R19.P1.T3.HULL_Ch3_FIN_PRODS_Topic: Rolling_the_Hedge_Forward

[gargi.adhikari]

In Reference to R19.P1.T3.HULL_Ch3_FIN_PRODS_Topic: Rolling_the_Hedge_Forward :-
Hi- I was revisiting this Topic and had some questions- For Rolling the Hedge Forward should the scenario be " When the Expiration Date occurs Prior to the Delivery date instead of the "Delivery date of the futures contract occurs prior to the Expiration Date of the hedge" .....? Trying to make sure that am not understanding it wrong .. :-( Very grateful for any insights on this...

 

[David Harper CFA FRM]

Hi @gargi.adhikari The text is correct, but I empathize with your finding it curious (I think I know why you wonder about this!). To clarify terms, delivery date refers to the maturity of the futures contract so it's the futures contract's delivery period (which could be a whole month). The "expiration of the hedge" refers to target date of the underlying price risk or exposure; i.e., if a producer is selling in the future, the date of future sale against which (s)he wants to hedge; if a buyer will be purchasing (eg) oil at a future date, the future date of purchase against which the buyer wishes to conduct a long hedge. So, to me, "the expiration of the hedge" can be a confusing phrase because it refers to time the underlying price risk factor against which the future is hedging. That said, our text looks correct because Hull is referring to a "stack and roll" and ...

"Sometimes the expiration date of the hedge is later than the delivery dates of all the futures contracts that can be used. The hedger must then roll the hedge forward by closing out one futures contract and taking the same position in a futures contract with a later delivery date. Hedges can be rolled forward many times." -- Hull, John C. Options, Futures, and Other Derivatives (9th Edition) (Page 68). Prentice Hall. Kindle Edition.

So (eg) if the underlying exposure is an oil purchase (sale) in 12 months, the "stack and roll" might take a long (short) position in a "stack" of one- or two month (they being liquid) futures contracts and "roll forward" the short-term contracts.

The reason i think i know why you wondered about this is because earlier (in Chapter 3) Hull says:

"The choice of the delivery month is likely to be influenced by several factors. In the examples given earlier in this chapter, we assumed that, when the expiration of the hedge corresponds to a delivery month, the contract with that delivery month is chosen. In fact, a contract with a later delivery month is usually chosen in these circumstances. The reason is that futures prices are in some instances quite erratic during the delivery month. Moreover, a long hedger runs the risk of having to take delivery of the physical asset if the contract is held during the delivery month. Taking delivery can be expensive and inconvenient. (Long hedgers normally prefer to close out the futures contract and buy the asset from their usual suppliers.).

In general, basis risk increases as the time difference between the hedge expiration and the delivery month increases. A good rule of thumb is therefore to choose a delivery month that is as close as possible to, but later than, the expiration of the hedge. Suppose delivery months are March, June, September, and December for a futures contract on a particular asset. For hedge expirations in December, January, and February, the March contract will be chosen; for hedge expirations in March, April, and May, the June contract will be chosen; and so on. This rule of thumb assumes that there is sufficient liquidity in all contracts to meet the hedger’s requirements. In practice, liquidity tends to be greatest in short-maturity futures contracts. Therefore, in some situations, the hedger may be inclined to use shortmaturity contracts and roll them forward. This strategy is discussed later in the chapter." -- Hull, John C. Options, Futures, and Other Derivatives (9th Edition) (Page 57). Prentice Hall. Kindle Edition.

So in a more typical hedge strategy, he's saying that (for example) if the "expiration date of your hedge" is November (ie, producer planning to sell commodity in November, or buyer planning to buy in November), then the ideal futures contract expiration date is not October of even November, but December or the soonest delivery month after November. So, the basic advice is to select delivery soon after the target hedge date; but the stack and roll is a more sophisticated method where, by definition, short-term futures contracts are being used. I hope that helps!

 

[gargi.adhikari]

@David Harper CFA FRM Thank you so much for the taking the time to explain the statement above I see the point I was missing- Much gratitude for pointing me to that