Hedging

Section: Risk Management and Hedging with Derivatives Estimated study time: 45 minutes Content: Hedging is the use of derivatives or other financial instruments to reduce or offset an existing risk exposure. A perfect hedge eliminates risk entirely; most practical hedges are imperfect, reducing rather than eliminating risk. The fundamental logic of hedging is to create a derivative position whose value moves inversely to the underlying exposure — losses on the hedged position are offset by gains on the hedge. The effectiveness of a hedge depends on how well the derivative's payoff correlates with the underlying exposure. Basis risk arises when the hedge is not perfectly correlated with the exposure — for example, when a futures contract on a correlated but not identical asset is used (cross-hedge), or when the futures delivery date doesn't match the hedging horizon (time-basis risk). For equity portfolios, futures contracts are the most efficient hedging instrument. The optimal hedge ratio (number of futures contracts) is: N* = (β_target – β_portfolio) × (V_portfolio / V_futures), where V_portfolio is the portfolio value and V_futures = futures price × contract multiplier. To reduce portfolio beta from 1.2 to 0, N* = (0 – 1.2) × (V_portfolio / V_futures) — requiring a short position in futures. To increase beta (e.g., from 0.8 to 1.5), the formula gives a positive N* — a long futures position. This flexibility makes equity index futures indispensable for tactical asset allocation, allowing rapid beta adjustments without the transaction costs and market impact of trading the underlying stocks. For fixed income portfolios, futures contracts on Treasury bonds or interest rate futures (e.g., Treasury note futures) allow duration management. The number of futures contracts to achieve…