Hull Chp 3: Hedging strategies with Futures

[Vince Loh]

Hi David, in your study notes pg 30, you compared 2 scenarios for a coffee produce that plans to sell 100 pounds of coffee on a future date with;
(1) a predetermined $3.00 per pound, vs
(2) at the future spot price.

If the coffee producer wants to hedge with coffee futures, you indicated that the appropriate hedge for (1) is a long position but for (2) is a short position.

Could you explain please? I am not getting it.

Thanks.
Vince

 

[David Harper CFA FRM]

Hi @VinceL

Sure. Let's just imagine you are the coffee producer with a promise to sell 100 pounds of coffee, to me, in one year.

1. If you promise to sell for $3.00, then you basically have a short forward contract position (I have a long position in the forward contract). Fast forward one year and let's say the spot price (ie.., in one year) is $4.00/pound. You would have been better off to make no promise with respect to the price and instead just promised the quantity, because you will be selling to me for $3.00 when the spot price is $4.00 (your opportunity cost is $1.00). The hedge is a long position at $3.00 because it mostly eliminates future price risk: the opportunity loss of $1.00 is offset by the $1.00 gain on you long futures position. But it cuts both ways. On the other hand, if the future spot price in one year is only $2.00, then you would prefer to have not hedged. But your long hedge loses a dollar in that case. This is similar (and simplified version of) the Metallgesellschaft case study: the firm had sold short fixed-price forward oil contracts; i.e., promises to deliver (sell) oil at a fixed price in the future. Their hedge was long futures oil contracts (never mind the maturity mismatch).
   
2. If you promise to sell only quantities but the price is not predetermined, this is the more typical textbook case. Now, your exposure happens of the future spot price goes lower to $2.00 simply because you will be selling to me at the lower realized future spot price. In this case, the hedge is a long futures position because it will offset with a $1.00 gain. I hope that helps!

 

[Vince Loh]

Thanks David.

 

[yatin_93]

Hi David,

Does this mean the current study material should have said Long hedge position instead of Short position in hedge for the Second point?

Since my initial position is already a short if I take a short position on the hedge. How does it offset my position?

Referring to Page 4 of chapter 8

 

[David Harper CFA FRM]

@yatin_93 Nope, looks correct. Our note is below. The first scenario is similar to the case of Metallgesellshaft T1.Ch 9) whose exposure was long-term fixed-price contracts to deliver oil. The second scenario is the classic commodity producer who plans to sell in the future at the prevailing (but currently unkown) price.

"A key difference: is the future price predetermined? Consider a coffee producer who plans to sell 100 pounds of coffee on a future date under two different scenarios:

1. To a key customer, the coffee producer promises to sell 100 pounds, on a date one year in the future, at $3.00 per pound.
2. To a key customer, the coffee producer promises to sell 100 pounds, on a date one year in the future, at the future spot price (which is obviously unknown today)

If the coffee producer wants to hedge with coffee futures, the hedge differs depending on the scenario:

1. In the first scenario, the producer is exposed to a future spot price increase, such that the appropriate hedge is a long position in coffee futures contracts. Because the sales price of $3.00 is predetermined, the underlying exposure is effectively a short position, such that the hedge instrument is a long position to offset.
2. In the second scenario, the producer is exposed to a future spot price decrease, such that the appropriate hedge is a short position in coffee futures contracts. In this case as the future sale price is not predetermined, the underlying exposure is effectively a long position such that the hedge instrument is a short position." -- BT Study Note, Chapter 8, page 4

 

[yatin_93]

Hi David, thank you for the prompt revert.

I am struggling to grasp the concept behind the 2nd point wherein the future spot price is not predetermined.

Is there perhaps a simpler illustration or an alternative example I may refer to?

Apologies for the trouble.

 

[David Harper CFA FRM]

Hi @yatin_93 (It's no trouble, I'm here to help as much as I can!) The 2nd scenario is actually the common use case. Here is a classic example from the CME group, see https://www.cmegroup.com/trading/ag...th-grain-and-oilseed-futures-and-options.html although I'm going to edit (delete) the five words that I think are confusing (if not imprecise):

"The Short Hedge: To give you a better idea of how hedging works, let’s suppose it is May and you are a soybean farmer with a crop in the field; or perhaps an elevator operator with soybeans you have purchased but not yet sold. In market terminology, you have a long cash market position. The current cash market price for soybeans to be delivered in October is $12.00 per bushel. If the price goes up between now and October, when you plan to sell, you will gain. On the other hand, if the price goes down during that time, you will have a loss.

To protect yourself against a possible price decline during the coming months, you can hedge by selling a corresponding number of bushels in the futures market now and buying them back later when it is time to sell your crops in the cash market. If the cash price declines by harvest, any loss incurred will be offset by a gain from the hedge in the futures market. This particular type of hedge is known as a short hedge because of the initial short futures position." -- page 9.

... that's a classic example: a commodity producer (e.g., corn, soybean, wheat, cotton) who plans to sell at a future date in the cash (aka, spot) market. But we can never know the future spot (future cash market) price! For example, we cannot know the future price of gold, there can only be an expected future spot price as given by some pricing/valuation model. However, we do today observe futures prices; i.e., prices for future delivery. So if you are this producer who plans to sell in the spot market in the future, then you are exposed to (i.e., you don't want to see!) a decline in the spot price, while you own the commodity and before you sell it in the spot/cash market. You are effectively long the commodity (i.e., you are long the commodity's spot price) such that the hedge is a short position in a future contract. I hope that's helpful!

P.S. for any future reader, I think the brochure is mistaken to write "The current cash market price for soybeans to be delivered in October," but it's CME, they should know, so I'll take any feedback on that clause that I've deleted, in case I'm just missing something ?!

 

[yatin_93]

@David Harper CFA FRM great help. Thanks.