Hedging Using Futures

Question 1

Long hedge

Answer 1

• purchase an asset in the future to lock in a
  favourable price.
• avoiding the risk of price increases
• net price: 𝑆2 + (𝐹1 − 𝐹2) 𝑜𝑟 𝐹1 + 𝑏2

Question 2

Short hedge

Answer 2

• sell an asset in the future to lock in a favourable
  price.
• avoiding the risk of price falls
• net price: 𝑆2 − (𝐹2 − 𝐹1) 𝑜𝑟 𝐹1 + 𝑏2

Question 3

Ending Basis B2

Answer 3

b 2 =S 2 −F 2
​

It’s the difference between the spot and futures price at the time the hedge is closed.

Question 4

Selection of Hedging Contracts

Answer 4

High Correlation
🔍 What It Means:
Choose a futures contract whose price moves closely with the asset you’re hedging.

🔁 Why?
The better the match, the less basis risk you take on — your hedge will be more effective.

Delivery Month Close to the Hedge Horizon (but after)
🔍 What It Means:
Choose a futures contract that expires just after the date when your price risk ends.

🔁 Why?
If the futures contract expires too early, your hedge ends before you need it
→ You’re exposed to risk again.

If it expires too far later, you increase basis risk.

Question 5

Hedging Strategies Using
Futures
* Suppose today is June 8th. A company knows that at some
point in October or November, it will need to purchase
20,000 barrels of crude oil. Currently, crude oil futures
traded on the New York Mercantile Exchange (NYMEX) have
delivery months every month of the year. Each contract size
is 1,000 barrels of crude oil.
* On June 8, the futures price was $48.00 per barrel. The
company needs to purchase crude oil on November 10, so it
offsets its futures position on that day. On November 10,
the spot price and futures price were $50.00 per barrel and
$49.10 per barrel, respectively.

Answer 5

1) If you are the financial manager of this company, how would you hedge in the futures market?
Long hedge
December contract
Number of contracts =
20,000
1,000
= 20 contracts
2) How much does the company pay in total for 20,000 barrels of crude oil?
𝐹2 − 𝐹1 = 49.10 − 48.00 = 1.10
𝑏2 = 50 − 49.10 = 0.9
Actual price:
Method 1: 𝑆2 − (𝐹2−𝐹1) = 50-1.1=48.90
Method 2: 𝐹1 + 𝑏2 = 48+0.9=48.90
* Total purchase cost = 20,000 × 48.90 = $978,000

Question 6

Cross Hedging

Answer 6

Cross Hedging uses the derivative of one asset to hedge
another asset
Optimal Hedge Ratio Formula: ℎ
∗
= 𝜌
𝜎𝑆
𝜎𝐹
Optimal Number of Contracts: 𝑁
∗
=
ℎ
∗𝑄𝐴
𝑄�

Question 7

An airline expects to purchase 2 million gallons of jet fuel in one month
and decides to use heating oil futures for hedging. What is the optimal
hedge ratio? How many contracts should the company buy or sell to hedge
its exposure if each heating oil contract traded by CME Group is on 42,000
gallons? (𝝈𝑺 = 0.0263, 𝝈𝑭 = 0.0313 and 𝝆 = 0.928.)

Answer 7

ℎ
∗
= 𝜌
𝜎𝑆
𝜎𝐹
= 0.928 ×
0.0263
0.0313
= 0.7798
𝑁
∗
=
ℎ
∗𝑄𝐴
𝑄𝐹
= 0.7798 ×
2,000,000
42,000
= 37.13
* The airline will take a long position in 37 heating oil futures.