Introduction to Corporate Finance

ONLINE CHAPTER

23-3a HEDGING WITH FUTURES CONTRACTS

Futures contracts are a very effective mechanism for hedging. In addition to futures markets for metals,

there are futures markets for foreign currencies, interest rates, share indexes and commodities. Long

hedges involve buying a futures contract to offset an underlying short (sold) position. Short hedges involve

selling a futures contract to offset an underlying long (purchased) position.

Hedging with Foreign Currency Futures

The multinational company with the SF10 million exposure discussed earlier could have chosen to

hedge that exposure in the futures market rather than with a forward contract by selling 80 Swiss franc

futures contracts (each mandating delivery of SF125,000). Recall that the multinational company

will be receiving a payment of SF10 million in 90 days. By selling 80 SF futures contracts that expire

after the date on which it will receive the SF payments (because futures contracts have fixed delivery

periods, they will only rarely exactly match a trader’s desired payment date), the company can hedge this

exposure using futures rather than forwards. Suppose that the current settle price for Swiss franc futures

is $0.6057/SF. When the SF payment is received, the company will exchange it for dollars at whatever

the spot $/SF exchange rate happens to be at the time, and will simultaneously buy 80 SF futures

contracts with the same delivery date as the contracts purchased earlier – thereby offsetting, or closing

out, its futures position. If the dollar value of the Swiss franc declines from $0.6050/SF to, say, $0.5000/

SF during the 90 days in question, then the company will lose $0.1050/SF, or a total of $1,050,000, on

its spot market sale of the SF payment. However, this loss will be offset by the profit the company will

achieve on its futures position. For example, if the futures price declines from $0.6057/SF to $0.5007/

SF, the profit in the futures position will be $0.1050/SF, or a total of $1,050,000, exactly offsetting the

loss in the cash market position. If the Swiss franc appreciates rather than depreciates against the dollar,

then the company will gain on its cash market transaction and lose on its futures contracts. Either way,

hedgers can use a futures contract to hedge an underlying commercial risk without actually having to

take physical delivery on the futures contract.

Hedging with Interest Rate Futures

We can use futures contracts to hedge interest rate risk in much the same way that we hedged foreign

exchange risk. Consider a corporate treasurer who anticipates borrowing $1 million in five months.

The loan will be at 100 basis points over the three-month LIBOR at the time of borrowing. LIBOR is

currently at 5%. Eurodollar futures contracts for delivery in six months are trading at a yield of 5.2%.

By selling one Eurodollar futures contract, the treasurer can effectively lock in a borrowing rate of 6.2%

(5.2% plus 100 basis points) for the three months beginning in six months. As in the currency contract,

the treasurer would close out the position in Eurodollar futures and borrow at the same time.

23-3b CONCERNS WHEN USING FUTURES CONTRACTS

In the previous examples, we ignored several potential problems associated with using futures markets to

hedge. We discuss some of these problems in the following sections.

Basis Risk

The basis in a futures contract is the difference between the futures price and the spot price. Basis risk

arises from the possibility of unanticipated changes in the basis. As the maturity date approaches, the

basis goes to zero. This simply means that when a futures contract is about to expire, the futures price

basis
In a futures contract, this is
the difference between the
futures price and the spot
price

basis risk
The possibility of
unanticipated changes in
the difference between the
futures price and the spot
price