Hedging a portfolio with futures

Table of Contents

List of figures and tables

List of abbreviations

Abstract

I. Introduction
1. Problem background
2. Course of examination

II. Main Part
1. Futures
1.1 Definition
1.2 Types of futures
1.3 Trading futures
1.3.1 Exchange and clearing house
1.3.2. Margins and daily settlement
1.3.3 Basis and convergence
1.4 Market participants and their motivation
2. Hedging with futures
2.1 Definition
2.2. Types of hedges
2.2.1 Short hedge
2.2.2 Long hedge
2.2.3 Cross hedging
2.3 Hedge Ratio
3. Hedging of a portfolio – an example
3.1 The portfolio and the future
3.2 Determining the hedge ration
3.3 Impact of market development

III Conclusion

List of literature

List of figures and tables

Figure 1.1: Market share by Commodity Type at CBOT and CME in 2002

Table 1.1: Changes in a broker account with future due to daily settlement

Figure 1.2: Convergence

Table 3.1: Stock portfolio

Table 3.2: S&P 500 future product specification traded at CME

Table 3.3: S&P 500 future prices as of 07/11/2003

List of abbreviations

illustration not visible in this excerpt

Abstract

Undertaking business always involves taking risk. The future development of a company and their business is more uncertain the higher the risk that the company is facing. Risk management is a important factor in operating business. With the development of future markets entrepreneurs and investors obtained another risk management tool that made it possible to reduce risk. Futures are derivatives that can be used either for speculating or risk management. Especially in the area of financial futures, a rapid growth could be observed during the last few decades. Almost every month a new type of contract appears to meet the needs of a continuously growing corporate and institutional market.

This paper considers future contracts as hedging application to reduce price risk. Futures are standardized contracts to buy or sell an asset in the future. There are various types of futures which differ in the type of the underlying asset.

Futures are traded at organized exchanges. We consider the trading of future, their requirements, and market participants and their motivation.

Different commercial users of future contracts hedge in different ways. A long hedge is used to reduce price risk of an anticipated purchase whereas a short hedge reduces the price risk of an asset that is already held. If there is no exact, the hedgers needs matching, contract available, the hedger should use a cross hedging strategy. With all these strategies the hedger takes, to the asset opposite, a position in the future market that is highly correlated with the change in price of the asset in the spot market. Losses in one market are offset by gains in the other market.

For a successful hedge it is essential to choose an appropriate contract and hedge ratio. Faults can result in losses. The example of hedging a stock portfolio shows the application of an index future and presents the behavior of the hedged portfolio in different scenarios of stock market development.

I INTRODUCTION

1. Problem background

In times of globalization and international business, political and economic events showed that the risk for involved market participants increases (e.g. international trade). Companies have to deal with more risk from exchange rate, interest changes and foreign exposures. A consequence from these developments is an increased uncertainty and less control over the outcomes for companies that increased the need for new risk management tools to face these problems.

A company can be viewed as a portfolio of business and financial risk. From this follows that business management is a practice of risk management. The primary tool used to minimize exposures and risks are derivatives.^[1]

The following paper deals with the use of futures as a risk management tool for hedging portfolios.

2. Course of examination

At the beginning there is a definition of futures and basic points of future contracts are presented. Furthermore, there is an overview of the types of futures and their field of application.

The second part discusses the different hedging strategies with futures and their process of application and we will show the use of futures for hedging a portfolio in practice in an example of a stock portfolio.

II MAIN PART

1. Futures

1.1 Definition

“A derivative is a financial contract whose value is derived from, or depends on, the price of some underlying asset.”^[2] Futures are a class of derivative contracts.

A future contract is a legally binding contract to take or make a delivery of a given quantity and quality of a commodity at an agreed price on a specific date in the future. A financial future is where the commodity is a financial product. The buyer (long position) of a future is required to purchase the underlying commodity, whereas the seller (short position) of the future is required to sell it.

1.2 Types of futures

The types of futures differ due to their underlying goods. There are four different categories of the underlying. It can be a physical commodity, a foreign currency, an interest-earning asset, or an index.^[3]

In the category of commodity futures, contracts are traded in agricultural goods such as grain, oil, livestock, forest products, textiles and foodstuffs, and in metallurgical goods, e.g. gold, silver and copper. The metallurgical category also includes petroleum products such as heating oil and gasoline. Furthermore, the Chicago Mercantile Exchange provides the opportunity to trade future contracts on weather. These “contracts are listed on U.S. cities that face significant weather-related risks. CME weather futures […] are based on an index of heating degree days and cooling degree days. Designed to enable businesses to hedge risks associated with unexpected or unfavorable weather conditions, these products play an important role in managing risk.”^[4]

The second category is futures traded on interest-earning assets. This group of futures only began trading in 1975. Now it is this group that has seen the most explosive growth. Futures of this category include Treasury Bills, Treasury Bonds, Treasury Notes, Municipal Bonds, and Eurodollar Deposits. In addition, foreign exchanges also trade debt instruments. Almost every month a new type of contract appears to meet the needs of a continuously growing corporate and institutional market.

The third category is futures traded on foreign currencies. It became possible when freely floating exchange rates were established in the early 1970s. Most major foreign currencies are traded such as the Canadian dollar, Japanese yen, British pound, Swiss franc, and the Euro. Additionally, there are also cross currency futures traded. The forward market in currencies is much larger than the foreign exchange futures market.

The last category of futures is traded on indexes, whereby the major part is stock indexes. Today, there are futures on most major indexes, e.g. the S&P 500, New York Stock Exchange Index, Russell 2000, S&P 400 Midcap, or the Value Line index. Stock index futures are settled in cash because there is no possibility for the delivery of a good. The only possibility for the trader to settle his positions is to buy or sell an offsetting position or a cash settlement at expiration.

The relative importance of each commodity type is shown in Figure 1.1 including the trades of future contracts at the Chicago Board of Trade (CBOT) and the Chicago Mercantile Exchange (CME) in 2002 as two of the most important exchanges for futures in the United States.

Figure 1.1: Market share by Commodity Type at CBOT and CME in 2002

illustration not visible in this excerpt

Source: Own illustration according to http://www.cbot.com/cbot/docs/34227.xls? cid=7788 and http://www.cme.com/ftp.cfm/pub/volmthly#, as of 07/10/2003

1.3 Trading futures

1.3.1 Exchange and clearing house

Futures are highly standardized based on quantity and quality of the underlying commodity, expiration month, delivery terms and dates, trading hours, daily price limits and minimum fluctuation.^[5] This standardization of future contracts promotes liquidity for the exchange.

Futures are traded on organized exchanges, e.g. at the Chicago Board of Trade (CBOT) by a system of open outcry. A trader has to offer a buy or sell to all the other traders on the trading floor (pit) through open outcry. The traders also use a system of hand signals to express their requests. Every trader in the pit has to hold a membership of the exchange, a so called seat. The seats can be traded at an exchange and can be seen as an asset of the trader. For example a full seat in the CBOT costs 354,000 USD as of 06/24/2003.^[6]

Exchange members are classified as either commission brokers who execute orders for other parties, or locals that are members of the exchange by themselves and trade for their own account. Commission brokers generate income by charging commissions for each trade and taking no price risk. Locals are individuals who try to profit by buying contracts at smaller prices and selling them with a higher price.

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^[1] According to Collins ,B. M./Fabozzi, F. J.: Derivatives and Equity Portfolio Management, 1999, p.2

^[2] According to Dubofsky, D. A./Miller,T. W., Derivatives – Valuation and Risk Management, 2003, p.3

^[3] According to Kolb, R. W., Understanding Future Markets, 1994, p.19

^[4] http://www.cme.com/products/commodity/weather.cfm, as of 07/04/2003

^[5] According to Kolb, R. W., Understanding Future Markets, 1994, p.7

^[6] According to http://www.cbot.com/cbot/quotes/seat_prices/0,2398,12+41+251,00.html, as of 07/07/2003