futures

Discussion relating to general questions on Market Risk Analysis
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risk taker
Posts: 41
Joined: Wed Aug 10, 2011 12:52 pm

futures

Postby risk taker » Sat Aug 20, 2011 7:45 am

Dear Carol,

I'm trying to understand the futures market.

If, lets say, i am an oil consumer who needs to purchase oil in the future, therefore could have a hedging need. Furthermore, lets say, my expected future spot price of oil is 110 and also i have a picture of the estimated risk assoicated with the expected outcome. Then I come to the oil futures market to hedge and find out that the prevailing market price of a futures contract for oil is 135. Obviously, the purpose of hedging is to transfer risk, but in my thinking, as a hedger, i also want to consider if my hedging makes economic sense i.e. weighing the benefits of risk being transfered against the costs of doing so, in other words, is the prevailing market futures price i believe worthwhile for me to enter into? This is my question: 1) is this a valid consideration? 2) if it is, then what should go into my proper thinking, in this albeit over-simplified example, when i, as a hedger, need to decide on whether to buy the futures or not??

Hope you could shed some light!

Thank you!

Liam

coalexander
Posts: 815
Joined: Sun Sep 28, 2008 10:30 pm

Re: futures

Postby coalexander » Sat Aug 20, 2011 12:08 pm

Dear Liam,

Suppose the futures contract matures at time T. By definition the spot and futures price are the same at time T, so for any t < T, E_t(S_T)=F_{T,T}. This means you can not only hedge, but eliminate ALL risk at time T, as perceived at time t, if you can buy the futures contract maturing at T in exactly the right quantities to match your underlying exposure at time t. This is the 1:1 or naive hedge.

The only risk that remains is basis risk, which arises either when there is no exact futures contract available (you have to choose heating oil to hedge jet oil, for instance) or when you want to close out the futures before maturity. Plus there may be a tiny position risk if you can't match your underlying exposure exactly (e.g. futures contracts come in 42,000 gallon sizes, and your exposure is 100,000 gallons). Basis risk may be better hedged using a minimum variance rather than 1:1 hedge ratio. It is not possible to eliminate all basis risk (or position risk) but basis risk can usually be reduced very substantially.

You seem to be confusing speculation with hedging -- often done. In this framework you try to make a profit as well as reduce risk. the problem then becomes one of portfolio allocation to highly correlated assets. All this is explained in much detail in the chapter on Futures in volume III. I suggest you read that and then ask if you have any specific questions about what I've written there,

Cheers, Carol

risk taker
Posts: 41
Joined: Wed Aug 10, 2011 12:52 pm

Re: futures

Postby risk taker » Sat Aug 20, 2011 3:39 pm

Hi Carol,

Thanks so much for your answer! You hit the nail on the head - indeed, in that question I posed, i was not simply satisfied with locking in price certainty, I was also concerned with that given the market futures price i entered into, on the expiration date, this futures contract might lose me money to an extent that I cannot tolerate. I will look into that chapter you refered to!

Cheers, Liam

risk taker
Posts: 41
Joined: Wed Aug 10, 2011 12:52 pm

Re: futures

Postby risk taker » Tue Aug 28, 2012 6:10 am

I read the section on mean-variance approach to hedging. The rationale of it is to minimize the standard deviation of hedged portfolio P&L and to maximize the expected P&L over the hedging period. But given the graph III.2.15, i dont see that a mean-variance hedger has reduced price risk, instead the price risk has increased in the pursuit of enhancing expected P&L. It seems that mean-variance hedging is really about speculation, not reducing risk at all. So why do we still call it hedging?

Thanks!

Risk taker

coalexander
Posts: 815
Joined: Sun Sep 28, 2008 10:30 pm

Re: futures

Postby coalexander » Tue Aug 28, 2012 8:15 am

Because Johnson called it that when he introduced it in 1960....but I agree, its not hedging in the traditional 'insurance' sense, as I explain on pages 102 - 104 of Vol II.

risk taker
Posts: 41
Joined: Wed Aug 10, 2011 12:52 pm

Re: futures

Postby risk taker » Tue Aug 28, 2012 8:42 am

Cheers Carol.

With respect to Johnson's hedging criterion which is to minimize price risk and maximize expected P&L, isnt this criterion contradictory? Because minimizing or reducing price risk automatically implies lower expected P&L. I dont understand how both is possible.

Did you get my other questions posted on Vol 3 forum?

Thanks again!

Risk taker

coalexander
Posts: 815
Joined: Sun Sep 28, 2008 10:30 pm

Re: futures

Postby coalexander » Tue Aug 28, 2012 6:07 pm

The mean-variance criterion is to maximize expected P&L - gamma/2 Variance P&L, where gamma is risk aversion. So it jointly aims to max expectation while penalizing variance, the more so if gamma is large.

I got your post on Vol 3, and the delay in reply is because I am trying to understand your question, which is not that clear...seems more like statements than a question....but will get onto it probably tomorrow,

Cheers, Carol


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