HEDGING
STRATEGIES
USING FUTURES
CONTENTS
* Hedging, perfect hedge, hedge-and-forget
strategies
* Short hedges, long hedges
* Arguments for and against hedging
* Basis, basis risk
* Cross hedging
* Stock indices, sorts of stock indices, MSCI
Korea, FTSE Korea, Barclays Capital Aggregate
Bond Index (Lehman Aggregate Bond Index)
* KOSPI series
HEDGING
What is Hedging?
A way of reducing risk.
An exposure to the price of an asset
Using futures markets to reduce a particular risk that
HEDGING
(CONT’D)
Perfect Hedge
A perfect hedge is one that completely eliminates the risk.
Hedge-and-forget strategies
Hedge-and-forget strategies is the kind of hedge which assumed that no attempt is made to adjust the hedge once it has been put in place and the hedger simply takes a
SHORT HEDGES
A short hedge involves a short position in futures
contracts.
A short hedge is appropriated when the hedger already
SHORT HEDGES
(CONT’D)
It can be illustrated that a short position
in futures contracts on delivery day
If future price > spot price
Gain
On the contrary
LONG HEDGES
A long hedge involves a long position in futures
contracts.
A long hedge is appropriated when a company knows it
LONG HEDGES
(CONT’D)
It can be illustrated that a long position
in futures contracts on delivery day
If future price < spot price
Gain
On the contrary
ARGUMENTS
FOR
AND
AGAINST
HEDGING
share holders
holding well-diversified portfolios, can eliminate many of the risks faced by a company. They do not require the company to hedge these risks.
Company
may find that it is increasing rather than decreasing risk by hedging if none of its competitors does so.
Treasurer
may fear criticism from other executives if the company makes a gain from movements in the price of the
ARGUMENTS
FOR
AND AGAINST
HEDGING
Shareholders are usually well diversified and can make
their own hedging decisions
It may increase risk to hedge when competitors do not
Explaining a situation where there is a loss on the hedge
BASIS
The basis is the difference between the spot price of an
asset and its futures price.
BASIS RISK
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.
These problems give rise to what is termed basis risk.
BASIS RISK
(CONT’D)
In general, basis risk increases as the time difference
between the hedge expiration and the delivery month increases.
One key factor affecting basis risk is the choice of the
futures contract to be used for hedging which concludes
the asset underlying the futures contract and the delivery month.
So it is necessary to carry out a careful analysis to
CROSS HEDGING
If the asset underlying the futures contract and the asset
whose price is being hedged are different, it can be called Cross Hedge.
Hedge ratio
the ratio of the size of the position taken in futures contracts to the size of the exposure.
CROSS HEDGING
If the hedger wishes to minimize the variance of
a position, a hedge ratio different from 1.0 may be appropriate.
Proportion of the exposure that should optimally
be hedged is
STOCK INDICES
Stock indices track changes in the value of a
hypothetical portfolio of stocks.
If the hypothetical portfolio of stocks remains
fixed, the weights assigned to individual stocks in the portfolio do not remain fixed.
The underlying portfolio is then automatically
SORTS OF STOCK
INDICES
The Dow Jones Industrial Average is based on a portfolio
consisting of 30 blue-chip stocks in the United States.
The Standard & Poor’s 500 (S&P 500) Index is based on a
portfolio of 500 different stocks: 400 industries, 40 utilities, 20 transportation companies, and 40 financial institutions.
The Nasdaq 100 is based on 100 stocks using the National
Association of Securities Dealers Automatic Quotations Service.
The Russell 1000 Index is an index of the prices of the 1000
MSCI KOREA
The MSCI AC (All Country) Pacific Index is a free
float-adjusted market capitalization weighted index that is designed to measure the equity market performance of the developed and emerging markets in the Pacific
region. As of June 2007, the MSCI AC Pacific Free Index consisted of the following 12 developed and emerging market countries: Australia, China, Hong
FTSE KOREA
FTSE Asiatop & Asian Sector Index Series FTSE Group have created a comprehensive range
of tradable indices for the Asia equity markets. The market-driven design allows both domestic and global investors the ability to follow
performance either by market capitalisation or by sector. The indices are the ideal basis for both on-exchange and OTC (over-the-counter) derivative products, mutual funds and exchange-traded
FTSE KOREA
(CONT’D)
The universe is the FTSE All-World Index Series, with
constituents from the following markets: China (H shares & B shares)
Hong Kong (Hong Kong stocks, Red Chips & HSBC)
Indonesia
India
Korea
Malaysia
Philippines
Singapore
Taiwan
LEHMAN AGGREGATE BOND
INDEX
Also called Barclays Capital Aggregate Bond Index
a broad base index, maintained by Barclays Capital,
which took over the index business of the now defunct Lehman Brothers, and is often used to represent
KOSPI SERIES
KOSPI
A stock price index plays an important role both as a
general indicator of price fluctuations in the stock market and as a nation’s economic indicator.
Publication
KOSPI is updated on the KRX website every 10 seconds and is available in statistical KRX publication “KRX
KOSPI SERIES
(CONT’D)
Calculation
KOSPI is calculated as follows with Current
Market Capitalization (=market capitalization at the time of comparison) as the numerator and Base Market Capitalization (=market
capitalization as of January 4, 1980) as the denominator.
BETA OF PORTFOLIO
To hedge the risk in a portfolio the number of contracts
BETA OF PORTFOLIO
When ß =1 the return on the portfolio tends to
mirror the return on the market
When ß =2 the excess return on the portfolio
tends to be twice as great as the excess return on the market, and a portfolio with a ß of 2 is twice as sensitive to market movements as a portfolio with a beta 1
