Basis Risk and Hedging Strategies

Study Notes

Basis Risk

The difference between the spot price and futures price
Increases when the spot price moves higher relative to the futures price

Impact of Basis Risk on Long Hedge

A long hedge aims to benefit from price increases by locking in a lower purchase price
Increased basis risk reduces the benefit of a long hedge as potential gains from the futures contract may not fully offset the increased spot price

Impact of Basis Risk on Short Hedge

A short hedge aims to benefit from price decreases by locking in a higher selling price
Increased basis risk benefits a short hedge as the futures position loses less than the increase in spot price, making the short position more favorable

Implied Volatility

Assumes the options market price reflects the stock's current volatility
The implied volatility is derived from the Black-Scholes model

Synthetic Call

A synthetic call creates the same payoff as a call option, but at a lower cost:
- Long put
- Long stock
- Short risk-free bond

Synthetic Put

A synthetic put creates the same payoff as a put option:
- Long call
- Short stock
- Long risk-free bond

Short Hedge:

Strategy used when you believe prices will decrease
You take a short position in futures

Long Hedge:

Strategy used when you believe prices will increase
You take a long position in futures

Arbitrage

Identify price discrepancies between derivative markets and underlying assets
Overpriced derivatives: Short the derivative, borrow and buy the underlying asset
Underpriced derivatives: Long the derivative, short sell the underlying asset and invest the proceeds

Synthetic Strategies:

If you short a derivative because it is overpriced, you go long a synthetic
If you long a derivative because it is underpriced, you go short a synthetic

Futures and Option Position Relationship

Long position in futures is equivalent to a long call
Short position in futures is equivalent to a long put

Options Strategies

Straddle/Strangle: A straddle is a strategy that allows for the potential to profit from price movements in either direction of the underlying asset. A strangle achieves the same thing but uses different strike prices for the call and put
- Long call
- Long put
- Both with same exercise price and time to expiration
Protective Put:
- Long put
- Long stock
- You are bullish, but hedging against potential price decreases
Covered Call:
- Short call
- Long stock
- You are bearish, but hedging against potential price increases
Strap:
- Two long calls
- One long put
- Bullish strategy, maximum profit unlimited, minimum capped
Strip:
- Two long puts
- One long call
- Bearish strategy, maximum unlimited, minimum determined by price differential

Spreads

Bull Spread: Buying one call with a lower strike price and selling one call with a higher strike price
- Profit when the underlying asset price rises
- Limited profit, but also capped risk
Bear Spread (using Calls): Buying one call with a higher strike price and selling one call with a lower strike price
- Profit when the underlying asset price falls
- Limited profit, but also capped risk
Bear Spread (using Puts): Buying one put with a higher strike price and selling one put with a lower strike price
- Profit when the underlying asset price falls
- Limited profit, but also capped risk

Time Spreads

Creating spreads involves changing the time to expiration of the options
This allows for opportunities to profit from expectations of volatility changes in the underlying asset

Description

Explore the concepts of basis risk and its impact on long and short hedges. Understand how basis risk affects price locking strategies and learn about implied volatility and synthetic calls. This quiz will test your knowledge of risk management in finance.