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22: Hedging, Speculation, and Arbitrage
VII: Futures 22: Hedging, Speculation, and Arbitrage
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Futures Hedge Speculate Arbitrage
use futures to reduce risk on an existing position Speculate use futures to take on risk in the hope of making a profit Arbitrage Use the difference between spot and futures prices to generate risk-free profit
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Hedge Identify the existing risk
50,000 bushels of soybeans growing in the fields The current price of $4.20/bushel can change before George can harvest & sell
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Existing Risk: Long soybeans
© Oltheten & Waspi 2012
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Hedge An investment that offsets this risk Short soybeans
Short Soybean futures
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Hedge Strategy K K If soybean prices increase
Long Spot J Short Futures L If soybean prices decrease Long Spot L Short Futures J K K
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Offsetting futures risk November contracts deliver
Hedge Strategy Use November Futures October ? harvest plant Spot risk Offsetting futures risk November contracts deliver Lift Hedge Set Hedge
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Set the Hedge George sets the hedge in April Spot price: $4.20/bu
Futures price: 431 Basis (spot-futures) = -11¢
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November contracts deliver
Set the Hedge Set the hedge in April October ? harvest $4.20 November contracts deliver Lift Hedge 431 -11¢
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Set the Hedge Long Position (spot) Short Position (futures)
George Q. Farmer Hedge is set Long Position (spot) Short Position (futures)
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Long Position Short Position
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Scenario 1: Textbook Hedge
George harvests October 1 Spot price: $4.00/bu Futures price: 411 Basis (spot-futures) = -11¢
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November contracts deliver
Lift Hedge $4.00 $4.20 November contracts deliver 431 411 -11¢ -11¢ © Oltheten & Waspi 2012
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Lift the Hedge George Q. Farmer Hedge is set
Sell 10 November 431 [10*5,000*431 = $215,500] Margin: Hedge is lifted Buy 10 November 411 [10*5,000*411 = $205,500] Profit: Sell 50,000 soybeans Net Income:
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Lift the Hedge Textbook Hedge $4.00 price: 411 Spot price: $4.20
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Scenario 2: Not quite a Textbook Hedge
George harvests October 1 Spot price: $5.00/bu Futures price: 508 Basis (spot-futures) = -8¢
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November contracts deliver
Lift the Hedge $5.00 $4.20 November contracts deliver 431 508 -11¢ -8¢ © Oltheten & Waspi 2012
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Lift the Hedge George Q. Farmer Hedge is set
Sell 10 November 431 [10*5,000*431 = $215,500] Margin: Hedge is lifted Buy 10 November 508 [10*5,000*508 = $254,000] Profit: Sell 50,000 soybeans Net Income:
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Lift the Hedge Not quite a Textbook Hedge price: 508 Spot price: $4.20
$5.00 price: 508 price: 431
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Hedge Once the hedge is set George trades his Price Risk for Basis Risk
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Scenario 3: Not quite a Textbook Hedge
George harvests October 1 Spot price: $1.00/bu Futures price: 105 Basis (spot-futures) = -5¢
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November contracts deliver
Lift Hedge $1.00 $4.20 November contracts deliver 431 105 -11¢ -5¢ © Oltheten & Waspi 2012
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Lift the Hedge George Q. Farmer Hedge is set
Sell 10 November 431 [10*5,000*431 = $215,500] Margin: Hedge is lifted Buy 10 November 105 [10*5,000*105 = $52,500] Profit: Sell 50,000 soybeans Net Income:
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Lift the Hedge Trade Price Risk for Basis Risk $1.00 price: 105
Spot price: $4.20 $1.00 price: 105 price: 431
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Hedge George also grows corn (10,000 bushels)
Futures contracts defined as 5,000 bushels Cents per bushel Corn futures deliver March, May, July, September, & December.
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Set the Hedge In April Spot corn is $2.00/bushel
December corn futures trade at 195 Margin requirements at $400 and $300 per contract
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December contracts deliver
Set the Hedge $2.00 December contracts deliver 195 +5¢ © Oltheten & Waspi 2012
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Set the Hedge George Q. Farmer Hedge is set
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Lift the Hedge In October Spot corn is /bushel
December corn futures trade at
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December contracts deliver
Set the Hedge $2.00 December contracts deliver 195 +5¢ © Oltheten & Waspi 2012
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Lift the Hedge George Q. Farmer Hedge is set
Sell 2 December 195 [2*5,000*195 = $19,500] Margin: Hedge is lifted Net Income:
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November contracts deliver
Set the Hedge $2.00 November contracts deliver 195 +5¢ © Oltheten & Waspi 2012
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Futures II
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