CHAPTER 3
Hedging Strategies Using Futures
Problem 3.1.
Under what circumstances are (a) a short hedge and (b) a long hedge appropriate?
A short hedge is appropriate when a company owns an asset and expects to sell that asset in the
future. It can also be used when the company does not currently own the asset but expects to do
so at some time in the future. A long hedge is appropriate when a company knows it will have to
purchase an asset in the future. It can also be used to offset the risk from an existing short
position.
Problem 3.2.
Explain what is meant by a perfect hedge. Does a perfect hedge always lead to a better outcome
than an imperfect hedge? Explain your answer.
A perfect hedge is one that completely eliminates the hedger’s risk. A perfect hedge does not
always lead to a better outcome than an imperfect hedge. It just leads to a more certain outcome.
Consider a company that hedges its exposure to the price of an asset. Suppose the asset’s price
movements prove to be favorable to the company. A perfect hedge totally neutralizes the
company’s gain from these favorable price movements. An imperfect hedge, which only partially
neutralizes the gains, might well give a better outcome.
Problem 3.3.
Give three reasons why the treasurer of a company might not hedge the company’s exposure to a
particular risk.
(a) If the company’s competitors are not hedging, the treasurer might feel that the company will
experience less risk if it does not hedge. (See Table 3.1.) (b) The shareholders might not want
the company to hedge because the risks are hedged within their portfolios. (c) If there is a loss on
the hedge and a gain from the company’s exposure to the underlying asset, the treasurer might
feel that he or she will have difficulty justifying the hedging to other executives within the
organization.
Problem 3.4.
Suppose that the standard deviation of quarterly changes in the prices of a commodity is $0.65,
the standard deviation of quarterly changes in a futures price on the commodity is $0.81, and the
coefficient of correlation between the two changes is 0.8. What is the optimal hedge ratio for a
three-month contract? What does it mean?
The optimal hedge ratio is
065
08 = 0642
081
This means that the size of the futures position should be 64.2% of the size of the company’s
exposure in a three-month hedge.
Problem 3.5.
A company has a $20 million portfolio with a beta of 1.2. It would like to use futures contracts
on a stock index to hedge its risk. The index futures is currently standing at 1080, and each
contract is for delivery of $250 times the index. What is the hedge that minimizes risk? What
should the company do if it wants to reduce the beta of the portfolio to 0.6?
The formula for the number of contracts that should be shorted gives
20 000 000
12 = 889
1080 250
Rounding to the nearest whole number, 89 contracts should be shorted. To reduce the beta to 0.6,
half of this position, or a short position in 44 contracts, is required.
Problem 3.6.
In the corn futures contract, the following delivery months are available: March, May, July,
September, and December. State the contract that should be used for hedging when the
expiration of the hedge is in a) June, b) July, and c) January
A good rule of thumb is to choose a futures contract that has a delivery month as close as
possible to, but later than, the month containing the expiration of the hedge. The contracts that
should be used are therefore
(a) July
(b) September
(c) March
Problem 3.7.
Does a perfect hedge always succeed in locking in the current spot price of an asset for a future
transaction? Explain your answer.
No. Consider, for example, the use of a forward contract to hedge a known cash inflow in a
foreign currency. The forward contract locks in the forward exchange rate — which is in general
different from the spot exchange rate.
Problem 3.8.
It is July 16. A company has a portfolio of stocks worth $100 million. The beta of the portfolio is
1.2. The company would like to use the December futures contract on a stock index to change
beta of the portfolio to 0.5 during the period July 16 to November 16. The index is currently
1,000, and each contract is on $250 times the index.
a) What position should the company take?
b) Suppose that the company changes its mind and decides to increase the beta of the
portfolio from 1.2 to 1.5. What position in futures contracts should it take?
a) The company should short
(12 − 05) 100 000 000
1000 250
or 280 contracts.
b) The company should take a long position in
(15 − 12) 100 000 000
1000 250
or 120 contracts.
