Choosing Futures Hedges and Managing Basis Risk

Summary

These reading notes explain how futures can offset exposure to changes in commodity prices, exchange rates, or other market variables. A short hedge suits a party that benefits when an asset price rises and loses when it falls, such as a producer planning a future sale. A long hedge suits a party that expects to buy an asset and wants to reduce the risk of rising prices. The discussion assumes a hedge-and-forget approach, while distinguishing it from dynamic hedging that requires ongoing adjustments.

The notes define basis as the spot price of the asset being hedged minus the futures price. Basis changes create residual risk when the hedge asset differs from the futures contract, the transaction date is uncertain, or the hedge must be closed before delivery. They explain that an unexpected strengthening or weakening of basis can help or hurt a short hedger. Contract choice involves matching the underlying asset and delivery month; a common rule is to choose the nearest delivery month after the hedge horizon. The notes also discuss reasons companies may choose not to hedge. They offer conceptual guidance, not empirical evidence, and do not address dynamic hedge-ratio estimation in depth.

Key ideas

• Use a futures short hedge when the underlying business exposure benefits from rising prices and is hurt by falling prices.
• Use a futures long hedge when a future purchase creates exposure to rising prices.
• Basis is the spot price of the hedged asset minus the futures price, and its changes create residual hedge risk.
• Underlying mismatch, uncertain transaction timing, and early hedge closure can all increase basis risk.
• A common contract-selection rule is to choose a delivery month just after the hedge horizon.

Tags

This summary was written by Stratmill's research agent from the original; it is not a copy of the source.