, establish a target price, etc.) are applicable to long hedging for any commodity, including industrial commodities such as copper, rubber,etc., and foods such as cocoa, coffee, sugar, etc.For purposes of illustration, we’ll assume that you get interested in hedginghogs on March 7 and decide to find out about protecting the price of hogs you willbe buying in June. On March 7, June hog futures are selling for $40.50 per hundredweight (see Table 17.2).Because you’re attempting a long hedge to protect the cost of buying hogsfor slaughter, you will be buying futures. We will assume there are two costsinvolved—a commission cost, which you must pay your broker (in our example,that’s approximately 12 cents per hundredweight), and interest on margin. (Thiscost is somewhat hidden and may be non-existent if your broker pays interest onthe margin deposit. It’s the amount of money your margin could have earned if itwere in a bank savings account, for example, rather than on deposit with your broker.) For our example here, it’s about 3 cents per hundredweight. So, the total costof buying the futures is $40.65 per hundredweight.As explained earlier, if you were buying hogs somewhere other than in thePeoria area or hogs of a quality substantially different than those priced on thehog futures contract, you should take into account the location difference (locationbasis) and quality difference (quality basis) in estimating the net price you wouldhave in the hogs if you received them in actual delivery on the futures contract. We’llassume here that you normally buy hogs in Peoria, and by the time you get them170
Commodity Hedging in Action
Table 17.2 Futures versus Cash Hog Prices(Prices in dollars per hundredweight)
March
April
May
7142127411182529162330
ClosingJuneFutures
TopSt. LouisPrice
40.5042.9543.8545.5045.5546.8046.7047.7547.7047.0048.6048.9549.20
40.7541.0040.7540.2541.0042.2542.2542.5044.7547.2549.0048.7548.75
ClosingTopJune Futures St. LouisPriceCash PriceJune
234569101112131617181920
49.2749.6549.2049.1549.2550.1050.5050.7750.8052.2053.5553.7054.6556.0556.85
48.0048.0048.7549.2549.2549.5050.2550.0049.7551.0052.5053.0053.5056.0057.50
to your plant the price is equivalent to the Peoria top price. We’ll also assume thatyou’re buying the same quality as is represented on the futures contract—200–220pound USDA 1-, 2-, 3-, or 4-graded quality hogs.As shown in Table 17.3, the target price you expect to pay for hogs by hedging them on the futures market is, therefore, $40.65 cwt.Now comes the $64,000 question—or maybe we should call it the $40.65question: Do you expect to be able to buy hogs in the cash market in June for lessthan $40.65? Or do you look for cash prices above that? If you expect them to beless and are reasonably certain your expectations will be realized, you probablywon’t want to hedge. If you expect them to be considerably higher than $40.65,you will. We’ll say that you are looking at a price of over $45 per hundredweightin June, so you decide to hedge.Now let’s determine exactly how your hedge would have worked out. Timepasses and June 20 arrives. On that date, June futures are selling at $56.85. Becauseyou bought for $40.65 and sold at $56.85, you have a net gain on the futures of$16.20 per hundredweight.171
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Table 17.3 Worksheet for Live Hog HedgeFutures price for JuneCommissionInterest on marginTotal costLocation difference (transportation and shrinkagefrom Peoria)—or, normal price (differential)Quality differenceTarget price
$40.50.12.03$40.65
Expected cash priceBuy futures (including commission and margin) on March 7Sell futures on June 20Net gain or loss on futuresPurchase live cash hogs on June 20Minus gain on futuresActual cost of live hogs
$45.00$40.6556.85+16.20$57.50–16.20$41.30
00$40.65
On June 20, you also buy the actual, walking-around live hogs and get themto your plant at the equivalent Peoria top price on that date of $57.50 per hundredweight. That $57.50 per hundredweight is a dollar more than you expected topay, and $16.85 over what your target price was when you hedged. However, sinceyou have a $16.20 gain on futures, you can apply that to the actual cost of thehogs. This makes the total net cost of the hogs equal to $41.30. Not quite the target price, but close. The hedge did its job. It protected against major price risk.The target price was not met exactly. Why? Because the futures price and theprice you paid in the cash market for actual hogs were not exactly equal at thetime you offset your futures contract. If they had been equal, you would have paidexactly a net of $40.65 for the hogs. For example, had you removed your hedgeon June 6, you would have paid $49.25 per hundredweight for your live hogs (seeTable 17.2), but because futures were at the same price, the gains would haveexactly offset the losses and the net price would have been $40.65. If you hadremoved the hedge on June 2, you would have paid only $39.58.There are a couple of caveats. Our packer here was long; that is, he had purchased the futures. When the buyer goes into the delivery period—in this instance,
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Commodity Hedging in Action
any time during the month of June—he may receive delivery of hogs on the futurescontract; and he could receive them in Peoria, East St. Louis, or any of the otherexchange-approved delivery points. You need to keep this fact in mind wheneveryou carry a long position into the delivery period for any commodity.
THE STORAGE HEDGENow let’s turn our attention to another type of hedge—the storage hedge, i.e.,using the futures market to help pay the costs of storing a product. This type of hedgeis possible because the normal relationship between cash and futures prices forstorable commodities is a futures price higher than the cash price and the moredistant futures higher than nearer-term futures, reflecting the cost of storage.Anyone who owns the product will be induced to store it for a period of timeonly if he expects to be able to sell it at a sufficiently high price to pay the storagecosts. Conversely, people who buy the product will have to pay storage charges ifthey buy it in advance of their time of need. To avoid having capital tied up instorage and other facilities, they are willing to pay a slightly higher price at a latertime if someone else will store it for them. Hence, distant futures prices are normally above near-term or cash market prices. As the futures month approaches thedelivery period, cash prices will converge toward futures as carrying charges areearned or become less (see Figure 17.1). This phenomenon allows businesspeopleto put a product in storage, sell it forward on a futures contract and, as the basisnarrows, earn a profit to help cover storage costs. It should be obvious that such ahedge is not practical in non-storable commodities.
Figure 17.1 Cost-of-Carry Illustrated
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A word of caution: Not all markets for storable commodities are always normal, i.e., futures prices above cash. Sometimes they become inverted, i.e., cashabove futures. In that instance, the storage hedge does not work.Let’s assume that a farmer has harvested 20,000 bushels of corn. On October10, the farmer’s local grain elevator offers him $3 a bushel, the going cash rate. Atthat time the Chicago May futures price is $3.60. Because the farmer owns thecorn, he has these alternatives:a. Selling the cash product for immediate delivery.b. Selling it on a cash forward contract.c. Selling it on a futures contract through a short hedge.If the farmer does none of these, he will be speculating in the cash market.In considering the alternatives, let’s assume that the farmer decides to storethe corn on the farm and hedge it by selling it in the May futures, thus earning atleast some of the storage costs. In evaluating May futures, the farmer needs toconsider whether a May futures price of $3.60 provides him, after the storage period, with a net local price high enough to cover storage costs, interest, insurance,etc., plus a profit to make the storage worthwhile.Let’s assume that he plans to sell the cash product sometime in April. Thefarmer calculates that he will need $3.40 as a target price to cover the cost of storage, 35 cents, plus 5 cents profit. His present basis (cash to May futures) is 60cents under May. Historical basis patterns for the farmer’s area show that the localbasis narrows to about 10 cents under May in April. This will give the farmer a target price of $3.50 per bushel ($3.60 – $.10 for location basis). His hedging costsare 2 cents per bushel, thus the net target price is $3.48 per bushel.Assume the farmer sells four contracts of May futures at $43.60 per bushel.Time passes, April 15 arrives, and the cash price of corn at his local market is$3.45. May futures have fallen to $3.53, indicating a basis of 8 cents. The farmersells the corn on the cash market and lifts his hedge. He nets $3.50 per bushel onthe hedge. The transaction is summarized in Table 17.4.Another quicker way of doing the above calculations is simply to look at thechange from the buying basis to the selling basis. Add the basis gain to the original purchase price, subtract the costs of hedging, and you will know the net pricereceived. When using a carrying charge hedge, remember these two rules:a. If the basis is narrowing (the selling basis is less than the buying basis),you are earning at least part of your storage charges.b. If the basis is widening (the selling basis is above the buying basis), yourhedge is costing you more money than not hedging.
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Table 17.4 Hedging CornCash MarketOctober 10Harvests 20,000 bushels ofcorn, local price $3 per bu.April 15Sells 20,000 bushels of corn,local price $3.45 per bu.+ $.45
Basis
Futures Market
$.60
Sells 4 May futures at $3.60
$.08
Buys 4 May futures at $3.53
$.52
+ $.07
(Hedging costs are estimated at 2 cents per bushel. Hence, net basis gain is $.50.)
This points up the importance of knowing your basis patterns and selectingthe most opportune time to lift your hedge. These storage hedge rules are equallyapplicable to grains, gold, silver, etc.
TRYING OTHER EXAMPLES YOURSELFNow you know what a short hedge, a long hedge, and a storage hedge look like.We could not cover examples in every commodity, hence we covered two livestockand one grain hedge. However, the principles we used throughout are applicableto a wide number of other commodities. Work out some examples for yourself todetermine how well the hedge works. You also could plug in some hypothetical situations in which the futures price goes up and you lose money on futures.You will find that as long as prices eventually converge to your expectedbasis, your hedge will work out as you expected it would. That’s what hedging isall about—knowing your basis patterns. When you hedge, you essentially trade thegreater uncertainty associated with absolute price change for the lesser uncertainty associated with basis change or relative price change.
SELECTING A HEDGE BROKERIn selecting a broker for hedging, you should look for someone who is interestedand willing to service hedge accounts. Some registered representatives prefer to
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handle hedge accounts. Others are not willing to spend the time and effort necessary to do a good job. A suitable broker should be able to explain the various aspectsof hedging to you, aid you in calculating price relationships, and be willing to helpyou give and receive delivery, if necessary. A good broker also should be able to provide fast and reliable execution of orders.
WHAT ABOUT DELIVERY?Although about 98 percent of all futures contracts are offset and not delivered, thereare times when it would be advantageous for a hedger to accept delivery . . . when,for a particular location, accepting or giving delivery is the most profitable alternative.At that same time, at another location, it may not be the most advantageous. Indeciding whether you want to give or take delivery, you should calculate all of yourcosts involved in accomplishing the delivery and then compare that to the best priceyou can get in another market.Some futures contracts do not allow delivery of the physical commodity.Instead, the remaining longs and shorts at the end of trading simply settle theirprice differences through a cash payment. These contracts are the norm in financial futures, but relatively new in agricultural futures.
DECISION-MAKING ON HEDGINGThe internal organization of the decision-making machinery on hedging for a firmis quite important, because hedging should be a part of a firm’s total managementstrategy. It’s important that the top people in a firm, including the president and theboard of directors, be aware of how and why the futures market is being used forhedging. If they understand that hedges do not always work out perfectly and thatthere will be times when the gains and losses in the futures market will not exactly offset the gains or losses in the cash market, the chances of futures trading becoming an integral and useful part of the firm’s management decisions are much greater.For decision-making, some firms establish committees to review the basic economic data, estimate risk exposures, coordinate the decisions that need to be madebetween buying and selling, and make the actual decisions in the futures market.Other firms have one person responsible for trading, with a committee to providebasic outlook data, advice, and guidelines on his use of the futures market.In all cases, there should be a close liaison between the comptroller of the firmand the person having responsibility for the hedging, because hedging is basically a financial operation and can have an important effect on the finances of the firm.It also can have implications for tax purposes.176
Commodity Hedging in Action
HOW MUCH TO HEDGEA major concern facing all hedgers is deciding just how much to hedge. Should youcover 100 percent of your exposure, or is 50 percent sufficient? How about 10percent of it, or none?There are no hard and fast rules. The proportion of risk you hedge is a personal decision. Generally, the answer to the question should be based on some, orall, of the following factors:a. Your Net Capital The greater your capital base, the more risk you can
withstand. If you are well-capitalized and unhedged and prices moveagainst you, the loss may not be catastrophic. On the other hand, if youare poorly capitalized, you probably can’t afford to take very much risk.A small adverse price change could mean bankruptcy. In those instances,hedging to protect small positive price margins, or to protect against further losses, may be well-advised.b. Your Expectation About Prices When you put on a hedge, you have
essentially accepted a price. When you decide if you want to accept aprice, whether it’s one available in the futures or in the cash market, youneed to have a standard against which you can compare the availableprices. The standard should be either a forecasted price (your forecast orsomeone else’s), a break-even price, a budgeted price, or some acceptable price you have identified. You also need to consider the strength ofyour expectation, i.e., the probability that the forecasted price, or expected price, will be realized if you do not hedge.c. Your Cash Flow Expectations Hedges require cash deposits at your bro-
ker. If your futures position loses money, that money must be depositedin cash with your broker on a daily basis. If you do not meet variationmargin calls, the broker will liquidate your position. You may then findyourself unhedged at exactly the time you need it.Hence, in deciding how much you want to hedge, keep in mind how the variation margin calls may affect the cash-flow needs of the rest of your business.
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Chapter 18
Energy Hedging—Some Examples
One of the most successful new futures contracts introduced in recent years wasthe crude oil futures offered in the early 1980s by the New York MercantileExchange (NYMEX). This contract, which benefited from the earlier success ofthe NYMEX’s No. 2 Heating Oil contract, further introduced futures hedging andderivative product risk-management techniques to the petroleum industry. Applyingthese ideas to crude oil was an almost instant success. The success of this contractled to the development of other energy-related contracts, most notably, contractsfor unleaded gasoline and natural gas.Since then, energy futures trading has grown to be one of the most activegroups of futures in the world. Further, energy futures have become a widely usedhedging tool.Oil is one of the world’s most important commodities. It is produced in manycountries, consumed everywhere, and accounts for a large percentage of international trade. Its prices are very sensitive to political and economic changes.Crude oil is usually refined, a process that results in two major products: fueloil and gasoline. The prices of all three products are related and usually follow similar patterns, though not with precise timing (see Figures 18.1 and 18.2). The prices179Copyright 2001 The McGraw-Hill Companies. Click Here for Terms of Use.
Chapter 18
Figure 18.1 Crude, Heating Oil, and Gasoline Futures Prices (weekly data)
Figure 18.2 Heating Oil Less Gasoline (weekly data)
of the products are clearly interrelated because their supply is derived from the samesource—crude oil. However, they react to different demand forces, and for that reason the spread between fuel oil and gasoline prices can be volatile, though it usually stays within a limited range. All of this creates price risk (and hedging or tradingopportunities) to producers, refiners, distributors, manufacturers, homeowners, etc.Chapter 19, which deals with spreads, contains an example of the use ofthese three contracts to implement a trading strategy called “the crack.” It is roughly equivalent to operating a refinery—buying crude futures and selling heating oiland gasoline futures.The following are some examples of typical energy hedges.
HEDGE #1: REFINER—HEDGING THE SALE OF EXCESSINVENTORYAssume that Hopeful Energy, a medium-sized refiner located on the Gulf Coast, ordinarily contracts to sell its No. 2 fuel oil production f.o.b. pipeline. The contracts180
Energy Hedging—Some Examples
require that the buyer take a minimum amount of No. 2 fuel oil each month. Thecompany produces more than the minimum amount because, on average, the contractors take considerably more than their minimums. Assume also that in Januarysome of the buyers decide to take only the minimum quantities specified in their contract. As a result, Hopeful Energy’s inventories begin building. They are faced withseveral alternatives. They can immediately cut back on the refining activity, butthis can have the disadvantage of increasing their average production costs per gallon. They also can sell off their excess inventory for immediate delivery, or they canhedge it. Let’s assume that their cash/futures basis (gulf spot price minus the futuresprice) has been averaging 5 cents per gallon, and that it will cost another 5 cents pergallon to carry the product in inventory over the expected life of the hedge.If the futures price for No. 2 fuel delivery in March is at 56 cents, thenHopeful Energy knows that its net hedged sale price is 55 cents per gallon (56cents, less basis of .5 cents, and cost-of-carry .5 cents).Assume Hopeful Energy sells the futures at 56 cents. Time passes and in themiddle of February, Hopeful gets an opportunity to sell the fuel oil in the cash market at a net price of 53 cents. It then buys back the futures it previously sold at aprice of, say, 51.25 cents per gallon. In this instance, the cash/futures basis haswidened and the net result is a windfall profit. Table 18.1 below contains a summary of this transaction.
HEDGE #2: FORWARD SALE TO HEDGE THE PURCHASEOF INVENTORY NEEDSAssume that Smith is a large independent distributor of fuel oil to retail outlets inthe Midwest. The manager tries to beat the competition by keeping the company’s price quotes low during rising markets. The manager does this by buyinginventory and stockpiling fuel oil whenever he thinks prices are likely to be risingin the months immediately ahead. Sometimes the manager is right. Sometimes heis wrong. Smith’s immediate problem is that refiners are reluctant to sell to themanager for delivery more than a few weeks in advance. Assume Smith’s managerTable 18.1 Refiner’s Hedge of Fuel Oil InventoryCashJan. Net ExpectedPrice$.55Feb. Actual Sale.52.03
Expected Basis–1.00+.751.75
FuturesSell March Futures @$.56Buy March Futures @ 51.25+4.75181
Chapter 18
wants to take advantage of private forecasts showing tighter supplies and higherfuel oil prices six months ahead. He can’t do it through forward contracting in thecash market, because the refiners won’t forward contract that far ahead. The futuresmarkets are an alternative for him.Assume the manager enters the futures market and buys No. 2 fuel oil futuresfor delivery six months out at a price of 60 cents a gallon, 4 cents more than thecurrent spot price. The 4 cents differential reflects the cost-of-carry and the market’s general expectation that prices are likely to be higher six months from todaythan they are currently. Assume that time passes and the prices do indeed rise in asteady fashion. Each month, as Smith’s manager purchases his needs in the cashmarket, he reduces his futures hedge by an equivalent amount, taking the profitsfrom the long futures position and adjusting the cost of his purchases in the cashmarket.
HEDGE #3: SELLING INVENTORY IN TRANSITGolden Touch Trading Co. buys and sells gasoline in a pipeline originating on theGulf Coast and ships it to the Midwest. Sometimes it buys gasoline without having already sold it, thus it is exposed to possible decreases in price. Assume thaton October 15, Golden Touch Trading buys 100,000 barrels of gasoline from amajor refinery on the Gulf Coast at a spot market price of 89.5 cents per gallon. Itwould schedule to lift it from the pipeline about a week later, say, October 22. Ittakes approximately one month for that shipment to wind its way through the system and reach the Midwest. Thus, Golden Touch would expect to deliver the product to some buyer about the middle of November. Assume also that Golden Touchhas not found a buyer for the product yet, but knows that between October 15 andthe third week of November, as the product is moving through its distribution system, it will find a buyer. The company can protect itself by selling unleaded gasoline futures on the NYMEX.If Golden Touch’s basis averages about 75 cents and the cost for shipping addsanother 3 cents a gallon, this means that for Golden Touch to make a profit on thisproduct, it must obtain a price of 99.5 cents per gallon (89.5 cents + 10 cents).Assume the NYMEX unleaded gasoline futures for December are selling at$1 per gallon. At that price, Golden Touch knows it can make a slight profit on thetransaction.To protect against a price fall, the company would sell the gasoline futuresat NYMEX, go about its business listing the gasoline and shipping it northward,finding buyers in the cash market, and, as it made the sales in the cash market,lifting its hedge. If its basis calculation is correct, it will achieve its expected market price.
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Energy Hedging—Some Examples
Note in all of these examples, as in any hedge activity, the stability of theexpected basis is the key element for success. This expected stability is measuredby correlation. If the correlation is 1.00, and the rate of change in the two prices(cash and futures) remains relatively constant as they march through time, youwill get very effective hedges. Normally, the stability of the basis, and the expected rate of change in the two prices, is measured by regression analysis. The regression coefficient reflects the rate of change in the two prices, and its inverse establishes the number of futures contracts you need to hedge for a given quantity orexposure amount.
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Chapter 19
Fact and Fiction About Spreads
Joe Boswell first appeared on the commodity trading scene about six months ago . . .the morning after a dinner party where he had listened for almost an hour while a welldressed stranger described commodity conquests in numbers that boggled his mind.In the succeeding months, Joe became a trader. He won some and he lostsome, the latter category unfortunately predominating because—in spite of thereasonable guidance he was getting from his broker—Joe’s own preparation for trading commodities did not extend much beyond that party conversation.It was also during this time that Joe first heard of a “spread.” He knew it tobe a trading strategy calling for buying a contract for delivery in one month andselling a contract for delivery of the same or a different commodity in anothermonth, and that it was considered a conservative method of trading. A little furtherinvestigation revealed to him that by spreading he would be trading two contractsfor only a little more commission than he’d pay to trade one, and in the case of thecattle spread he was considering he would need only $300 margin instead of the$700 necessary to trade one contract outright.Joe figured that was a good deal. He would be getting two for almost the priceof one . . . and he would be being “conservative,” which suited his Midwestern185Copyright 2001 The McGraw-Hill Companies. Click Here for Terms of Use.
Chapter 19
upbringing perfectly. So he bought June live cattle at $41 and simultaneously soldDecember live cattle at $44. Two days later, June cattle were at $39.50 and Decembercattle were at $45. By spreading, Joe had, without delay, lost $1,500. In retrospect,had he taken an outright position of one contract in either of those two months, themost he would have lost over that time period would have been $600.Joe has since disappeared from the commodity trading scene and is still wondering, among other things, how a “conservative” method of trading could resultin his losing more money than if he had not been so “conservative” and been simply long or short.What Joe didn’t know (and what his broker had apparently failed to impressupon him) is that spreading transactions in and of themselves is not necessarily aconservative method of trading. Sometimes the prices for different futures monthsof the same commodity fluctuate independently, making such spreads more riskythan outright positions. This is particularly true for “perishable” commodities likecattle and hogs.1
SEMANTICSThe terms “spread” and “straddle” are sometimes used interchangeably but frequently confused. The term “spread” is often used to refer to the simultaneouspurchase of a futures contract for delivery in one month and sale of a futures contract for the same commodity for delivery in another month (e.g., the purchase ofMay corn and the sale of July corn). The term “straddle” is frequently used to referto simultaneous trades that arch across two different markets (e.g., the purchase ofJuly pork bellies and the sale of July hogs).To avoid confusion, we’ll use only the term “spread,” calling these “intracommodity spreads” and “inter-commodity spreads,” respectively.The objective of a spread is to make a profit by correctly anticipating variations in the relative market strength of the two positions involved. A spread trader is not concerned with the absolute price change in either one of the contracts butonly with the relative price change between the two futures contracts.For example, assume that February pork bellies are trading at 40 cents andMay pork bellies at 45 cents. A trader who believes that a five-cent premium forthe May contract is not justified or will not be justified prior to the expiration ofthe February contract might buy the February pork bellies and sell the May porkbellies at the prevailing five-cent-per-hundredweight differential. Later, if theabsolute price levels change so that February is at 46 cents and May is at 49 cents,
1.
Even though brokers offer special margins for spreads, be careful; not all of the things they callspreads are economic spreads.
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Fact and Fiction About Spreads
the differential will have narrowed to three cents—leaving a two-cent profit (minuscommissions) on the transaction.Obviously, if one is to favor being long one contract and short another, as onemust in a spread, one must have reason to believe that forces affecting the two arerelated. They must be related, or else the two prices will act independently and onewill be in the position of having two distinct outright trades and not a spread at all.Buying cocoa and simultaneously selling corn, for example, is not considered aspread. It is merely the establishment of two unrelated trading positions. On theother hand, the purchase of grain sorghum versus the sale of corn (or vice versa) isa true spread because, while there are forces tending to make these two markets actsomewhat differently, the two commodities are substitutes for each other in thelivestock feed economy and, indeed, their price movements are related.
“TIME” SPREADS“Time” spreads involve the purchase of a futures contract for delivery in one monthand the sale of a futures contract in the same commodity for delivery in anothermonth. For example, the purchase of a futures contract of corn for delivery in Mayand the sale of a futures contract of corn for delivery in July. The purpose here isto take advantage of discrepancies that arise between the two prices as a result ofthe difference in the time of maturity of the two contracts. In order for such aspread to have any economic logic, of course,