A futures contract is not a passive bet — for most institutional users it is a risk-management tool. An oil producer who will sell a million barrels in August and an airline facing a fuel bill in October are both exposed to commodity prices they cannot control. Futures allow them to transfer that price risk to a speculator willing to bear it, in exchange for locking in a price today.
But perfect hedges are rare. The asset to be hedged is usually not exactly what the futures contract delivers. The hedge may need to be unwound before the futures delivery date. And even when the futures asset and the hedged asset are the same, the futures price does not move one-for-one with the spot price on an arbitrary unwind date. The residual uncertainty — basis risk — is the central practical concern of futures hedging.
This note develops the full toolkit: short and long hedges; the definition and dynamics of basis; the minimum-variance hedge ratio for cross hedging; stock index futures and portfolio beta management; and stack-and-roll for long-dated exposures. The companion derivation note develops the underlying calculus and OLS interpretation.
Learning objectives. After this note you should be able to:
- construct a short or long futures hedge for a commodity exposure;
- define basis and explain how basis risk arises in both exact and cross hedges;
- compute the minimum-variance hedge ratio and the optimal number of contracts for a cross hedge;
- use stock index futures to hedge an equity portfolio, change a portfolio's beta, or isolate alpha;
- explain stack-and-roll and identify its liquidity risk.
In this lesson
- Short and long hedges
- Basis risk
- Cross hedging
- Stock index futures and equity portfolio hedging
- Stack and roll
Before you start
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