Derivatives: Valuation and Risk Management

By David A. Dubofsky; Thomas W. Miller Jr. | Go to book overview

CHAPTER 7

Risk Management with Futures
Contracts

7.1 INTRODUCTION
Because futures are so similar to forwards, most of the concepts that were covered in Chapter 4, Using Forward Contracts to Manage Risk, also apply when one is hedging with futures contracts. Thus, you should review Chapter 4 before reading this chapter. Often, transactions costs, liquidity, accounting rules, and basis risk will determine which contract is preferred.In this chapter, we will discuss traditional hedging theory, which applies to the use of futures to manage price risk. Liquidity risk and basis risk are important considerations when one is comparing futures and forwards for risk management. Also, forward contracts entail greater credit risk, which is the risk that your counterparty will not abide by the terms of the forward contract. In contrast, futures clearing houses and the mark-to-market process essentially eliminate credit risk when futures are used. Using futures to manage price risk also introduces the following risks:
1. Because futures contracts are standardized, the underlying asset, the delivery location, the quantity, and the delivery date may all differ from the asset that is being hedged. This risk is called basis risk.
2. If the underlying asset of the futures contract is sufficiently different from the asset being hedged, it is important to determine the degree to which price changes of the two assets are correlated.
3. If the date of the hedging horizon lies beyond the date of the most nearby futures contract, then the choice the correct delivery date must be made. Frequently, hedges must be rolled forward by offsetting the position of nearby contracts and entering into a position in contracts with more distant delivery dates.
4. Because futures are marked to market daily, futures hedges must be tailed.

In this chapter, these and other aspects of hedging with futures contracts will be discussed.

Futures contracts enable market participants to alter risks they face that are caused by adverse, unexpected price changes. One of the main reasons cited for the existence of futures markets is that they are a low cost, effective way to transfer price risk. It is no accident that interest rate futures markets did not evolve until the 1970s. Before then, unhedged long or short positions in debt instruments were considerably less risky because their prices rarely changed. Figure 7.1 presents interest (discount) rates on three-month Treasury bills since 1950, and Figure 7.2 is a graph depicting yields available on long-term AAA-rated corporate bonds since 1919. Both graphs show that interest rates fluctuated relatively little during the 1940s, 1950s, and early 1960s. When interest rates became volatile in the late 1960s and 1970s, the demand for ways to hedge against this

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