Podcast
Questions and Answers
Hedgers utilize futures markets with the primary goal of maximizing potential profits from price fluctuations.
Hedgers utilize futures markets with the primary goal of maximizing potential profits from price fluctuations.
False (B)
A perfect hedge guarantees the complete elimination of risk, an outcome that is commonly achieved in futures markets.
A perfect hedge guarantees the complete elimination of risk, an outcome that is commonly achieved in futures markets.
False (B)
In hedge-and-forget strategies, adjustments are frequently made to the hedge position in response to market changes.
In hedge-and-forget strategies, adjustments are frequently made to the hedge position in response to market changes.
False (B)
The strategy of tailing primarily addresses the differences in tax implications between futures and forward contracts.
The strategy of tailing primarily addresses the differences in tax implications between futures and forward contracts.
If a company stands to lose money when the price of a commodity decreases, the treasurer should take a long futures position to hedge.
If a company stands to lose money when the price of a commodity decreases, the treasurer should take a long futures position to hedge.
A short hedge is most suitable when a company anticipates needing to purchase an asset in the future.
A short hedge is most suitable when a company anticipates needing to purchase an asset in the future.
For a U.S. exporter expecting to receive euros, a long futures position would hedge against the risk of the euro decreasing in value.
For a U.S. exporter expecting to receive euros, a long futures position would hedge against the risk of the euro decreasing in value.
When an oil producer hedges their sales contract by shorting futures and the spot price decreases, they gain from the futures position, offsetting losses from the oil sale.
When an oil producer hedges their sales contract by shorting futures and the spot price decreases, they gain from the futures position, offsetting losses from the oil sale.
In long hedges, a company sells futures contracts to lock in a future purchase price of an asset.
In long hedges, a company sells futures contracts to lock in a future purchase price of an asset.
If a copper fabricator takes a long position to hedge and the spot price increases, they lose on the futures contracts.
If a copper fabricator takes a long position to hedge and the spot price increases, they lose on the futures contracts.
Closing out a futures position in the delivery month guarantees physical delivery of the underlying asset.
Closing out a futures position in the delivery month guarantees physical delivery of the underlying asset.
Daily settlement has a significant impact on the overall performance of a hedge, drastically altering the final payoff.
Daily settlement has a significant impact on the overall performance of a hedge, drastically altering the final payoff.
Hedging allows companies to specialize in their primary business activities by mitigating financial risks they are not experts in predicting.
Hedging allows companies to specialize in their primary business activities by mitigating financial risks they are not experts in predicting.
Shareholders always have as much information as a company’s management regarding the risks faced by the company.
Shareholders always have as much information as a company’s management regarding the risks faced by the company.
Commissions and transaction costs make hedging more expensive for large corporations compared to individual shareholders.
Commissions and transaction costs make hedging more expensive for large corporations compared to individual shareholders.
If competitors do not hedge, then hedging will always lead to fluctuating profit margins.
If competitors do not hedge, then hedging will always lead to fluctuating profit margins.
When competitors do not hedge and the price of raw materials increases, a company that hedges will see its profit margin remain constant.
When competitors do not hedge and the price of raw materials increases, a company that hedges will see its profit margin remain constant.
A hedge using futures contracts invariably leads to an increase in a company's profits compared to not hedging at all.
A hedge using futures contracts invariably leads to an increase in a company's profits compared to not hedging at all.
Hedging reduces risk for the company, but it may increase risk for the treasurer if others perceive that decision negatively.
Hedging reduces risk for the company, but it may increase risk for the treasurer if others perceive that decision negatively.
A gold mining company engaging in hedging always aims to attract shareholders who want to benefit when the price of gold increases.
A gold mining company engaging in hedging always aims to attract shareholders who want to benefit when the price of gold increases.
Basis risk arises when the asset being hedged is exactly the same as the asset underlying the futures contract.
Basis risk arises when the asset being hedged is exactly the same as the asset underlying the futures contract.
The basis is calculated as the futures price of a contract minus the spot price of the asset to be hedged.
The basis is calculated as the futures price of a contract minus the spot price of the asset to be hedged.
A strengthening of the basis refers to a decrease in the difference between the spot price and the futures price.
A strengthening of the basis refers to a decrease in the difference between the spot price and the futures price.
If a hedger uses a short hedge because it plans to sell an asset and the basis strengthens unexpectedly, they will realize a lower price for the asset.
If a hedger uses a short hedge because it plans to sell an asset and the basis strengthens unexpectedly, they will realize a lower price for the asset.
Cross hedging involves hedging an asset with a futures contract on the exact same underlying asset, ensuring minimal basis risk.
Cross hedging involves hedging an asset with a futures contract on the exact same underlying asset, ensuring minimal basis risk.
When choosing a futures contract for hedging, it is generally recommended to select a delivery month that is as close as possible to, but earlier than, the expiration of the hedge.
When choosing a futures contract for hedging, it is generally recommended to select a delivery month that is as close as possible to, but earlier than, the expiration of the hedge.
The hedge ratio is defined as the size of the exposure divided by the size of the position taken in futures contracts.
The hedge ratio is defined as the size of the exposure divided by the size of the position taken in futures contracts.
When the asset underlying the futures contract is the same as the asset being hedged, the optimal hedge ratio is always equal to 1.0.
When the asset underlying the futures contract is the same as the asset being hedged, the optimal hedge ratio is always equal to 1.0.
If the changes in a futures price always mirrors the changes in the spot price perfectly, the optimal hedge ratio is 0.5.
If the changes in a futures price always mirrors the changes in the spot price perfectly, the optimal hedge ratio is 0.5.
Hedge effectiveness is defined as the square root of R-squared ($R^2$) from the regression of changes in spot price against changes in futures price.
Hedge effectiveness is defined as the square root of R-squared ($R^2$) from the regression of changes in spot price against changes in futures price.
Tailing the hedge involves adjusting the futures position to reflect the latest values of the position being hedged and the futures contract.
Tailing the hedge involves adjusting the futures position to reflect the latest values of the position being hedged and the futures contract.
In a stock index, dividends are always included in the calculation so that the index tracks the total return on investment.
In a stock index, dividends are always included in the calculation so that the index tracks the total return on investment.
If the hypothetical portfolio of stocks remains fixed, the weights assigned to individual stocks in the portfolio also remain fixed over time.
If the hypothetical portfolio of stocks remains fixed, the weights assigned to individual stocks in the portfolio also remain fixed over time.
Futures contracts on stock indices are typically settled by delivering the underlying stocks that comprise the index.
Futures contracts on stock indices are typically settled by delivering the underlying stocks that comprise the index.
To hedge a well-diversified equity portfolio that mirrors an index, the optimal hedge ratio is assumed to be 0.5.
To hedge a well-diversified equity portfolio that mirrors an index, the optimal hedge ratio is assumed to be 0.5.
A portfolio with a beta of 0.5 is twice as sensitive to movements in the index as a portfolio with a beta of 1.0.
A portfolio with a beta of 0.5 is twice as sensitive to movements in the index as a portfolio with a beta of 1.0.
Hedging an equity portfolio always guarantees a higher return than simply selling the portfolio and investing in a risk-free instrument.
Hedging an equity portfolio always guarantees a higher return than simply selling the portfolio and investing in a risk-free instrument.
To increase the beta of a portfolio, one should take a short position in index futures contracts.
To increase the beta of a portfolio, one should take a short position in index futures contracts.
The stack and roll strategy is used when the expiration date of the hedge is earlier than the delivery dates of all available futures contracts.
The stack and roll strategy is used when the expiration date of the hedge is earlier than the delivery dates of all available futures contracts.
In the stack and roll strategy, hedges are rolled forward by closing out one futures contract and taking the opposite position in a contract with a later delivery date.
In the stack and roll strategy, hedges are rolled forward by closing out one futures contract and taking the opposite position in a contract with a later delivery date.
Hedgers utilize futures markets with the primary goal of amplifying potential profits, irrespective of associated risks.
Hedgers utilize futures markets with the primary goal of amplifying potential profits, irrespective of associated risks.
A perfect hedge guarantees complete elimination of all risks associated with price fluctuations.
A perfect hedge guarantees complete elimination of all risks associated with price fluctuations.
Hedge-and-forget strategies involve frequent adjustments to the hedge position based on market monitoring.
Hedge-and-forget strategies involve frequent adjustments to the hedge position based on market monitoring.
In hedging, futures contracts always behave identically to forward contracts, without any need for adjustments.
In hedging, futures contracts always behave identically to forward contracts, without any need for adjustments.
A company gaining $20,000 for each 1 cent increase in a commodity price should take a long futures position to hedge.
A company gaining $20,000 for each 1 cent increase in a commodity price should take a long futures position to hedge.
A short hedge is suitable for an individual who anticipates purchasing an asset in the future.
A short hedge is suitable for an individual who anticipates purchasing an asset in the future.
An exporter who will receive foreign currency in the future can use a short futures position to offset risks from changes in exchange rates.
An exporter who will receive foreign currency in the future can use a short futures position to offset risks from changes in exchange rates.
If an oil producer locks in a price of $90 per barrel using a short hedge, and the spot price at delivery is $80, they will have a loss compared to not hedging.
If an oil producer locks in a price of $90 per barrel using a short hedge, and the spot price at delivery is $80, they will have a loss compared to not hedging.
Long hedges are employed by companies that expect to sell an asset in the future and want to lock in current prices.
Long hedges are employed by companies that expect to sell an asset in the future and want to lock in current prices.
A copper fabricator can lock in the price of copper they need in the future using a long futures contract.
A copper fabricator can lock in the price of copper they need in the future using a long futures contract.
If a copper fabricator hedges and the spot price decreases, the fabricator would have been better off not to hedge.
If a copper fabricator hedges and the spot price decreases, the fabricator would have been better off not to hedge.
It is generally cheaper for individual shareholders to hedge risks compared to large corporations due to lower transaction costs.
It is generally cheaper for individual shareholders to hedge risks compared to large corporations due to lower transaction costs.
Shareholders can diversify risks more easily than corporations, potentially making hedging by corporations less important.
Shareholders can diversify risks more easily than corporations, potentially making hedging by corporations less important.
If a company chooses to hedge when its competitors do not, its profit margins will remain constant regardless of price fluctuations.
If a company chooses to hedge when its competitors do not, its profit margins will remain constant regardless of price fluctuations.
Hedging always increases a company's profits compared to not hedging, regardless of market movements.
Hedging always increases a company's profits compared to not hedging, regardless of market movements.
Hedging decisions should be made without considering the existing risk profile of the company's business activities.
Hedging decisions should be made without considering the existing risk profile of the company's business activities.
Basis risk arises due to the uncertainty of the basis at the initiation of a hedge.
Basis risk arises due to the uncertainty of the basis at the initiation of a hedge.
The basis is defined as the futures price of a contract minus the spot price of the asset to be hedged.
The basis is defined as the futures price of a contract minus the spot price of the asset to be hedged.
Basis risk is eliminated when the asset being hedged is identical to the asset underlying the futures contract.
Basis risk is eliminated when the asset being hedged is identical to the asset underlying the futures contract.
An unexpected decrease in the basis benefits a company using a short hedge because it receives a higher price for the asset.
An unexpected decrease in the basis benefits a company using a short hedge because it receives a higher price for the asset.
Cross hedging involves hedging an asset with futures contracts on the same underlying asset.
Cross hedging involves hedging an asset with futures contracts on the same underlying asset.
When cross hedging, it is always optimal to set the hedge ratio equal to 1.0.
When cross hedging, it is always optimal to set the hedge ratio equal to 1.0.
If the correlation between changes in spot and futures prices is zero, the optimal hedge ratio is also zero.
If the correlation between changes in spot and futures prices is zero, the optimal hedge ratio is also zero.
Hedge effectiveness is defined as the square root of the proportion of variance eliminated by hedging.
Hedge effectiveness is defined as the square root of the proportion of variance eliminated by hedging.
The optimal number of futures contracts for hedging is independent of the size of the position being hedged.
The optimal number of futures contracts for hedging is independent of the size of the position being hedged.
Tailing the hedge involves adjusting the futures position to reflect the correlation between percentage one-day changes in futures and spot prices.
Tailing the hedge involves adjusting the futures position to reflect the correlation between percentage one-day changes in futures and spot prices.
When tailing a hedge in practice, the futures position is generally changed every day to reflect the latest values.
When tailing a hedge in practice, the futures position is generally changed every day to reflect the latest values.
Stock index futures contracts are typically settled by delivering the underlying portfolio of stocks.
Stock index futures contracts are typically settled by delivering the underlying portfolio of stocks.
The weight of a stock in a price weighted stock index remains fixed.
The weight of a stock in a price weighted stock index remains fixed.
To hedge a portfolio that mirrors the S&P 500, the number of futures contracts to short is calculated by dividing the portfolio's value by the value of one futures contract.
To hedge a portfolio that mirrors the S&P 500, the number of futures contracts to short is calculated by dividing the portfolio's value by the value of one futures contract.
Beta measures the diversifiable risk of a portfolio.
Beta measures the diversifiable risk of a portfolio.
A portfolio with a beta of 0.5 is more sensitive to market movements than a portfolio with a beta of 1.0.
A portfolio with a beta of 0.5 is more sensitive to market movements than a portfolio with a beta of 1.0.
Changing the stocks in a portfolio is necessary to alter its beta.
Changing the stocks in a portfolio is necessary to alter its beta.
If you are confident that your stockpicking skills will outperform the market, you should take a long poisition in index futures.
If you are confident that your stockpicking skills will outperform the market, you should take a long poisition in index futures.
In a stack and roll strategy, the hedger closes out one futures contract and takes the opposite position in a contract with a later delivery date.
In a stack and roll strategy, the hedger closes out one futures contract and takes the opposite position in a contract with a later delivery date.
Rolling forward hedges always eliminates any cash flow pressures.
Rolling forward hedges always eliminates any cash flow pressures.
In stack and roll hedging, only the first delivery month has sufficient liquidity to meet your needs.
In stack and roll hedging, only the first delivery month has sufficient liquidity to meet your needs.
During stack and roll hedging activities, there is misalignment between cash flows of the hedger and financial instruments.
During stack and roll hedging activities, there is misalignment between cash flows of the hedger and financial instruments.
In hedging, focus should be restricted to potential profits.
In hedging, focus should be restricted to potential profits.
Hedgers utilize futures markets primarily to amplify potential profits from price fluctuations.
Hedgers utilize futures markets primarily to amplify potential profits from price fluctuations.
A perfect hedge guarantees complete elimination of all risks.
A perfect hedge guarantees complete elimination of all risks.
Adjusting a hedge frequently after it has been established is known as a 'hedge-and-forget' strategy.
Adjusting a hedge frequently after it has been established is known as a 'hedge-and-forget' strategy.
A company gaining from a commodity price increase should take a long futures position to hedge.
A company gaining from a commodity price increase should take a long futures position to hedge.
A short hedge involves a long position in futures contracts.
A short hedge involves a long position in futures contracts.
A U.S. importer expecting to pay Japanese yen in 3 months benefits from a long futures position in yen.
A U.S. importer expecting to pay Japanese yen in 3 months benefits from a long futures position in yen.
Closing out a futures position in the delivery month does not change the effectiveness of the hedge, compared to allowing delivery.
Closing out a futures position in the delivery month does not change the effectiveness of the hedge, compared to allowing delivery.
Daily settlement in futures contracts has no impact on the performance of a hedge.
Daily settlement in futures contracts has no impact on the performance of a hedge.
Shareholders always possess as much information as a company's management regarding the risks faced by the company.
Shareholders always possess as much information as a company's management regarding the risks faced by the company.
A company that hedges when its competitors do not can always expect stable profit margins.
A company that hedges when its competitors do not can always expect stable profit margins.
Hedging always guarantees an increase in a company's profit compared to not hedging.
Hedging always guarantees an increase in a company's profit compared to not hedging.
The basis is defined as the futures price minus the spot price of an asset.
The basis is defined as the futures price minus the spot price of an asset.
Basis risk arises from the uncertainty of the basis at the initiation of a hedge.
Basis risk arises from the uncertainty of the basis at the initiation of a hedge.
A company using a short hedge benefits from an unexpected weakening of the basis.
A company using a short hedge benefits from an unexpected weakening of the basis.
Cross hedging occurs when the asset underlying the futures contract is identical to the asset being hedged.
Cross hedging occurs when the asset underlying the futures contract is identical to the asset being hedged.
The hedge ratio that minimizes variance can be found by regressing changes in the futures price against changes in the spot price.
The hedge ratio that minimizes variance can be found by regressing changes in the futures price against changes in the spot price.
In calculating the optimal number of futures contracts, only the size of the position being hedged matters, not the size of one futures contract.
In calculating the optimal number of futures contracts, only the size of the position being hedged matters, not the size of one futures contract.
Tailing the hedge involves calculating the correlation between percentage one-day changes in futures and spot prices.
Tailing the hedge involves calculating the correlation between percentage one-day changes in futures and spot prices.
Stock index futures are typically settled by physical delivery of the underlying stocks in the index.
Stock index futures are typically settled by physical delivery of the underlying stocks in the index.
Stack and roll is a strategy used when the expiration date of a hedge is earlier than the delivery dates of available futures contracts.
Stack and roll is a strategy used when the expiration date of a hedge is earlier than the delivery dates of available futures contracts.
Flashcards
Hedging
Hedging
Reducing risk using futures markets.
Perfect Hedge
Perfect Hedge
Eliminates risk completely (rare).
Short Hedge
Short Hedge
Selling futures to hedge an existing asset.
Long Hedge
Long Hedge
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Shareholder Hedging
Shareholder Hedging
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Hedging vs. Competitors
Hedging vs. Competitors
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Hedging and Risk Reduction
Hedging and Risk Reduction
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Basis
Basis
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Basis Risk
Basis Risk
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Strengthening of the Basis
Strengthening of the Basis
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Weakening of the Basis
Weakening of the Basis
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Cross Hedging
Cross Hedging
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Hedge Ratio
Hedge Ratio
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Minimum Variance Hedge Ratio
Minimum Variance Hedge Ratio
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Tailing the Hedge
Tailing the Hedge
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Stock index
Stock index
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Hedging an Equity Portfolio
Hedging an Equity Portfolio
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Changing Beta
Changing Beta
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Stack and Roll
Stack and Roll
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Study Notes
- Hedgers participate in futures markets to mitigate specific risks, like price fluctuations in oil, exchange rates, or stock market levels.
- A perfect hedge eliminates risk entirely, but they are rare, so the focus is on constructing hedges that perform as close to perfect as possible.
- Hedge-and-forget strategies involve taking a futures position at the beginning and closing it out at the end, without adjustments in between; dynamic hedging adjusts frequently.
- It initially treats futures contracts as forward contracts, but later addresses adjustments like "tailing," which accounts for the difference between futures and forwards.
Basic Principles
- The goal of hedging is to neutralize risk by taking a position that offsets potential losses or gains.
- A company that gains or loses $10,000 for every 1 cent change in a commodity price should take a short futures position that offsets this risk.
Short Hedges
- A short hedge involves a short position in futures contracts.
- Short hedges are suitable when owning an asset expected to be sold in the future.
- Short hedges can also be used when an asset will be owned in the future.
- A U.S. exporter expecting to receive euros in 3 months can use a short futures position to offset the risk of the euro's value decreasing.
- An oil producer can hedge their exposure by shorting futures contracts, effectively locking in a price close to the futures price at the time of the hedge.
- An oil producer agrees to sell 1 million barrels of crude oil at the market price on August 15, and on May 15, the spot price is $80 per barrel, and the August futures price is $79 per barrel.
- The company shorts 1,000 futures contracts, but suppose the spot price on August 15 is instead $75 per barrel.
- The company realizes $75 million from the oil sale and gains approximately $4 million from the futures position, for a total of $79 million.
- Alternatively, if the price on August 15 is $85, the company makes $85 million from the oil sale but loses $6 million on the futures position, but still ends up with about $79 million.
Long Hedges
- Long hedges involve taking a long position in a futures contract.
- Long hedges benefit a company that knows it will need to purchase an asset in the future, wanting to lock in a price now.
- A copper fabricator needing 100,000 pounds of copper on May 15 can hedge by taking a long position in four futures contracts at 320 cents per pound.
- If the spot price on May 15 is 325 cents per pound, the fabricator gains $5,000 on the futures contracts but their net cost is approximately $320,000.
- If the spot price is 305 cents per pound on May 15, the fabricator loses $15,000 on the futures contract but pays $305,000 for the copper. Again, the net cost is approximately $320,000.
- Using futures contracts can be better than buying in the spot market on January 15 at 340 cents per pound, which incurs interest and storage costs.
- Closing out the futures position in the delivery month has the same effect as taking delivery, but delivery can be costly and inconvenient.
- Daily settlement affects hedge performance, realizing the payoff throughout the hedge's life rather than all at the end.
Arguments For and Against Hedging
- Companies should hedge risks in areas where they lack expertise and focus on their core competencies.
- Many risks are left unhedged in practice.
- Shareholders can hedge themselves, however, shareholders may not have the same access to information or transaction costs as the company.
- Diversified shareholders may already be immune to the risks faced by the company.
Hedging and Competitors
- Hedging may not be beneficial if it is not the norm in your industry.
- A company that doesn't hedge can expect constant profit margins, while a company that does can expect fluctuating margins, dependent on the direction of price movements.
Hedging Can Lead to a Worse Outcome
- Hedging can either increase or decrease profits compared to not hedging.
- If the price of the underlying asset increases, there may be questions from board members about losing money of the hedge contract, while gaining from the sale of the commodity.
- Senior executives must fully understand the nature of hedging.
- Hedging strategies should be set by the board and communicated to management and shareholders.
Basis Risk
- The asset being hedged may not be the same as the asset underlying the futures contract.
- The hedger may be unsure of exactly when the asset will be bought or sold.
- The futures contract may be closed out before the delivery month.
The Basis
- The basis is the difference between the spot price of the asset to be hedged and the futures price of the contract used.
- Basis = Spot price of asset to be hedged - Futures price of contract used
- If the asset to be hedged and the asset underlying the futures contract are the same, the basis should be zero at the expiration of the futures contract.
- An increasing basis is a strengthening basis; a decreasing basis is a weakening one.
- Basis risk results from the uncertainty about the final basis value (b2) at the time the hedge is closed out.
- Basis changes can improve or worsen a hedger’s position, depending on whether the hedge is short or long and whether the basis strengthens or weakens.
- Cross hedging involves using a futures contract on a different asset and increases basis risk.
Choice of Contract
- The key factors are the asset underlying the futures contract and the delivery month, which affects basis risk.
- Choose a delivery month close to, but later than, the hedge expiration to minimize basis risk.
- A common approach is to pick a delivery month that is as close as possible to, but later than, the expiration of the hedge.
Cross Hedging
- Cross hedging occurs when the asset underlying the futures contract is different from the asset being hedged.
Calculating the Minimum Variance Hedge Ratio
- The hedge ratio is the ratio of the size of the position taken in futures contracts to the size of the exposure.
- The minimum variance hedge ratio is calculated via h = ρ(σS/σF)
- Where ρ is the coefficient of correlation between changes in the spot price and changes in the futures price.
- QA : Size of position being hedged (units)
- QF : Size of one futures contract (units)
- N : Optimal number of futures contracts for hedging.
- N=h(QA/QF)
Tailing the Hedge
- Tailing the Hedge is used when futures contracts are used for hedging.
- Daily settlement is a series of on-day hedges.
- Correlation calculated between percentage one-day changes in the futures and spot prices to reflect this.
- N = (h * VA) / VF
Stock Index Futures
- Stock index futures can be used to manage exposures to equity prices.
- A stock index tracks changes in the value of a hypothetical portfolio of stocks.
Stock Indices
- The Dow Jones Industrial Average is based on 30 blue-chip stocks, weighted by price, and traded by the CME Group; most active contract is Mini DJ Industrial Average.
- The Standard & Poor’s 500 (S&P 500) uses 500 stocks weighted by market capitalization, traded by the CME Group; the Mini S&P 500 contract is most active.
- The Nasdaq-100 uses 100 stocks from the Nasdaq, and the Mini Nasdaq-100 contract is the most actively traded on the CME Group.
- Stock index futures contracts are settled in cash; positions are closed at the opening or closing price of the index on the last trading day.
Hedging an Equity Portfolio
- Stock index futures can hedge a well-diversified equity portfolio.
- N=VA/VF is the number of futures contracts that should be shorted.
- Va = Current value of the portfolio
- Vf = Current value of one futures contract
- When the portfolio does not mirror the index, the capital asset pricing model is used.
- N=β (VA/VF) is the number of futures contracts that should be shorted, where β is the parameter beta from the capital asset pricing model.
- The hedge ratio h is the slope of the best-fit line when percentage one-day changes in the portfolio are regressed against percentage one-day changes in the futures price of the index.
Reasons for Hedging an Equity Portfolio
- Hedging can be justified if the investor feels that the stocks in the portfolio have been chosen well.
- Another reason for hedging may be that the hedger is planning to hold a portfolio for a long period of time and requires short-term protection in an uncertain market situation.
- The alternative strategy of selling the portfolio and buying it back later might involve unacceptably high transaction costs.
Changing the Beta of a Portfolio
- Futures contracts can change the beta of a portfolio to a value other than zero.
Locking in the Benefits of Stock Picking
- Investors should short VA/VF index futures contracts, where β is the beta of the portfolio, VA is the total value of the portfolio, and VF is the current value of one index futures contract.
Stack and Roll
- Stack and roll is used when the expiration date of the hedge is later than the delivery dates of all available futures contracts.
- The hedger rolls the hedge forward by closing out one futures contract and taking the same position in a contract with a later delivery date.
- Stack and roll involves entering into a series of futures contracts to create a long-dated futures contract by trading short-dated contracts.
- Companies often use a 1-month futures contract for hedging because it is the most liquid.
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