Chapter 3 Hedging Strategies Using Futures University of Colorado at - PowerPoint PPT Presentation

University of Colorado at Boulder – Leeds School of Business – FNCE4040 Derivatives FNCE4040 – Derivatives Chapter 3 Hedging Strategies Using Futures

University of Colorado at Boulder – Leeds School of Business – FNCE4040 Derivatives Hedging and Risk Management • Hedging is used as a form of risk management: – You can use futures to minimize the uncertainty on the future cash flows resulting from an existing portfolio of assets (physical or financial) • Risk management does not end when you put the hedge on: you still need to manage – Market risk – Counterparty risk – Funding risk

University of Colorado at Boulder – Leeds School of Business – FNCE4040 Derivatives To Hedge or Not To Hedge? PROs CONs • Companies should • Shareholders can make focus on the main their own hedging business they are in decisions and take steps to • It may increase risk to minimize risks arising hedge (e.g. Ashanti 1999) from interest rates, • Explaining to exchange rates, and shareholders a loss on other market variables the hedge when there is a gain on the underlying can be difficult

University of Colorado at Boulder – Leeds School of Business – FNCE4040 Derivatives Hedging considerations When you put on a hedge you need to ask yourself: • Am I hedging the exact thing I want to hedge? – If not, you still have some residual market risk that you need to manage, and it can be large • Do I need to worry about my counterpart? – If yes, then you need to manage that risk • Do I need additional cash flows? – Often yes and you need to manage that risk

University of Colorado at Boulder – Leeds School of Business – FNCE4040 Derivatives Long & Short Hedges • A long futures hedge is appropriate when you know you will purchase an asset in the future and want to lock in the price • A short futures hedge is appropriate when you know you will sell an asset in the future and want to lock in the price

University of Colorado at Boulder – Leeds School of Business – FNCE4040 Derivatives Basis Risk • Basis is usually* defined as the spot price minus the futures price • Basis risk arises because of the uncertainty about the basis when the hedge is closed out (*) in some commodity markets the market jargon “basis” or “spread” refers to the price difference between grades or locations, and the difference between contract months is called “calendar spread”.

University of Colorado at Boulder – Leeds School of Business – FNCE4040 Derivatives Long Hedge for Purchase of an Asset • Define F 1 : Futures price at time hedge is set up F 2 : Futures price at time asset is purchased S 2 : Asset price at time of purchase b 2 : Basis at time of purchase S 2 Cost of asset F 2 − F 1 Gain on Futures S 2 − ( F 2 − F 1 ) = F 1 + b 2 Net amount paid

University of Colorado at Boulder – Leeds School of Business – FNCE4040 Derivatives Short Hedge for Sale of an Asset Define F 1 : Futures price at time hedge is set up F 2 : Futures price at time asset is sold S 2 : Asset price at time of sale b 2 : Basis at time of sale S 2 Price of asset F 1 − F 2 Gain on Futures Net amount received S 2 + ( F 1 − F 2 ) = F 1 + b 2

University of Colorado at Boulder – Leeds School of Business – FNCE4040 Derivatives Choice of Contract Month • Especially for physical commodities, choose a delivery month that is as close as possible to, but later than, the end of the life of the hedge • When there is no futures contract on the asset being hedged, choose the contract whose futures price is most highly correlated with the asset price. This is known as cross- (or proxy-) hedging.

University of Colorado at Boulder – Leeds School of Business – FNCE4040 Derivatives HEDGING OIL

University of Colorado at Boulder – Leeds School of Business – FNCE4040 Derivatives Risk Management example: oil • You own an oil field – You have fixed and variable costs – Your revenues will depend on the oil price at the moment of sale • How can you lock you revenues? – You can enter a long term sales contract with a corporation that buys oil – You can enter a forward contract with a bank – You can sell oil futures – What are the pro’s and con’s of each strategy?

University of Colorado at Boulder – Leeds School of Business – FNCE4040 Derivatives Example – hedge oil production • You own an oil field and hedge revenues • You produce WTI-like oil near Cushing, OK • You know you will produce 1mm bbl in March • You sell 1000 March WTI contracts (NYMEX) – initialmarginrequirement=$4,950/contract – So you deposit $4,950,000 – Maintenance margin is $4,500/contract. So for your position it is ___________

University of Colorado at Boulder – Leeds School of Business – FNCE4040 Derivatives Example – hedge oil production (cont) You short 1,000 contracts at 48.75 Margin Profit Settle Margin Day Account (Loss) Price Call Balance aka P/L $0 $4,950,000 $0 1 $48.75 ($250,000) $4,700,000 $0 2 $49.00 $50.75 ($1,750,000) $2,950,000 $2,000,000 3 $52.00 ($1,250,000) $3,700,000 $1,250,000 4 $3,000,000 $7,950,000 $0 5 $49.00 …

University of Colorado at Boulder – Leeds School of Business – FNCE4040 Derivatives Example – hedge oil production (cont) • You continue to manage your short futures position until last trade day (20-Feb-2013) • Given your physical business location and the type of oil you produce, you let the futures contract expire and go into delivery • On 22-Feb-2013 you receive a delivery notice • You deliver 1mm bbl of WTI-like grade into Cushing and receive the futures price as of the last trade day

University of Colorado at Boulder – Leeds School of Business – FNCE4040 Derivatives Example – hedge oil production (cont) • This hedge removes the revenue risk associated with the price of oil • However, you are now left with a cash flow needs from having to meet margin calls • Just in a few days, you need approx. $8mm • How much cash do you anticipate needing to meet margin calls during the hedge life? • Let’s take a look at oil price history – You are holding your position for roughly 1m – Total cash needed ≅ sum of daily moves – So look at monthly cumulative price changes

University of Colorado at Boulder – Leeds School of Business – FNCE4040 Derivatives WTI prices – 1 st nearby ($/bbl) 160 140 120 100 80 60 40 20 0 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

University of Colorado at Boulder – Leeds School of Business – FNCE4040 Derivatives WTI price daily differences ($/bbl) 20 Average = 0.01 Min = -14.3 15 Max = 16.4 StDev = 1.12 10 5 0 -5 -10 -15 -20 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

University of Colorado at Boulder – Leeds School of Business – FNCE4040 Derivatives Example – hedge oil production (cont) • Daily changes do not tell you how much cash collateral you may need • Need to look at the cumulative daily changes over the hedge holding period • In our example, we hold the hedge for ~1m: – Average = 0.06 ($/bbl) – StDev = 4.9 – Min =-54.2 – Max = 21.0 • You may need as much as $21 or 54mm !!!

University of Colorado at Boulder – Leeds School of Business – FNCE4040 Derivatives Example – hedge oil – variation A • Assume your oil is WTI grade but not at Cushing • You plan to sell the oil in the open physical market in Cushing • It costs $8/bbl to transport oil to Cushing • How does your hedging strategy change, assuming you can only hedge with WTI? – How many contracts will you short? – Will you let your futures position go into delivery?

University of Colorado at Boulder – Leeds School of Business – FNCE4040 Derivatives Example – hedge oil – variation B • Assume now that – Your oil is still WTI grade but not at Cushing – It still costs $8/bbl to transport oil to Cushing – You have a contract with a local refinery which will take your oil at the WTI price, minus $4/bbl • How does your hedging strategy change, assuming you can only hedge with WTI? – How many contracts will you short? – Will you let your futures position go into delivery?

University of Colorado at Boulder – Leeds School of Business – FNCE4040 Derivatives Example – hedge oil – variation C • Assume now that – Your oil is less than WTI grade and not at Cushing. Your oil is worth roughly 95% of WTI – It still costs $8/bbl to transport oil to Cushing – You have a contract with a local refinery which will take your oil at (𝑋𝑈𝐽 × 0.95 − 4) ($/bbl) • How does your hedging strategy change, assuming you can only hedge with WTI? – How many contracts will you short? – Will you let your futures position go into delivery?

University of Colorado at Boulder – Leeds School of Business – FNCE4040 Derivatives HEDGING EQUITY

University of Colorado at Boulder – Leeds School of Business – FNCE4040 Derivatives Hedging equity returns • May want to be out of the market for a while. Hedging avoids the costs of selling and repurchasing the portfolio • Suppose stocks in your portfolio have an average beta of 1.0, but you feel they have been chosen well and will outperform the market in both good and bad times. Hedging ensures that the return you earn is the risk- free return plus the excess return of your portfolio over the market.