Page 60 - DMGT513_DERIVATIVES_AND_RISK_MANAGEMENT

Unit 5: Pricing of Future Contracts

Risks in the Futures Markets Notes

As we have already seen, one the most important applications of the futures is for hedging.
Futures contracts were initially introduced to help farmers who did not want to bear the risk of
price fluctuations. The farmer could short hedge in March (agree to sell his crop) for a September
delivery. This effectively locks in the price that the farmer receives. On the other side, a cereal
company may want to guarantee in March the price that it will pay for grain in September. The
cereal company will enter into a long hedge.
There are a number of important insights that should be reviewed. The first is that we should be
careful about what we consider the investment in a futures contract. It is unlikely that the
margin is the investment for most traders. It is rare that somebody plays the futures with a total
equity equal to the margin. It is more common to invest some of your capital in a money market
fund and draw money out of that account as you need it for margin and add to that account as
you gain on the futures contract. It is also uncommon to put the full value of the underlying
contract in the money market fund. It is more likely that the futures investor will put a portion
of the value of the futures contract into a money market fund. The ratio of the value of the
underlying contract to the equity invested in the money market fund is known as the leverage.
The leverage is a key determinant of both the return on investment and on the volatility of the
investment. The higher the leverage, the more volatile are the returns on your portfolio of
money market funds and futures.
The most extreme leverage is to include no money in the money market fund and only commit
your margin. The concept of basis risk was introduced earlier. It is extremely unlikely that you
can create a perfect hedge.

Did u know? What is perfect hedge?
A perfect hedge is when the loss on your cash position is exactly offset by the gain in the
futures position.

Self Assessment

State the following are true or false:
11. Beta is a measure of the systematic risk of a security that cannot be avoided through
diversification.
12. Beta is a relative measure of risk – the risk of an individual stock relative to the market
portfolio of all stocks.

13. If the security's returns move more (less) than the market's returns as the latter changes,
the security's returns have less (more) volatility (fluctuations in price) than those of the
market.

5.4 Optimal Hedge Ratio

The Hedge Ratio (HR) is the number of futures contacts one should use to hedge a particular
exposure in the spot market. In other words, the hedge ratio is the ratio of the size of the position
taken in futures contracts to the size of the exposure.
Hedge Ratio (HR) = Quantity of Futures Position (QF)/Quantity of Cash Position(QS)

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