Hedging and Futures Markets Flashcards
Different Risk
Quantity
- no idea of volume and there are weather effects: can get some insurance otherwise no cover.
Price
- Prices change due to lag between supply decision and marketing; risk of price falling
Income = P X Q
Futures markets can reduce price risk not quantity.
Exchange Rate Risk
Importer buying capital goods in a foreign currency when exchange rate might change by the time order is complete. (Traditional insurance will not provide cover)
Hedging
Taking a position in the futures market that is exactly opposite to that held in the spot/forward market
Balancing risk in one market with risk in another (more later on)
Making a gain in one market to offset a loss in another.
Traditional View of Hedging
Designed to eliminate or reduce risk - naive?
Holbrook Working
Moved from accepting naive model to more realistic form
Profit can be made from hedging as the basis changes (not just eliminating risk but make a profit at the end)
Stein and Johnson
Portfolio Approach
Multi-commodity or commodities as part of a wide range of assets
Arbitrage hedging or carrying charge hedger
Relies on convergence of spot and futures prices Risk free return e.g. buy oil spot at $100 in June and at the same time sell futures for november at $105. If storage is less than a $5 a barrel then a guaranteed return is made.
Operational Hedging
Creates flexibility in the cash market e.g. forward sell in a different currency so sell futures in that currency at the same time
Anticipatory Hedging
More traditional view of hedging and suggests concern about prices in the spot market
Not driven by profit motive
Suppose a farmer is planting a crop and worried that prices will fall then trading futures in anticipation of this might help reduce losses
CASE 1: An agent holding stocks that are unsold fears prices will fall - Price Risk, afraid of prices going down
The agent will hedge in the futures market by purchasing SELL contracts so the agent is LONG in the spot and SHORT in the futures - make money in future market.
Thus if spot prices fall, looses n the spot market as she sells at a lower price but gains in futures by closing out (i.e. purchases a BUY contract at a lower price than she purchased the SELL contract)
SHORT HEDGING
CASE 2: An agent has a forward contracted to sell, fears prices will rise so when she buys to meet the contract she will make loses.
The agent will hedge in the futures market by purchasing BUY contracts so she is SHORT in the spot (i.e owes the commodity) and LONG in the futures (ie.e is owed the commodity)
If spot prices do rise, losses in sot are offset by gains in futures when closing out occurs (i.e. purchases a SELL contract a a higher price than she purchased the BUY contract)
This known as LONG HEDGING
Relationship between Future and Spot price
Central to hedging is this relationship
The two types of markets - Contango & Backwardation
Two issues with setting price
- Choice of asset underlying futures contract
(easy to deal with in most cases) - Choice of contract month
(Simple route is to match delivery in the physical market but usually later as: markets are volatile in delivery month - fear of having to take/make delivery if timing is wrong.
Basis Risk and Price Risk
Trades face spot price risk, trading futures does not eliminate risk: they are simply swapping it for basis risk.
Why?
Basis risk is generally smaller providing it is well behaved
Mechanical Hedging
Set up rules for buying and selling contracts until maturity and test how well they perform against unhedged and fully hedged positions (Ederington 1979)
Testing with thin markets using the same approach (Pennings and Meulenberg, 1997)
Despite the apparent advantages, not all take the opportunity to hedge - policy concerns arise if markets become more liberal (see Pannell et al 2008)
