P1.T3. Hull, Chapter 3. Bionic Turtle FRM Video Tutorials. By: David Harper CFA, FRM, CIPM

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1 P1.T3. Hull, Chapter 3 Bionic Turtle FRM Video Tutorials By: David Harper CFA, FRM, CIPM Note: This tutorial is for paid members only. You know who you are. Anybody else is using an illegal copy and also violates GARP s ethical standards.

2 P1.T3. Hull, Chapter 3 Agenda Hull, Options, Futures, and Other Derivatives (8th Edition) Chapter 3: Hedging Strategies Using Futures 2

3 P1.T3. Hull, Chapter 3 Learning Spreadsheets Workbook Exam Relevance (XLS not topic) Spreadsheets T Futures Hedge High Minimum Variance Hedge Medium Basis Risk Note: If you are unable to view the content within this document we recommend the following: MAC Users: The built-in pdf reader will not display our non-standard fonts. Please use adobe s pdf reader ( PC Users: We recommend you use the foxit pdf reader ( or adobe s pdf reader ( Mobile and Tablet users: We recommend you use the foxit pdf reader app or the adobe pdf reader app. All of these products are free. We apologize for any inconvenience. If you have any additional problems, please Suzanne at suzanne@bionicturtle.com. 3

4 Hull, Chapter 3: Hedging Strategies Using Futures 4

5 Define and differentiate between short and long hedges and identify situations where they are appropriate. Long forward (or futures) hedge: agreement to buy in the future Hedger does not currently own the asset. Expects to purchase in the future. A short forward (or futures) hedge: agreement to sell in the future Hedger already owns the asset. An airline depends on jet fuel. Enters into futures contract (a long hedge) to protect from exposure to high oil prices Farmer wants to lock in a sales price to protect against a price decline. 5

6 Describe the arguments for and against hedging and the potential impact of hedging on firm profitability. In favor of hedging Companies should focus on their core business and minimize risks arising from financial variables and market variables (e.g., interest rates, exchange rates) Against hedging Shareholders are diversified and can make their own hedging decisions May increase risk to hedge when competitors do not Explaining a loss on the hedge (if gain on the underlying) can be difficult 6

7 Define and compute the basis. Basis = Spot Price (S 0 ) minus ( ) Futures Price (F 0 ) = S 0 F 0 $4.00 $0.20 $3.80 $4.20 $0.00 $4.20 Financial Assets: Futures Price (F0) Spot Price (S0) 7

8 Define and compute the basis. May-13 May-14 Spot $4.00 $4.20 Futures $3.80 $4.20 Basis $0.20 $0.00 Spot ($4.20) Futures (gain/loss) $0.40 Total cost ($3.80) $4.00 $0.20 $3.80 $4.20 $0.00 $4.20 Basis weakens (decreases) from $0.20 to $0 8

9 Define and compute the basis. Company will buy: 25,000 lbs of copper in Sep-09 Contract (pounds) 25,000 Number of contracts 1 Forward in Time: Basis converges May-09 Sep-09 Sep-09 Sep-09 Spot $1.90 $1.95 $2.00 $2.05 Futures $2.00 $1.95 $2.00 $2.05 Basis ($0.10) $0.00 $0.00 $0.00 Unhedged Cost Cost ($48,750) ($50,000) ($51,250) Long Hedge Futures gain, per lb ($0.05) $0.00 $0.05 Total Futures Gain ($1,250) $0 $1,250 Net Cost ($50,000) ($50,000) ($50,000) 9

10 Define and compute the basis. Company will buy: 25,000 Contract (pounds) 25,000 Number of contracts 1 Basis Weakens (vs. expected 0) Basis strengthens (vs. expected 0) May-09 Sep-09 Sep-09 Spot $1.90 $2.00 $2.00 Futures $2.00 $2.05 $1.95 Basis ($0.10) ($0.05) $0.05 Unhedged Cost Cost ($50,000) ($50,000) Long Hedge Futures gain, per lb $0.05 ($0.05) Total Futures Gain $1,250 ($1,250) Net Cost ($48,750) ($51,250) 10

11 Define the various sources of basis risk and explain how basis risks arise when hedging with futures. Strengthening of the basis: Spot price increases by more than the futures price basis increases. If unexpected, strengthening is favorable for a short hedge and unfavorable for a long hedge Weakening of the basis: Futures price increases by more than the spot price basis declines If unexpected, weakening is favorable for a long hedge and unfavorable for a short hedge 11

12 Define the various sources of basis risk and explain how basis risks arise when hedging with futures. But basis risk arises because often the characteristics of the futures contract differ from the underlying position. Contract Commodity. Contract is standardized (e.g., WTI oil futures) Commodities are not exactly commodities (e.g., hedger has a position in different grade of oil) Liquidity (exchange) Trade-off Basis risk 12

13 Define cross hedging. Cross hedge: When asset underlying hedge is different from asset being hedged Hedging purchase of jet fuel Not futures for jet fuel so use heating oil 13

14 Define, compute and interpret the minimum variance hedge ratio and hedge effectiveness. The optimal hedge ratio (a.k.a., minimum variance hedge ratio) is the ratio of futures position relative to the spot position that minimizes the variance of the position. σ S h h* S * Q N Q F * A standard deviation of ΔS, change in spot σ F standard deviation of ΔF, change in futures ρ is the coefficient of correlation between Δ S and Δ F. F 14

15 Define, compute and interpret the minimum variance hedge ratio and hedge effectiveness. Regressing Spot on Forward Spot Forward 15

16 Define, compute and interpret the minimum variance hedge ratio and hedge effectiveness. (heating oil futures) (jet fuel spot) Standard Dev $3.13 $2.63 Correlation (MV) Hedge ratio 0.78 Airline will purchase 2,000,000 NYMEX oil futures (gallons) 42,000 Number of contracts S 2.63 h* (0.928) 3.13 F h * QA ,000,000 N* Q 42,000 F 16 16

17 Define, compute and interpret the optimal number of futures contracts needed to hedge an exposure For example, if the volatility of the spot price is 20%, the volatility of the futures price is 10%, and their correlation is 0.4, then: h* S F 20% h* (0.4) % h * N N contracts Q Number of contracts * A F 17

18 including a tailing the hedge adjustment. Tailing the hedge: Replace units with values: N h * Q Q * A F N h * V V * A F The net effect is to multiply the original hedge ratio by the ratio of [spot price/futures price] 18

19 Demonstrate how stock index futures contracts can be used to change a stock portfolio s beta. Given a portfolio beta ( ), Current value of the portfolio (P), and Value of stocks underlying one futures contract (A), The number of stock index futures contracts (i.e., minimizes the portfolio variance) is given by: N P A 19

20 Demonstrate how stock index futures contracts can be used to change a stock portfolio s beta. When the goal is to shift portfolio beta from ( ) to a target beta ( *), the number of contracts required is given by: N ( * ) P A 20

21 Demonstrate how stock index futures contracts can be used to change a stock portfolio s beta. Assume: Value of portfolio is $10 million S&P 500 Futures Price = 1240 Portfolio beta ( ) is 1.5 Contract = $250 Index Target beta = 1.2 N P $10,000,000 ( * ) ( ) 9.7 A (1240)(250) We short ~ 9.7 contracts. (-) = short (+) = long 21

22 Describe what is meant by rolling the hedge forward and discuss some of the risks that arise from such a strategy. When the delivery date of the futures contract occurs prior to the expiration date of the hedge, the hedger can roll forward the hedge: close out a futures contract and take the same position on a new futures contract with a later delivery date. Exposed to: Basis risk (original hedge) Basis risk (each new hedge) = rollover basis risk 22

23 End of P1.T3. Hull, Chapter 3 Visit us on the 23