Derivatives: Markets, Valuation, and Risk Management

CHAPTER 5

Risk Management Strategies: Futures

This chapter builds on Chapters 3 and 4. In Chapter 3, we learned the mechanics of expected return and risk. In Chapter 4, we learned about the no-arbitrage price relation that links the price of a forward/futures to the price of its underlying asset. This chapter explores the role of forward/futures contracts in managing expected return and risk. In moving forward through the chapter, we will use only the term “futures” rather than “forward and futures” for expositional convenience. The risk management techniques apply to both contracts equally well. The decision to use “futures” rather than “forwards” is based on the fact that historical futures data are more broadly available for estimation purposes. Since the chapter deals with expected return and risk, the most natural place to begin is with a demonstration of how futures fit within the capital asset pricing model (CAPM). We then focus on using futures contracts to manage different types of risks. We begin with price risk and show how an airline can hedge the cost of jet fuel. Next we focus on revenue risk and show how a farmer can hedge the sales proceeds of his crop in an environment with both price and quantity risks. For other corporate risk managers, gross margin (i.e., uncertain revenue less uncertain costs) risk is often the primary risk management focus. Oil refiners, for example, are concerned about the difference between the revenue they realize through the sale of heating ...