Short Hedges: Example a Hedging May 15: short 1000 August oil futures (each contract is written on 1000 barrels) August 15: close out the position Outcome Exxon effectively locks in a selling price of $1875/bae Charles cao
6 Charles Cao Short Hedges: Example ◼ Hedging: ◼ May 15: short 1000 August oil futures (each contract is written on 1000 barrels) ◼ August 15: close out the position ◼ Outcome: ◼ Exxon effectively locks in a selling price of $18.75/barrel
Short Hedges: Example If the oil price proves to be $17.50 on August 15 (spot price) ExXon receives $17. 50 under the sale contract ExXon receives $1.25 from the futures contract If the oil price proves to be $19.50 on August 15 (spot price) ExXon receives $19.50 under the sale contract Exxon loses $o.75 (19. 50-18.75) from the futures contract Charles cao
7 Charles Cao Short Hedges: Example ◼ If the oil price proves to be $17.50 on August 15 (spot price) ◼ Exxon receives $17.50 under the sale contract ◼ Exxon receives $1.25 from the futures contract ◼ If the oil price proves to be $19.50 on August 15 (spot price) ◼ Exxon receives $19.50 under the sale contract ◼ Exxon loses $0.75 (19.50-18.75) from the futures contract
Long hedges Involves a long position in the futures contract It is appropriate when the hedger has to purchase assets in the future and wants to lock in a price now Charles cao
8 Charles Cao Long Hedges ◼ Involves a long position in the futures contract ◼ It is appropriate when the hedger has to purchase assets in the future and wants to lock in a price now
Hedging using futures contracts It is not perfect There may be a difference between the hedged asset and the asset underlying the futures contracts You do not know the date when the asset will be purchased or sold Mismatch between the expiration date and the date when the asset will be bought or sold Charles cao
9 Charles Cao Hedging Using Futures Contracts ◼ It is not perfect: ◼ There may be a difference between the hedged asset and the asset underlying the futures contracts ◼ You do not know the date when the asset will be purchased or sold ◼ Mismatch between the expiration date and the date when the asset will be bought or sold
Hedging Using Futures Contracts all these issues relate to the basis risk Basis risk spot price of asset to be hedged- futures price of contract used If the hedged asset is the same as the asset underlying the futures contract, the basis risk is 0 on the expiration day Before the expiration day the basis risk could be positive or negative (see the picture) Charles cao
10 Charles Cao Hedging Using Futures Contracts ◼ All these issues relate to the basis risk ◼ Basis risk = spot price of asset to be hedged - futures price of contract used ◼ If the hedged asset is the same as the asset underlying the futures contract, the basis risk is 0 on the expiration day ◼ Before the expiration day, the basis risk could be positive or negative (see the picture)