Chapter 2- Speculation, hedging, and spreading Flashcards
Pyramiding
Speculative strategy that involves increasing the size of an open, profitable position by declining increments as the commodity price rises. Can be utilized in any profitable account, whether that account is long or short.
Switching strategy
a speculator extends the holding period by liquidating a position in a contract month nearing delivery and simultaneously establishes a position in a contract of a more distant contract month (rolling).
Hedging
strategy used by producers and users to protect their respective interest. Hedging is the purchase or sale of a futures contract as a temporary substitute for a later cash transaction. it is a method of transferring risk
What type of risk does a hedged position still carry
Basis risk- the potential adverse change in the relationship of the cash price and futures price (a change in basis) while the hedged position is open. Because basis is more stable than cash or futures market prices alone, a hedged position entails less risk than an unhedged position.
Basis Risk
The potential adverse change in the relationship of the cash price and futures price while the hedged position is open.
Short hedger
sells futures to lock in a cash price (the price when the hedge was placed)
When are short hedges used?
to protect the value of inventory or the future selling price of a commodity.
what happens to p/l if the basis strengthens in a short hedge?
There will be larger profit.
Who uses short hedge?
any owner or producers of a commodity, who may suffer from falling prices.
would a hedger who is long or short the basis sell a futures contract to protect against a decline in price.
Long basis. Also known as short (selling) hedge.
Does a short hedger want the basis to strengthen or weaken
Strengthen. In a normal market, the hedger wants the difference between the cash and futures price to decrease.
Strengthening basis
increase in basis- the cash price may increase more quickly than the futures price, or the cash price may decrease more slowly than the futures price. Widening cash over futures spread, narrowing futures over cash spread.
Someone who owns or will own the commodity is long or short the basis?
Long
7 traits of a short hedge
- Futures contracts are sold
- The short hedge is a substitute sale.
- if prices decline, the profit on futures will offset cash market losses.
- The hedge seeks to protect against falling prices
- If prices rise, loss on futures is offset by a higher sale price in the cash market.
- The short hedger is long the basis
- The short hedger wants the basis to strengthen.
Effective (true) price calculation
adjusting his initial cash cost when the hedge is placed by the change in the basis.
Effective sale price= Cash cost when hedge is placed + or - basis CHANGE
Effective price = Sale price + or - change in futures
Effective Price
the final cash price plus or minus the hedge of the futures or the original cash price plus or minus the basis change.
how to calculate the effect of the hedge on revenue
multiply the basis change by the number of units hedged.
Profit from selling hedged position
revenue minus production costs and hedging costs.
Short hedge
used to protect inventory by locking in a selling price for later cash sale.
Long hedge
used to protect a later cash purchase or a short actuals position.
When does a short actuals position occur
from a forward sale of (or other promise to sell) goods yet to be purchased by a distributor or manufactured by a producer or processor.
How is a forward sale hedged
long futures because the person is promising to deliver a good she doesn’t have.
Are long hedgers long or short the basis?
Short the basis. A long hedger has a short cash position (receiving now and owning later) hedged with a long futures position.
What is a weakening basis?
decrease in the cash price relative to the futures price
Why does a long hedge benefit from a weakening basis?
it reduces the effective cost of the asset purchased later in the cash market.
What is the true cost of assets purchased through a hedge?
the cash market price on the day the hedge was placed reduced by the amount by which the basis weakened.
How is effective cost (price) calculated
adjusting the cash price at the time the hedge was placed by any change of the basis after the hedge is lifted.
Why are spreads considered less risky?
Because the tend to move in the same direction
What is intracommodity spread?
A spreader is long and short futures contracts on the SAME commodity
what is intradelivery spread?
contracts mature during the same delivery month.
What does “Inter” mean in regards to spreads?
What are the 3 main types?
different. intercommodity spread means different commodities, intermarket spread is different markets, and interdelivery spreads are different delivery months.
What is a bull spread in a normal market?
profit if the price of the commodity rises. The investor goes long nearby futures contract and short the distant futures. The investor wants the spread to narrow.
Does an investor want a bull spread to widen or narrow in an inverted market?
Widen
What is a bear spread
an investment strategy seeking to profit if the price of the commodity falls. The trader goes short the nearby contract and long the distant contract. The investor wants the price difference to widen in a normal market.
How do interest rate futures bull and bear spreads differ from regular commodity spreads
the use reverse positions.
Do bull or bear spreads have limited risk
Bull spreads do
Bull Spread in a normal market traits 3
called long spread
long nearby and short distance
profits if spread narrows
Bear spread in a normal market 3 traits
called a short spread
long distant and short nearby
profits if spread widens
Bull Spread in an inverted market 3 traits
also called long spread
long nearby and short distance
profits if spread widens
Bear spread in an inverted market
called short spread
long distant and short nearby
profits if spread narrows
When can a p/l be calculated on a spread
When the spread is closed
What does a processor do
a business that buys raw material or semifinished goods (input) and adds value to make a finished product. Finished products (output) are ultimately sold to others.
What is a processing spread
a manufacturer or processsor buys futures to hedge a later purchase of raw material (input) and sells futures to hedge the later sale of a finished product (output).
When do processing spreads occur
processor simultaneously buy (long) and sell (short) related futures contracts.
Processor conditions 2
1) long hedgers on input- that is they buy futures now to hedge against rising costs associated with the later purchase of inputs.
2) Short hedgers on output- that is, they sell futures now to hedge against declining prices from sales of their products (output).
What is a processor hedge
buyst futures on his input and sells futures on his output. any other type of position is a speculative position.
3 types of processor spreads
Crack Spread
Feeder spread
Crush Spread
Crack Spread positions
- long crude oil futures to hedge the later purchase of crude oil and
- short heating oil and gasoline futures to hedge the later sale of the distillates.
What is cracking?
the process for turning crude oil into distillates
cattle feeder spreads us futures positions that are:
- Long feeder cattle and corn or soy meal futures to hedge the later purchase of young cattle and their feed; and
- short live cattle futures to hedge the later sale of fat (live) cattle.
What is the difference between live cattle and feeder cattle futures contracts?
Feeder cattle (thin cows) are processed (fattened) on feed lots; live cattle (fat cows) are the product of the cattle feeding process and are cattle ready for slaughter.
Crush Spread
long soybean futures and short oil and meal futures. Soybeans used to be crushed in vats to produce oil and meal hence the name crush spread.
a processors Crush spread futures spreads position
- Long soybean futures to hedge the purchase of the beans and
- short soybean oil and soybean meal futures to hedge the later sale of the bean products.
Gross processing margin (GPM)
identifies the gross return from processing on bushel of beans. it is also called gross margin because it accounts for the expense of only the input, the beans.
Reverse crush spread
Speculators may profit from the same situation that hurts the bean crusher with a reverse crush spread. The speculator sells soybean futures and buys soybean oil and soybean meal futures to profit on a decrease in bean prices and an increase in bean meal and oil prices.
