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FRM Part I · FRM Exam Part I · Using Futures for Hedging

A corporate treasurer hedges a commodity exposure with futures contracts that are marked to market daily. Which statement best describes the purpose of 'tailing the hedge'?

Tailing the hedge reduces the number of futures contracts, scaling the hedge ratio by roughly a discount factor, because futures gains and losses are settled daily and can be reinvested or financed before the horizon, whereas a forward settles only at maturity.

  1. AIncreasing the number of contracts to compensate for basis risk at expiry
  2. BReducing the hedge ratio by the factor of the discount rate to adjust for daily settlement of futures gains and lossesCorrect
  3. CChoosing a futures maturity later than the hedge horizon to avoid delivery
  4. DRolling the hedge into a nearby contract as the first contract approaches expiry

Explanation

Because futures are settled daily, gains and losses are realized and can be reinvested or financed before the horizon, unlike forwards. Tailing scales the hedge ratio down by approximately the discount factor (1/(1+r)^T, or the spot price relative to futures price in the tail factor) to account for this. Option A is wrong because basis risk is not fixed by adding contracts, and option C and D describe other practices.

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