Types of Hedging In The Financial Futures Market

There are basically three types of hedges used in the financial futures market today: (1) the long hedge, (2) the short hedge, and (3) the cross hedge. Cross hedges, as we will see, may be either long or short. Each types of hedge meets the unique trading needs of a particular group of investors. All three types have become increasingly popular as interest rates and security prices have become more volatile in recent years.
The long (or buying) Hedge
A long hedge involves the purchase of futures contracts today, before the investor must buy the actual securities desired at a later date. The purpose of the long hedge is to guarantee ("lock in") a desired yield in case interest rates decline before securities are actually purchased in the cash market.
As an example of a typical long-hedge transaction, suppose that a commercial bank, Life Insurance Company, pension funds, or other institutional investor anticipates receiving $ 1 million 90 days from today. Assume that today is April 1 and the funds are expected on July 2. The current yield to maturity on securities the investor hopes to purchase in July is 12.26 percent. We might imagine that these securities are long-term U.S. Treasury bonds, which appeal to this investor because of their high liquidity and zero default risk. Suppose, however, that interest rates are expected to decline over the next three months due to a recession. If the investor waits until the $1 million in cash is available 90 days from now, the yield on Treasury bonds may well be lower than 12.26 percent. Is there a way to lock in the yield available now even though funds will not be available for another three months?
Yes, if a suitable long hedge can be negotiated with another investor or trader. In this case the investor can purchase ("go long") 10 September Treasury bond futures contracts at their current market price. (Recall that Treasury bond futures are sold in $100,000 denominations.) Cash payment on these contracts will not be due until September. Suppose their price currently is 68-10, or $68,312.50 on a $100,000 face-value contract. Assume too that, as expected, bond prices rise and interest rates fall. At some later point the investor may be able sell the bond futures contracts at a profit, since prices on these contracts tend to rise along with rising bond prices in the cash market. Selling the bond futures contracts at a profit will help this investor offset the lower yields on Treasury bonds that will prevail in the cash market once the 1 million actually becomes available on July 2.
We note that on July 2 the investor goes into the spot market and buys $1 million in 8 percent, 20-year U.S. Treasury bonds at a price of 82-13. At the same time, the investor sells 10 September Treasury bonds futures contracts at 80-07. Due to higher bond prices (lower yields) in July, the investor loses $139,687.50, because the market price of treasury bonds has risen from 68-14 to 82-13. This represents an opportunity loss because the $1 million in investable funds was not available in April when interest rates were high and bond prices low. However, this loss is at least partially offset by a given in the futures market of $119,062.50, because the 10 September bond futures purchased on April 1st were sold at a profit on July 2. Over this period, bond futures contracts rose in price from 68-10 to 80-07. In effect, the investor will pay only $705,000 for treasury bonds bought in the cash market on July2. The market price of these bonds will be $824,062.50 (or 82-13) per bond, but the investor's net cost is lower by $119,062.25 due to a gain in the futures market.
The short (or selling) hedge
A financial device of growing popularity is the short hedge. This hedge involves the immediate sale of financial futures contracts until the actual securities must be sold in the cash market at some later point. Short hedges are especially useful to investors who may hold a large portfolio of securities which they plan to sell in the future but, in the meantime, must be protected against the risk of declining security prices. We examine a typical situation where a securities dealer might employ the short hedge.
Suppose the dealer holds $1 million in U.S. Treasury bonds, carrying an 8¾percent coupon and a maturity of 20 years. The current price of these bonds is 94-26 (or $948.125 per $1,000 par value), which amounts to a yield of 9.25 percent. However, the dealer is concerned because higher interest rates appear to be in the offing. Any upward climb in rates would bring about lower bond prices and therefore reduce the value of the dealer's portfolio. A possible remedy in this case is simply to sell bond futures contracts in order to counteract the anticipated decline in bond prices. For example, suppose the dealer decides to sell 10 Treasury bond futures contracts at 86-28, and 30 days later is able to sell $1 million of 20-year, 8¾ percent Treasury bonds at a price of 86-16 for yield of 10.29 percent. At the same time the dealer goes into the futures market and buys 10 Treasury bond futures contracts at 79-26 to offset the previous forward sale of bond futures.
The financial consequences of these combined trades in the spot and futures markets are offsetting. The dealer as lost $83,125 in the cash market due to the price decline in the bonds held. However, a gain of about $70,625 (fewer fees, commissions, and any tax liability) has resulted from the gain in the futures price. This dealer has helped to insulate the value of the portfolio from the risk of price fluctuations through a short hedge.
Cross hedging
Another approach to minimizing risk is the cross hedge- a combined transaction between the spot market and the futures market using different types of securities in each market. This device rests upon the assumption that the prices of most financial instruments tend to move in the same direction and by the same direction and by roughly the same proportion. Because this is only approximately true is any real-world situation, cross hedging does not usually result in forming a perfect hedge. Profits or losses in the cash market will not exactly offset losses or profits in the futures market. Nevertheless, if the investor's goal is to minimum risk, cross hedging is often preferable to a completely unhedged position.
As an example, consider the case of a commercial bank which holds good-quality corporate bonds carrying a face value of $5 million with an average maturity of 20 years. The bank's portfolio manager anticipates a rise in interest rates, which will reduce the value of the corporate bonds. Unfortunately, there is no futures market for corporate bonds, and therefore the portfolio manager cannot construct a prefect hedge involving these securities. However, futures contracts can be negotiated in U.S. Treasury bonds or even in Ginnie Mae passthroughs , providing either a long or a short hedge to offset the risk of a decline in the value of the corporate bonds.
To illustrate how such a cross-hedge transaction might take place, suppose that on January 2 the market value of the bank's corporate bonds is $3,673,437.50. This means that each $1,000 par value bond currently carries a market price of $734.6875 (or 73-15 on a $100 basis).the portfolio manager decides to 50 sell Treasury bond futures contracts at 81-20 (or $816.25 per $1,000 face value). About two and half months later, on March 14, interest rates have risen significantly. The value of each corporate bond has fallen to 64-13 (or $644.0625 per $1000 bond). At this point the Bank's portfolio manager decides to sell the bonds, receiving $3,220,312.50 from the buyer. This represents a loss on the bonds of $453,125.00. At the same time, however, the portfolio manager buys back 50 U.S. Treasury bond futures contracts at 69-20. The result is a gain from futures trading of 600,000. In this particular transaction the gain from futures trading more than offsets the loss in the cash market. Of course, this example of a cross hedge and the preceding example of long and short hedges are simplified considerably to make the fundamental principal of futures trading easier to understand. In the real world the placing and removal of hedges is an exercise requiring detailed study of the futures market and, in most cases, a substantial amount of trading experience.