This blog attempts to introduce the concept of hedging, as well as provide an overview of the topic Hedging Strategies using Futures covered in FRM-1 exam. During my preparation for the FRM-1 exam, I was always partly perplexed by the mechanism behind hedging and thus had to work harder on this topic compared to others. Hedging strategies is an important topic in FRM-1 where a good understanding of the underlying mechanism of hedging has a big payoff in terms of marks scored in the exam. FRM has traditionally focused on questions related to determination of number of contracts required for a complete hedge. This is mainly a fly-through of the topics.
For a more practice based approach, I would suggest you to enroll in our upcoming free webinar and attempt quiz to gauge your preparation level. It will go over the concepts of the topic through solving relevant problems. Hopefully, by utilizing all of these sources you will be able to have an awesome preparation of the FRM-1 exam!!
Now let us start by understanding what hedging essentially is¦.
What is a hedge?
So what is meant by a hedge? It is basically defined as making an investment to reduce the risk of adverse price movements in an asset. This means that investors usually try to cover for the exposure to risk caused by their portfolios by investing in an entity which provides an offsetting position in a related security, such as a futures contract. For example, if a portfolio manager has a long position on wheat stocks for 4 months, he/she could hedge the position by selling a futures contract, wherein he will sell the stock after 4 months for a fixed rate determined by the terms of the futures contract. This way, the portfolio is secured against a sudden drop in wheat prices which could result in severe losses!!
Short and Long Hedges
Short Hedge – This occurs when a hedger has an existing long position and hedges against a sudden drop in price by selling (shorting) futures contract. Thus even if the asset value depreciates, the futures contract will ensure a fixed income for the hedger. This strategy is relevant for a long position and a bearish (negative) outlook on prices.
Long hedge – This occurs when a hedger has a short position and hedges against a sudden rise in price of asset by buying(going long on) a futures contract. Thus even if the asset value appreciates, the futures contract will ensure a fixed rate at which the hedger can buy back the asset. This strategy is relevant for a short position and a bullish (positive) outlook on prices.
Basis in a hedge is defined as the difference in prices between the spot price on the asset being hedged and futures price on hedging instrument. ie.
If the spot price increases more than the futures price, the basis increases and strengthening of basis occurs. Similarly, if futures price increases more than spot price, the basis decreases and a weakening of the basis is said to occur.
The possibility of change in basis over the hedge horizon is termed as basis risk.
Optimal Hedge Ratio
Since the relationship between spot and futures positions is not perfect, a different hedge ratio is required for each scenario which is termed as the optimal hedge ratio. This ratio directly depends on the correlation between the spot and future prices.
A hedge ratio is the ratio of the size of the futures position relative to the spot position. The optimal hedge ratio, which minimizes the variance of the combined hedge position, is defined as follows:
The optimal hedge ratio can also be understood as the Beta of spot prices relative to future prices.
Determining Optimal number of Contracts
A common hedging application is the hedging of equity portfolios using futures contracts on stock indices (index futures). In this application, it is important to remember that the hedged portfolio’s beta serves as a hedge ratio when determining the correct number of contracts to purchase or sell. The number of futures contracts required to completely hedge an equity position is determined with the following formula:
Tailing the Hedge
Tailing the hedge is a technique used to optimize the hedge ratio with the passage of time. Over time as the value of the spot and futures vary, an appropriate adjustment must be made to maintain the optimum hedge ratio. The extra step needed to carry out this strategy is to multiply the hedge ratio by the daily spot price to futures price ratio. ie.
Adjusting Portfolio Beta
Hedging an existing equity portfolio with index futures is an attempt to reduce the systematic risk of the portfolio. If the beta of the capital asset is used as the systematic risk measure, then hedging boils down to a reduction of the portfolio beta.
This concludes our overview of the topic. There will also be regular posts to help you consolidate your preparation for FRM-1 exam. See you later!!
Details of the FREE Webinar:
Topic:Hedging Strategies using Futures (FRM-1 Exam)
Date: Saturday, 13 April 2013
Time: 6:30 PM – 7:30 PM IST
This session will deal with:
- Introduction to Hedging
- Risks involved in Hedging
- Choosing Optimal Future Contracts
- Adjustments of Portfolio Beta