Hedging: Long and Short <ul><li>Long futures hedge appropriate when you will purchase an asset in the future and fear a ri...
Arguments For Hedging <ul><li>Companies should focus on their main business and minimize risks arising from interest rates...
Arguments Against Hedging <ul><li>Well-diversified shareholders can make their own risk management decisions </li></ul><ul...
Basis Risk <ul><li>Basis is the difference between spot and futures prices </li></ul><ul><li>Basis risk arises because of ...
Choice of Hedging Contract <ul><li>Delivery month should be as close as possible to, but later than, the end of the life o...
Naive Hedge Ratio <ul><li>Divide the face value of the cash position by the face value of one futures contract </li></ul><...
Minimum Variance Hedge Ratio <ul><li>Proportion of the exposure that should optimally be hedged is </li></ul><ul><li>hedge...
Hedging Stock Portfolios <ul><li>If hedging a well-diversified stock portfolio with a well-diversified stock index futures...
<ul><li>But has all risk been eliminated? </li></ul><ul><li>Problems: </li></ul><ul><ul><li>Stock portfolio being hedged m...
Hedging Stock Portfolios <ul><li>Optimal number of contracts to hedge  a portfolio is </li></ul><ul><li>Future contracts c...
Rolling The Hedge Forward <ul><li>What if hedging further in the future than available delivery dates? </li></ul><ul><li>S...
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Hedging.ppt

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Hedging.ppt

  1. 1. Hedging: Long and Short <ul><li>Long futures hedge appropriate when you will purchase an asset in the future and fear a rise in prices </li></ul><ul><ul><li>If you have liabilities now, what do you fear? </li></ul></ul><ul><li>Short futures hedge appropriate when you will sell an asset in the future and fear a fall in price </li></ul><ul><ul><li>If you expect to issue liabilities, what do you fear? </li></ul></ul>
  2. 2. Arguments For Hedging <ul><li>Companies should focus on their main business and minimize risks arising from interest rates, exchange rates, and other market variables </li></ul><ul><ul><li>Non-intrusive risk management tool </li></ul></ul><ul><li>Hedging may help smooth income and minimize tax liabilities </li></ul><ul><li>Hedging may help smooth income and reduce managerial salaries </li></ul>
  3. 3. Arguments Against Hedging <ul><li>Well-diversified shareholders can make their own risk management decisions </li></ul><ul><li>It may increase business risk to hedge when competitors do not </li></ul><ul><li>Explaining a loss on the hedge and a gain on the underlying can be difficult </li></ul>
  4. 4. Basis Risk <ul><li>Basis is the difference between spot and futures prices </li></ul><ul><li>Basis risk arises because of uncertainty about the price difference when the hedge is closed out </li></ul><ul><li>Basis risk usually less than the risk of price or rate level changes </li></ul><ul><li>Basis risk depends on futures pricing forces </li></ul>
  5. 5. Choice of Hedging Contract <ul><li>Delivery month should be as close as possible to, but later than, the end of the life of the hedge </li></ul><ul><li>If no futures contract hedged position, choose the contract whose futures price is most highly correlated with the asset price </li></ul><ul><ul><li>Called cross-hedging </li></ul></ul><ul><ul><li>Additional basis risk </li></ul></ul>
  6. 6. Naive Hedge Ratio <ul><li>Divide the face value of the cash position by the face value of one futures contract </li></ul><ul><li>Problems: </li></ul><ul><ul><li>Market values should be focus </li></ul></ul><ul><ul><li>Ignores differences between the cash and futures instruments </li></ul></ul><ul><li>Variation: divide the market value of the cash position by the market value of one futures contract </li></ul>
  7. 7. Minimum Variance Hedge Ratio <ul><li>Proportion of the exposure that should optimally be hedged is </li></ul><ul><li>hedge per dollar of cash market value </li></ul><ul><li>Hedge ratio estimated from: </li></ul>
  8. 8. Hedging Stock Portfolios <ul><li>If hedging a well-diversified stock portfolio with a well-diversified stock index futures contract, what are implications? </li></ul><ul><ul><li>No diversifiable risk in the cash stock portfolio and futures hedge removes systematic risk </li></ul></ul><ul><ul><li>Since no risk, systematic or unsystematic, what can an investor expect to earn by hedging a well-diversified stock portfolio? </li></ul></ul>
  9. 9. <ul><li>But has all risk been eliminated? </li></ul><ul><li>Problems: </li></ul><ul><ul><li>Stock portfolio being hedged may have a different price volatility than the stock-index futures </li></ul></ul><ul><ul><li>Hedging goal is not to reduce all systematic risk </li></ul></ul><ul><li>Price sensitivity to market movements determined by beta </li></ul>Hedging Stock Portfolios
  10. 10. Hedging Stock Portfolios <ul><li>Optimal number of contracts to hedge a portfolio is </li></ul><ul><li>Future contracts can be used to change the beta of a portfolio </li></ul><ul><ul><li>If  * >(<)  S , hedging implies a long (short) stock index futures position </li></ul></ul>
  11. 11. Rolling The Hedge Forward <ul><li>What if hedging further in the future than available delivery dates? </li></ul><ul><li>Series of futures contracts used to increase the life of a hedge </li></ul><ul><li>Each time a futures contract matures, switch position into another, later contract </li></ul><ul><ul><li>Basis risk, cash flow problems possible </li></ul></ul>

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