Risk Differences Between Hedging Options with Index Futures or the Underlying

Summary

The note compares hedging an index option with index futures against hedging with the tradable underlying. It identifies the main risk differences as basis exposure between futures and the index, the need to roll expiring futures, differences in liquidity and trading spreads, and differences in financing, borrowing, and margin costs. Direct trading in the underlying avoids futures basis and contract roll risk, while futures may offer different liquidity or financing advantages.

The discussion is a qualitative checklist rather than a pricing model or empirical comparison. It gives no measurements, hedge ratios, or market-specific examples, so the relative importance of each factor depends on the instrument and its market conditions. Traders should account for these exposures and costs when choosing a hedge vehicle; the note does not establish that one approach is generally superior.

Key ideas

• Futures hedges introduce basis risk that direct hedges in the underlying do not have.
• Futures positions may need to be rolled before expiry, adding roll costs and exposure.
• Relative liquidity affects spreads and execution prices in either the underlying or its derivative.
• Financing, borrowing, and margin costs can differ between cash assets and derivatives.

Tags

# Hedging differences between equity and index options?


# Hedging differences between equity and index options?












Suppose we hedge an index option using futures on that index. How would the hedging strategy be different if the underlying could be traded directly (from a risk point of view)?

## Answer by Matt Wolf (score 2, accepted)

https://quant.stackexchange.com/a/7829

The differences essentially boil down to liquidity and pricing discrepancies between the underlying and the futures of the underlying.

- With futures you have to consider basis risk which you obviously do not face if you can trade in the underlying directly.

- Additionally, you need to roll futures contracts before they expire, hence you are faced with roll charges.

- Also, depending on liquidity profiles, there are assets in the market where for specific reasons the derivative is more or less liquid than the underlying itself which may impact spreads and prices you pay/receive when trading them.

- Another factor are financing charges: Some assets command higher or lower financing charges and borrow rates than their derivatives. Derivatives can most often be margined more cheaply than the cash underlying.

Those, in sum make up the differences and impact risk when considering whether or not to trade directly in the underlying or its derivative.

Shown in full with attribution under the source's licence. Licence: CC BY-SA 4.0 (Stack Exchange)

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