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Week 2 (chapter 3): Hedging strategies using futures (Purpose (do not want…
Week 2 (chapter 3): Hedging strategies using futures
Purpose
do not want to be exposed to price movements
to reduce or eliminate the exposure of price movements (
locking in a price
)
enter a derivatives position that makes money when this
unfavorable scenario occurs
being protected if the price move against you
do not benefit if the price move favorably
Optimal number of contracts
Stock index: it tracks changes in a
hypothetical portfolio
of stocks. The hypothetical portfolio contains all stocks in the market
1 index point = $25 AUD
Optimal futures hedge
Which futures contract?
What is the optimal size?
Long/ short position?
Arguments
In favor of hedging (lecture slide for more details)
Against hedging
A company that hedge can expect its profit margins to fluctuate
Hedge can lead to a worse outcome
Shareholders are usually well diversified and can make their own hedging decision
Basis risk (should focus more on this area)
Basis = Spot price - Future price
Basis risks arise because of the uncertainty about the basis (
b2
) when the hedge is closed out
Choice of contract
Cross hedging
: choose contract whose futures price is most highly correlated with asset price
Choose a delivery month that is
as close as possible
to (but later than) the end of the life of the hedge