Financial Futures: Short Hedges, Long Hedges

<< Using Futures Contracts: Hedgers

Risk Management, Risk Transfer, Financial Leverage >>

Investment Analysis & Portfolio Management (FIN630)

Lesson # 43

FUTURES Contd...

Financial Futures:

Financial futures are futures contracts on equity indexes, fixed-income securities, and

currencies. They give investors greater opportunity to fine tune the risk-return

characteristics of their portfolios. In recent years, this flexibility has become increasingly

important as interest rates have become much more volatile and as investors have sought

new techniques to reduce the risk of equity positions. The drastic changes that have

occurred in the financial markets in the last 15 to 20 years could be said to have generated a

genuine need for new financial instruments that allow market participants to deal with these

changes.

The procedures for trading financial futures are the same as those for any other commodity

with few exceptions. At maturity; stock-index futures settle in cash, because it would be

impossible or impractical to deliver all the stocks in a particular index. Unlike traditional

futures, contracts, stock-index futures typically have no daily price limits (although they can

be imposed).

We will divide the subsequent discussion of financial futures into the two major categories

of contracts, interest rate futures and, stock-index futures. Hedging and speculative

activities within each category are discussed separately.

Interest Rate Futures:

Bond prices are highly volatile, and investors are exposed to adverse price movements,

financial futures, in effect, allow bondholders and others who are affected by volatile

interest rates to transfer the risk. One of the primary reasons for the growth in financial

futures is that portfolio managers and investors are trying to protect themselves against

adverse movements-in interest rates. An investor concerned with protecting the value of,

fixed-income securities must consider the possible impact of interest rates on the value of

these securities.

Today's investors have the opportunity to consider several different interest rate futures

contracts that are traded on various exchanges. The Chicago Mercantile Exchange

trades contracts on Treasury bills and the one-month LIBOR rate as well as euro dollars.

The Chicago Board of Trade (CBT) specializes in longer-maturity instruments, including

Treasury notes (of various maturities, such as two-year and five-year) and Treasury bonds

(of different contract sizes).

Short Hedges:

Since so much common stock is "held by investors, the short hedge is the natural type of

contract for most investors. Investors who hold stock portfolios hedge market risk by selling

stock-index futures, which means they assume a short position.

A short hedge can be implemented by selling a forward maturity of the contract. The

purpose of this hedge is to offset (in total or in part) any losses on the stock portfolio with

gains on the futures-position. To implement this defensive strategy, an investor would sell

one or more index futures contracts. Ideally, the value of these contracts would equal the

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Investment Analysis & Portfolio Management (FIN630)

value of the stock portfolio. If the market falls, leading to a loss on the cash (the stock

portfolio) position, stock-index futures prices wilt also fall, leading to a profit for sellers of

futures.

Long Hedges:

The long hedger, while awaiting funds to invest, generally wishes to reduce the risk of

having to pay more for an -equity position when prices rise. Potential users of a long hedge

include the following:

1. Institutions with a regular cash flow who use long hedges to improve the timing of

their positions.

2. Institutions switching large positions who wish to hedge during the time it takes to

complete the process, (This could also be a short hedge.)

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