Why Futures Hedge Ratios May Need Tailing

Summary

The document introduces the idea that a futures hedge may require a ratio other than one contract for each unit of spot exposure, even when the hedge and underlying have matching maturity and asset. It asks how the tailing factor affects the hedge when interest rates and the timing of futures gains and losses are considered.

The example specifies a spot price, symmetric annual price moves, a discrete risk-free rate, and a carry assumption that offsets convenience yield. These conditions define a setup for studying futures hedge sizing, but the document stops at the question and provides no proposed hedge, derivation, graph, or numerical result. It is therefore useful as a prompt about the financing adjustment behind futures hedges, not as a complete method. Applying the idea requires the missing payoff path and a calculation that accounts for the timing of variation margin and financing.

Key ideas

• A futures hedge ratio can differ from one even when the futures and underlying otherwise match.
• Tailing adjusts hedge sizing to account for the timing and financing of futures cash flows.
• The example assumes symmetric annual spot moves and a stated discrete risk-free rate.
• The document poses the hedge problem but does not provide a solution or derivation.

Tags

# What is the correct hedging strategy using futures?


# What is the correct hedging strategy using futures?












In practice, even without maturity and underlying mismatch, hedging using futures does not always require a one-to-one hedge ratio. Tailing factor needs to be considered. Suppose the current spot price is $3. With 50 percent of the probability, the spot price will increase or decrease by 1 dollar for each year as shown in the graph below. If the annual discrete compounding risk-free rate is 10%, and the cost of carry offsets the convenience yield exactly, then what is your hedging strategy?

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