Hedging is a strategy to reduce the risk of losing money from an investment due to unfavorable changes in prices. For example, if you own some gold and you are worried that the price of gold will go down in the future, you can hedge your position by selling some gold futures contracts. A futures contract is an agreement to buy or sell an asset at a fixed price on a specific date in the future.
The basis is the difference between the current price of the asset (the spot price) and the price of the futures contract. Ideally, the basis should move in the opposite direction of the spot price, so that the loss in one position is offset by the gain in the other. However, this is not always the case, because the spot and futures prices are influenced by different factors, such as supply and demand, interest rates, storage costs, etc. This means that the basis can change unpredictably, and the hedge may not be perfect. This is called the basis risk.
Basis risk can arise from different sources, such as:
- Location: The asset and the futures contract may have different delivery points, which can affect the transportation and storage costs.
- Quality: The asset and the futures contract may have different characteristics or specifications, which can affect the value and usability of the asset.
- Time: The asset and the futures contract may have different expiration dates, which can affect the price movements and volatility of the asset.
To reduce the basis risk, the hedger should try to match the asset and the futures contract as closely as possible in terms of location, quality, and time. However, this may not be feasible or cost-effective, especially for less liquid or standardized assets. Therefore, the hedger should also monitor the basis and adjust the hedge ratio accordingly. The hedge ratio is the number of futures contracts needed to hedge one unit of the asset. A higher hedge ratio means a more aggressive hedge, and a lower hedge ratio means a more conservative hedge.
Basic Theory:
Basis risk occurs when there is a misalignment in the price movements of a derivative and its underlying asset. This discrepancy can lead to financial losses for investors and traders. Hedging basis risk involves taking offsetting positions to mitigate the potential impact of such misalignments.
Procedures:
- Identify the Basis Risk:
- Determine the relationship between the derivative and its underlying asset.
- Analyze historical price movements to identify instances of basis risk.
- Select a Hedging Instrument:
- Choose a hedging instrument that closely correlates with the underlying asset of the derivative.
- Common instruments for hedging basis risk include futures contracts and options.
- Calculate Hedge Ratios:
- Determine the appropriate hedge ratio, which represents the proportion of the derivative position that needs to be hedged.
- Hedge ratio = Covariance (Price changes of the derivative, Price changes of the hedging instrument) / Variance (Price changes of the hedging instrument)
- Execute the Hedge:
- Open positions in the hedging instrument according to the calculated hedge ratio.
- Regularly monitor and adjust the hedge position based on changes in market conditions.
Scenario with Real Numbers:
Let’s consider a scenario where an investor holds a portfolio of call options on Stock XYZ and wants to hedge the basis risk using Stock Index Futures.
| Item | Value |
|---|---|
| Number of call options | 100 |
| Current price of Stock XYZ | $50 |
| Option Delta | 0.6 |
| Futures contract multiplier | 250 |
| Number of futures contracts | 0.24 |
Calculation:
Hedge ratio = Option Delta = 0.6
Number of futures contracts = (Number of call options * Option Delta) / Futures contract multiplier
Assuming the futures contract multiplier is 250, the calculation becomes:
Number of futures contracts = (100 * 0.6) / 250 = 0.24
Result: The investor should open a position in 0.24 Stock Index Futures contracts to hedge the basis risk effectively.
Other Approaches:
- Cross-Hedging:
- Use a closely related but not identical asset for hedging.
- Requires careful analysis of the correlation between the hedging instrument and the derivative.
- Dynamic Hedging:
- Adjust the hedge ratio continuously based on changing market conditions.
- Requires active monitoring and quick decision-making.
