scenario The Risk The Appropriate Action

Hold a bond or bond portfolio

Interest rates will increase, decreasing the value of the bond

Sell futures on notes or bonds

Plan to purchase a bond

Interest rates will decrease, increasing the value of the bond

Buy futures on notes or bonds

Plan to issue a bond Interest rates will increase, decreasing the value of the bond

Sell futures on notes or bonds

Hedging situations - StockHedging situations - Stock

The Scenario The Risk The Appropriate Action

Hold Stock Portfolio Stock prices will fall, decreasing the value of the portfolio

Sell stock index futures

Plan to purchase a stock

Stock prices will increase, increasing the cost to purchase

Buy Stock index futures