C3: Futures Hedging

What is the primary goal of hedging?

To reduce uncertainty and risk, not to maximize profit

What is a long hedge?

Using futures to lock in the purchase price of an asset you will buy in the future

What is a short hedge?

Using futures to lock in the selling price of an asset you will sell in the future

Why do companies hedge?

To focus on core business and reduce exposure to market risks like price, interest rate, or exchange rate changes

What is a perfect hedge?

A hedge that completely eliminates risk, though rare in practice

What is basis?

The difference between the spot price and the futures price

What is basis risk?

The risk that the basis will change unpredictably, affecting hedge effectiveness

Why does basis risk arise?

Differences between assets, timing mismatches, or closing hedge before maturity

What does it mean to replace price risk with basis risk?

Hedging removes exposure to price changes but introduces uncertainty from basis movements

What is strengthening of the basis?

An increase in the difference between spot and futures prices

What is weakening of the basis?

A decrease in the difference between spot and futures prices

How does basis risk affect a long hedger?

Unexpected basis changes can increase the effective purchase price

How does basis risk affect a short hedger?

Unexpected basis changes can reduce the effective selling price

What is the key idea when choosing a futures contract for hedging?

Select a contract with a maturity just beyond the hedging horizon

Why avoid contracts expiring before the hedge ends?

They may require early closing and increase basis risk

Why avoid contracts expiring too late?

They may have more price volatility or delivery complications

What is cross-hedging?

Hedging using a futures contract on a different but related asset

When is cross-hedging used?

When no futures contract exists for the exact asset being hedged

What is the key requirement for effective cross-hedging?

High correlation between the asset being hedged and the futures contract asset

What are the two components of basis in cross-hedging?

Basis from futures vs spot and basis from differences between the two assets

What is the intuition behind the optimal hedge ratio?

It determines how much of the exposure should be hedged to minimize risk

What determines the optimal hedge ratio?

Volatility of spot and futures prices and their correlation

What does a higher correlation imply for hedging?

More effective hedging with lower residual risk

What is the optimal number of futures contracts?

The number of contracts needed to properly hedge a position based on size and hedge ratio

What is tailing adjustment?

Adjusting hedge size to account for daily settlement in futures

What are stock index futures?

Contracts based on a stock market index representing a portfolio of stocks

What do stock indices measure?

Capital gains/losses of a portfolio, typically excluding dividends

How are stock index futures settled?

Cash settled rather than physical delivery

What is beta in finance?

A measure of how sensitive an asset or portfolio is to market movements

What does a beta greater than 1 mean?

The asset is more volatile than the market

What does a beta less than 1 mean?

The asset is less volatile than the market

How are index futures used for hedging?

They adjust exposure to overall market risk

What does hedging a portfolio achieve?

Reduces exposure to market-wide movements

Why might an investor hedge equity returns?

To avoid selling assets, reduce taxes, or temporarily exit market exposure

What does it mean to change portfolio beta?

Adjusting market risk exposure using futures positions

How can futures increase portfolio beta?

Taking long futures positions increases market exposure

How can futures decrease portfolio beta?

Taking short futures positions reduces market exposure

What is stack and roll?

Continuously rolling forward futures contracts to maintain a hedge over time

Why is stack and roll used?

To hedge long-term exposures using shorter-term contracts

What is contango?

A market where futures prices are higher than spot prices

What is backwardation?

A market where futures prices are lower than spot prices

What is a key risk in rolling hedges?

Changes in futures pricing structure can create losses (roll risk)

What is liquidity risk in hedging?

The risk of needing cash for margin calls before gains are realized

What happened in the Metallgesellschaft (MG) case?

Large hedging strategy led to liquidity problems and significant losses

What caused MG’s losses?

Falling prices, contango market, and margin calls from rolling futures positions

What is the key lesson from MG?

Hedging strategies can fail due to liquidity pressures even if conceptually sound

Why can hedging appear to create losses?

Losses on futures may offset gains in the underlying, which may not be immediately visible

Why is hedging sometimes criticized?

It can reduce apparent profits and be difficult to explain to stakeholders

What is one argument against hedging?

Shareholders can diversify risk themselves

What is another argument against hedging?

It may disadvantage firms if competitors do not hedge

Why is communication important in hedging?

Misunderstanding hedging outcomes can lead to poor management decisions

Why do gold mining companies hedge?

To lock in prices for future production due to long project timelines

What is a key decision for firms regarding hedging?

Whether to hedge or remain exposed to price movements