R20.P1.T3.McDonald Ch6: Strip Hedges

[gargi.adhikari]

In Reference to R20.P1.T3.FIN_PRODS_McDonald_Ch6_Topic:Strip Hedges:-
Hi,
For Stack Hedges, BT notes state that
"If the forward curve gets steeper, the stack hedger may lose. On the other hand, if the forward curve flattens, then the stack hedger gains because he/she has locked in the commodity at a relatively lower price."

Question:- Does the same statement above apply for the Strip Hedge as well..? Or is it the reverse for Strip Hedges as we have already locked in the prices for all the sequential Forward Contracts and are not rolling forward like the Stack and re-establishing the Contract price..?

 

[David Harper CFA FRM]

Hi @gargi.adhikari I consider that a great question because (i) the note probably suffers from imprecision and (ii) I think this is such a great example of the broader, classic problem of distinguishing objectively between hedging and speculation. I believe this can be debated, so I will just give you my opinion: this is McDonald, I believe the answer to your question is: while implicitly the answer might be yes (because any comparison goes both ways), the explicit answer is no; in other words, the strip hedge does not overtly speculate on the shape of the forward curve because it matches the hedge with the various maturities of the exposures such that interim changes to the shape of the yield curve are not consequential (except insofar as they are opportunity cost or opportunity gain). In that way, my opinion is consistent with McDonald who states "There are at least two reasons for using a stack hedge [i.e., rather than a strip hedge]. First, there is often more trading volume and liquidity in near-term contracts.With many commodities, bid-ask spreads widen with maturity. Thus, a stack hedge may have lower transaction costs than a strip hedge. Second, the manager may wish to speculate on the shape of the forward curve. You might decide that the forward curve looks unusually steep in the early months. If you undertake a stack hedge and the forward curve then flattens, you will have locked in all your oil at the relatively cheap near-term price, and implicitly made gains from not having locked in the relatively high strip prices.However, if the curve becomes steeper, it is possible to lose. -- McDonald, Robert L.. Derivatives Markets (3rd Edition) (Pearson Series in Finance) (Page 187). Pearson HE, Inc.. Kindle Edition.

Say the oil forward curve is unrealistically {40 @ + 1 month, 50, 60, 70, 80, 90 @ 6 months}; i.e., too steep. And following McDonald's example an oil producer's underlying exposure is a contractual promise to deliver 1.0 million barrels per month at fixed (predetermined) prices. This exposure (where price risk is an increase in the spot) wants a long hedge; ie, long futures. The strip hedge is long ~ 1.0 million at each of +1, +2, ... + 6 months, so the strip hedge includes long F(+6 months) with K = $90. Continuing with my comically unrealistic example, say the curve goes flat, yikes! All maturities go to 40 or 50. McDonald's point is that a stack hedge here would have been better: stack ~ 6.0 million one month contracts at K = $60. Then, next month, the oil producer gets to re-establish (to use your good word!) with the new forward curve. So i view this as a sort of quasi-dynamic re-balancing of the hedge. [the note is imprecise because this is true for a long hedge, not a short hedge].

Implicitly or philosophically, I could see an argument that the strip is the reverse (i.e., it speculates but the opposite way) but my view would be that the strip doesn't speculate in the same way per your statement "we have already locked in the prices for all the sequential Forward Contracts." In this example, if the hedge is a strip with long 1.0 million at 6 months to buy at $90.0, then presumably that is hedging, the underlying promise to deliver (eg) at $100.0 for approximately a locked-in profit. This strip is "more hedge and less speculation" whereas the stack is "some hedge and some speculation [on the evolving oil forward curve over time." That's how i see it, I hope that's helpful!

 

[gargi.adhikari]

@David Harper CFA FRM Thanks David for sharing this insight !

 

[FlorenceCC]

Hi @David Harper CFA FRM,

Thank you for this paragraph, very helpful in understanding strip vs. stack hedge. However, it also made me realize I have sort of a big question mark on the strip hedge logic.
Just to re use your example above, but even if the curve is flatter in my opinion, unless you are really sure that the prices are going to go up and you are going to miss out with your fixed price contract, why would anyone enter into that type of hedge with long positions, especially if the curve is in contango. Because even if the curve simply remains static (markets stable, etc.) then you stand to lose a lot of money from this strip hedge. every time you close out a contract, you realize an actual loss on the futures position (i.e. if the spot remains somewhat around 40, but for instance F(+2)=60, your loss is -20 at the futures maturity when its price is roughly around the spot price). I guess the steeper the curve the riskier it is.
Unless we are betting on the prices going up (and then I would argue we are actually speculating rather than hedging), wouldn't we be better off not taking a position in futures? Because in that case, the worse we stand to lose is simply missing out on an opportunity to sell for more money. With the futures position, it is an actual realized loss if the prices don't go in the right direction.
I feel like I'm missing something but not quite sure what?

Thank you

Florence

 

[David Harper CFA FRM]

Hi @FlorenceCC I don't perceive that you've missed anything here, your logic looks solid to me! My illustrate example is extreme which maybe doesn't help. The components of total return on futures contract = spot return + roll return + collateral return (i.e., the cost of carry as represented by the risk free rate). So contango is a threat to either the stack or the strip hedge: if the hedge is a stack, then the roll return is negative but in a series of small losses; if the hedge is a strip, then the roll return is fewer (futures contract) transactions with larger per-contract loss on the roll. To perhaps simplify, if our initial contango is S(0) = 40 and F(0,T) = $60, then the stack hedge experiences cumulative loss of ~ $20 via a series of small roll losses that add up to ~ 20. But if it's a strip, maybe there is just one contract with a roll loss of $20. In either case, if the spot price does not change in the meantime (e.g., from $20 today to $20 in the future), then the total return on the futures contract will be informed by a (devastating) roll loss of ~ $20.00, either in many transactions (stack) or fewer/one transaction (strip).

But that's because the hedge is protecting against the risk of price increase, so it should expect to lose if the price decreases (hedges can be expensive!). My contango is unrealistically steep. Please note that in Metallgesellshaft's case, their history and expectation was oil backwardation (that was typical, and i think still is more typical?), so in backwardation, either the stack or strip will profit on the roll if the spot is static (although, as mentioned above, the stack perhaps more explicitly may be said to speculate on the shape of the forward curve).

But let's just assume the underlying exposure is a promise to deliver in the future at the predetermined price of $60.00. But your cost will be future S(T). In the contango, if the spot doesn't change from today, the future spot will be $20; the underlying exposure will profit $40.00, but the hedge loss of $40.00 will offset the entirely, so that the net profit is zero. But the reason we entered the hedge was in case of future S(T) = $80.00; in which case, the underyling exposure loses $20 (i.e., cost of 80 but sold for 60). Then the hedge helped because it profited $20.00. That's just to explain a hedge motivation ... but to your point, in terms of the futures contract itself, I think the contango is a threat to the futures contract because it implies negative roll return in either strip or strap, conditional on static spot.

Now, if contango is followed by increasing spot price, then the picture changes (or is at least mitigated, right?). And steep contango probably anticipated (embeds) the expectation of futures spot price increases. In this case of contango but increasing spot price, the long futures suffers on negative roll, but gains on the positive spot return (the increase in futures price correlated to increase in spot). So, I don't think there is anyway around the fact that steep contango plus static spot (which at some point is in defiance of steep contango!) is a deadly to the long. I hope that's helpful, thanks!

 

[FlorenceCC]

Thank you David for your explanations. They "connect the dots"!!!