4w FinEcon 2024fall v3

Summary

This script discusses the concept of hedging using futures contracts to mitigate risk. It explains the role of beta as a sensitivity measure for determining the optimal hedge ratio. The script provides examples of cross-hedging, where the underlying asset and the asset to be hedged are not identical, and how to calculate the necessary futures contracts for effective hedging. It also touches on basis risk, which arises from the uncertainty of the difference between the spot and futures prices at maturity. The importance of understanding when to take long or short futures positions for hedging is emphasized.

Takeaways

• 📊 **Cross Hedging**: Discusses the concept of hedging using futures contracts that are correlated but not identical to the underlying asset.
• 🔍 **Beta as a Measure**: Beta is used to measure the sensitivity and relationship between the underlying asset and the asset to be hedged.
• 💼 **Practical Example**: Provides an example of cross hedging by selling Samsung shares and using CP 200 futures to lock in the price.
• 📉 **Hedging Outcomes**: Explains that the outcome of cross hedging may slightly differ from the target due to differences in price changes between the underlying asset and the futures contract.
• 📈 **Basis Risk**: Highlights the risk that arises from the uncertainty of the basis, which is the difference between the spot price of an asset and its future price.
• 📋 **Optimal Hedging Ratio**: Discusses how to determine the optimal hedging ratio based on beta and the value of the underlying asset and futures contract.
• 🚀 **Another Example**: Describes an airline hedging jet fuel purchases using heating oil futures, showing how to calculate the optimal number of contracts.
• 💡 **Hedging Strategy**: Emphasizes the importance of understanding when to take long or short futures positions for hedging purposes.
• 🌐 **Basis Between Assets**: Illustrates the concept of basis by comparing the prices of different but related assets, such as CP 200 and Samsung stock, or heating oil and jet fuel.
• 📚 **Educational Session**: Concludes with a reminder of the importance of understanding hedging concepts, especially the timing and direction of futures positions relative to the asset being hedged.

Q & A

What is the optimal hedge ratio and how is it determined?

The optimal hedge ratio can be determined by Beta, which represents the sensitivity and relationship between the underlying asset and the asset to be hedged. It indicates how much of one asset is needed to hedge another.

What is meant by 'cross hedging' in the context of the transcript?

Cross hedging refers to the practice of using a different but correlated asset to hedge against the risk of an underlying asset. This is done when the assets are not identical.

Can you provide an example of cross hedging from the transcript?

Yes, an example given is where one would sell one share of Samsung in one year and hedge using CP 200 Futures, which is a different but related asset to Samsung stock.

How does the number of contracts needed for hedging in cross hedging scenarios get calculated?

The number of contracts needed for cross hedging is calculated using the optimal hedge ratio, which takes into account the Beta and the value of the underlying asset and the futures contract.

What is the significance of Beta in the context of hedging?

Beta is used as an indicator for the relationship between the underlying asset and the asset to be hedged. It helps determine the optimal hedge ratio.

What is basis risk and how does it relate to hedging?

Basis risk is the risk that the price move of the hedged asset will not perfectly correlate with the price move of the hedging instrument. It arises from the uncertainty of the difference between the spot price of an asset and its future price.

How does the change in the price of the underlying asset and the hedging instrument affect the hedging outcome?

The change in price can result in a difference between the target price and the actual amount received upon hedging, which is due to the non-identical nature of the underlying asset and the hedging instrument.

What is the role of the multiplier in calculating the value of a futures contract?

The multiplier is used to determine the value of one futures contract by multiplying it with the index value. For example, if the index value is 300 and the multiplier is 100, then the value of one contract is 30,000.

What is the outcome of a cross hedging strategy if the price of the underlying asset and the hedging instrument both go down?

If both the underlying asset and the hedging instrument prices go down, the hedger will receive less from selling the asset but will also gain more from the short position in the hedging instrument.

Why is hedging important for a business?

Hedging is important for a business to reduce risk, especially exchange rate risk. It allows the business to focus on its core operations without being exposed to unpredictable market fluctuations.

Can you explain the concept of taking a long or short position in futures for hedging?

Taking a long position in futures for hedging means buying futures contracts to lock in a price for a future sale. Conversely, taking a short position means selling futures contracts to lock in a price for a future purchase.