Hedging with Futures Takeo Aoki

Outline Overview of Hedging Illustration of Hedging Summary This is the outline of my presentation, which is very simple. First comes an overview of hedging. This will be like a review from last week. The next is an illustration of hedging. I will explain how hedging is conducted by using an example of wheat futures. Lastly, I will give a summary.

Hedging To mitigate the risk of an adverse move in prices by locking in the value for a cash position Long Hedge Protects against an increase in the price of a financial instrument or commodity to be purchased some time in the future Short Hedge Protects against a decline in the cash price of a financial instrument or commodity to be delivered some time in the future The purpose of hedging is to mitigate the risk of an adverse move in prices by locking in a value for a cash position To realize this purpose, there are two hedging positions, the long hedge and the short hedge. A Long hedge protects against an increase in the price of a financial instrument or commodity to be purchased some time in the future On the other hand,a short hedge protects against a decline in the cash price of a financial instrument or commodity to be delivered some time in the future

Example : Baking Company Assume you have a baking company. Your expenses are determined by wheat prices. You estimate that you will need 30,000 bushels of wheat in three months, and if you purchase them above $5/bushel, you will run a deficit. Yet the price of wheat may rise until then: you want to hedge the rise in wheat prices of three months later by using the wheat futures. Let’s see an example of hedging.

Assumptions Both the price of wheat and wheat futures is currently at $5.00 per bushel The break even point is $5.00 per bushel, which is $150,000 for 30,000 bushels of wheat The unit of a wheat futures contract is 5,000 bushels ($25,000/contract) Contracts expire in three months These are the assumptions for our example.

How many contracts do you need to use? Question 1 Should you long or short the futures to offset the rising price of wheat? Long the futures Question 2 How many contracts do you need to use? Hint: you need 30,000 bushels of wheat The unit of a wheat futures contract is 5,000 bushels 6 contaracts (=30,000/5000) Question1 Should you long or short the futures to offset the rising price of wheat? Which do you think is right? Yes, the long position because you want to avoid an increase in the price of wheat. Question2 How many contracts do you need to use? You need 30,000 bushels of wheat and a unit of the futures contract is each 5,000 bushels.

Scenario A In three months, the prices of wheat and the wheat futures have risen from $5 to $6 per bushel. Question3 How much will you pay for 30,000 bushels of wheat? $6.00*30,000=$180,000 $30,000 loss We will look at two scenarios about future wheat prices. In the first one the price will rise and in the other one prices will drop. Let’s discuss the first case in Scenario A. In three month, the price of wheat has risen from $5 to $6 per bushel. So what should you do? There are two transactions to hedge. Let’s think separately. First, you will go the the cash market and purchase the required amount of wheat at the spot price. How much will you pay for 30,000 bushels of wheat? The spot price of wheat is currently $6/ bushel and you need 30,000 bushels. So the answer is $180,000. Then you will have a $30,000 loss from purchasing wheat because the break even point is $150,000.

Scenario A To close your futures position, you will need to put a sell order for your futures at the price of $6/bushel. You can purchase wheat at $5/bushel by the futures contract and sell it at $6/bushel by a sell order. Question 4 How much will you gain from the futures? ($6-$5)*30,000=$30,000 $30,000 gain! There is no net gain or loss in your wheat purchase! However, you may make profit from the futures. To close your futures position, you need to put a sell order for your futures at the price of $6/bushel. This means you can purchase wheat at $5/bushel by the futures contract and sell it at $6/bushel by a sell order. Questioin4 How much will you gain from the futures? You need 30,000 bushels. So the answer is $6-$5 times 30,000 bushels = $30,000 You can gain $30,000 from the futures. This gain can offset the loss from buying wheat. As a result, There is no net gain or loss in your wheat purchase and you can get wheat at $5/ bushel

Scenario B In three months, the prices of wheat and the wheat futures have dropped from $5 to $4 per bushel. How much will you pay for 30,000 bushels of wheat? $4.00*30,000=$120,000 $30,000 gain! Scenario B In three months, the price of wheat has dropped from $5 to $4 per bushel. How much will you pay for 30,000 bushels of wheat? The answer is $120,000 because the spot price of wheat will be $4 per bushel in three months. So you will have a $30,000 gain

Scenario B To close your futures position, you will need to put a sell order for your futures at the price of $4/bushel. You will have to purchase wheat at $5/bushel by the futures contract and sell it at $4/bushel by a sell order. How much will you lose from the futures? ($4-$5)*30,000=-$30,000 $30,000 loss There is no net gain or loss in your wheat purchase! However, you may have losses from the futures in this case. To close your futures position, you will need to put a sell order for your futures at the price of $4/bushel. This means you will have to purchase wheat at $5/bushel by the futures contract and sell it at $4/bushel by a sell order. How much will you lose from the futures? The answer is $30,000 loss. Although you can save the costs by buying wheat at a low spot price, as a result, There is no net gain or loss in your wheat purchase and you can get wheat at $5/ bushel

Let’s illustrate these transactions with a graph. The Blue line shows the profit or loss from purchasing wheat at each spot price in the cash market. The Red line shows the profit or loss from a long futures position. The Green line shows the net profit or loss. When the price of wheat is $6, you will lose $30,000 from purchasing wheat but gain 30,000 from the futures. When the price of wheat is $4, you will gain $30,000 from purchasing wheat but lose 30,000 from the futures. In both cases, your net profit and loss are 0, this means you hedged successfully. So wherever the spot price of wheat will move in three months, you can get wheat at the price of $5 per bushel.

If you take a short hedge position, the result is the same. If you were a wheat farmer, you would prefer to take short hedge position. In this case, you can also lock the price of wheat to be sold. Then, your net profit and loss are always 0.

Summary Seller-Short Position Buyer-Long Position Price is locked and free from the risk of price fluctuation To sum up, if you are a seller, you would want to take a short position. If you are a buyer, you would like to take a long position. As a result, the price of the commodity is locked, and you will free from the risk of price fluctuation.

Questions?