P1.T3.710. Long and short hedges (Hull Chapter 3)

[Nicole Seaman]

Learning objectives: Define and differentiate between short and long hedges and identify their appropriate uses. Describe the arguments for and against hedging and the potential impact of hedging on firm profitability. Define the basis and explain the various sources of basis risk, and explain how basis risks arise when hedging with futures.

Questions:

710.1. You are meeting with your FRM study group when one of the members of the group says they are a bit unclear on the definition of the term "short hedge." The following conversation ensues:

I. Albert says "It's simple, if a company owns an asset but wants to hedge its plan to sell the asset at the future spot price, a short hedge is appropriate"
II. Barbara says "Yes, Albert that is true, but if the company plans to sell the commodity in the future at a predetermined price, then a long hedge is appropriate!"
III. Chris says "Barbara is correct, because a short hedge is simply a hedge where a short futures position is taken."
IV. Donald says "Exactly true, Chris. And that means that a short hedge can also be a cross-hedge; ie, these terms are not mutually exclusive."
V. Erin says "And I would like to add that the company does not need to own the asset in order to conduct a short hedge."
IV. Fred says "And I would like to add that a short hedge implies negative basis, just as a long hedge implies positive basis."

Which of the statements is (are) accurate?

a. Only Donald and Erin are accurate
b. Only Albert, Chris and Fred are accurate
c. All of the statements are accurate, except Barbara's
d. All of the statements are accurate, except Fred's


710.2. An industrial manufacturer of vehicle emissions control devices is heavily dependent on platinum as an input, and the price of platinum has a significant impact on the company's cost of goods sold (COGS). Among the following justifications, if true, which is the best reason for the company to hedge the price risk of platinum?

a. The company's shareholders are well diversified
b. The company has no demonstrable skill in predicting the price of platinum, yet is greatly exposed to it
c. Although the board does not understand hedging, most of the members will understand the better outcomes
d. Hedging is not the norm in the highly competitive platinum industry where peer-versus-peer profit margins are scrutinized by analysts


710.3. It is currently March and a company plans to purchase copper in December. The spot price of copper is $2.80 in March while the December futures contract price is $2.90; i.e., the forward curve is "in contango" with a -$0.10 basis. A company employs a long hedge on the assumption that the futures price will converge to the spot price in December, when the contract matures. The company's future "net cost" will include the cost to purchase copper at the future prevailing spot price plus (or minus) the gain (or loss) on the futures position. The company anticipates the spot/futures price will be $3.00 in December. The company goes long four contracts, each for 25,000 pounds of copper. http://www.cmegroup.com/trading/metals/base/copper_contract_specifications.html

Under these assumptions, each of the following statements is true EXCEPT which is false?

a. If the basis unexpectedly weakens, the company's net cost will be less than $290,000; i.e., the company will be better off than it planned
b. If the basis unexpectedly strengthens, the company's net cost will be more than $290,000; i.e., the company will be worse of than it planned
c. If the basis converges to zero as expected, the company's net cost will be $290,000 regardless of whether the spot price increases or decreases
d. If the forward curve unexpectedly shifts to backwardation (aka, inverted forward curve), the company's net cost will be less than $290,000; i.e., the company will be better off than it planned

Answers here:

• In forum

 

[shice]

710.1

D. Having a short hedge doesn't implicitly mean you have a negative basis. You could have a positive basis too?

 

[Nicole Seaman]

710.1

D. Having a short hedge doesn't implicitly mean you have a negative basis. You could have a positive basis too?

Hello @shice ,

David explains this in further detail in the paid section of the forum here: https://forum.bionicturtle.com/threads/p1-t3-710-long-and-short-hedges-hull-chapter-3.10546/. The paid section of the forum is for those who have purchased a study package, as these daily practice questions are part of our practice question sets in the study planner.

Thank you,

Nicole

 

[David Harper CFA FRM]

@shice I agree with you (and the correct answer agrees with you)! We are following Hull here with strict definitions of the basis, where basis = S(0) - F(0); and "short hedge" refers simply to a hedge that employs a short (futures) position as the hedge instrument. So, short hedge can be associated with either negative or positive basis.

 

[ankit4685]

Hi @David Harper CFA FRM,
Can you kindly help me to understand this concept ( short hedge bias can be both +ve and -ve ) again, to my knowledge

1. Short Hedge = Short Forward Contract : Basic = Spot - Forward : = -ve Bias .

how we will explain that Short hedge can be postive also.

Also, I'm not sure about "company plans to sell the commodity in the future at a predetermined price, then a long hedge is appropriate!", can you help me to understand this point too

 

[David Harper CFA FRM]

Hi @ankit4685 These are elsewhere explained multiple times in the forum, so we'd appreciate it you used the tags and/or searched to save time, but I'll give you a brief answer now since you're the only question today (Sunday):

1. We need the definitions to evaluation 710.1.IV. As you say, a short hedge is simply a hedge position that is short (just as a long hedge is a hedge positions that happens to be long); in commodities, a short hedge is a short futures contract that is performing a hedge role. Basis is the difference between the current spot price and the futures price, specifically B = S(0) - F(T) such that basis is positive (negative) during backwardation (contantgo) because a downward (upward) sloping curve means that futures prices are lower (higher) than the spot price so that F(T) is less than (greater than) current S(0). Symbolically, you are correct that (+S - F) can be used to convey/operate "long commodity + short futures" especially when synthesizing, but basis is just the point-in-time difference between the two prices such that, any any given time, Basis(T) = Spot(T) - futures(T+x). The statement is false because we can imagine a scenario where a short hedge occurs backwardation: a commodity producer is currently concerned the backwardation will get worse ("more backward," so to speak) and so "locks in" a net sale price even when futures prices are lower than current spot price. Maybe the spot price of copper is $3.00 and the future(+ 6 months) is $2.90 such that basis is positive +$0.10, but a commodity producer nevertheless wants to the hedge a planned sale in six months, at the then-prevailing but currently unknowable, future spot price, so she hedges with a short futures contract. At the same time, to understand this is to see how a short hedge is more natural when the curve is in contango (when you can lock in a higher net sale price) but a short hedge does not itself imply a negative basis. The false statement depends on accurate definitions.
2. We've discussed this already a lot in the forum (is why we appreciate some effort to search). There is a big difference, as the company with exposure, between (i) planning to sell in the future at the then-prevailing but unknowable future spot price and (ii) planning to sell at a predetermined price. The former is a typical exposure to price risk, the latter is atypical and well-illustrated by the Metallgesellschaft case study: the company had long-term forward contracts with customers to sell oil to them at the predetermined price. They didn't need to hedge here but how did they hedge? With short-term long positions in futures contracts! Because if you underlying exposure is (effectively) a short forward position (i.e., plan to sell at predetermined price), your risk is actually that prices increases because you've guaranteed a sale at the lower price (the opposite of how you feel if you just had an ordinary plan to sell in the future and you hope for spot price increases). See, i can't even write a short answer, have a good weekend, I'm off to record videos and work on the business

Append: similar questions here today at https://forum.bionicturtle.com/threads/short-hedge-long-hedge.22341