CHAPTER 3 HEDGING STRATEGIES USING FUTURES.docx - Chapter 3 Hedging Strategies using Futures Principles of hedging with futures Take a position in the

CHAPTER 3 HEDGING STRATEGIES USING FUTURES.docx - Chapter 3...

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Chapter 3 Hedging Strategies using Futures Principles of hedging with futures Take a position in the futures market, such that: Profit on the futures will offset any loss from the position in the spot market, if prices in the spot market move adversely. Example of short hedge Today is August 31. A gold mining company plans to sell 1,000 troy ounces of gold on October 1. Currently, the spot price of gold is US$1,252.85/troy ounce and the futures price of a gold futures contract with a size of 100 troy ounces and a delivery period in November is US$1,253.70/troy ounce. |------------------------------------|-----------------------| August 31 October 1 November Today Hedge termination date Delivery date of futures Risk If on October 1, the spot price of gold falls, the company will suffer an opportunity loss because it will be able to sell the gold only at a lower price in the spot market. Hedge The company hedges by selling 10 (1,000/100) gold futures contracts with a futures price of US$1,253.70/troy ounce on August 31. Outcome Scenario Spot price down Spot price up Spot price per troy ounce of gold on October 1 US$1,250 US$1,270 Futures price per troy ounce of gold on October 1 US$1,251.13 US$1,271.15 Gain/loss on futures/troy ounce 1,253.70-1,251.13 = US$2.57 1,253.70-1,271.15 = -US$17.45 Effective price of gold per troy ounce = Spot price on October 1 +gain/-loss on futures 1,250 + 2.57=US$1,252.57 1,270 -17.45 = US$1,252.55 Basis on October 1 1250-1251.13=-US$1.13 1270-1271.15=-US$1.15 Current futures price + basis on October 1 1253.70-1.13=US$1,252.57 1253.70-1.15= US$1,252.55 Value of the basis when the hedge is initiated 1,252.85-1,253.70= -US$0.85 1,252.85-1,253.70=-US$0.85 Change in basis -1.13-(0.85)=-US$0.28 -1.15-(0.85)=-US$0.30 Current spot price + change in basis 1,252.85-0.28=US$1,252.57 1,252.85-0.30=US$1,252.55 The hedge reduces the risk but there is still uncertainty in the basis Questions and problems 3.1. Under what circumstances are a short hedge appropriate? 1
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Example of long hedge Today is October 1. A hedger knows that he/she will have to purchase a certain asset in the future and wants to lock in a price now. For example, Nestle has entered into a contract to supply NesQuik to wholesalers in grocery products at a fixed price for the 750 gram tins in February of the next year. Production starts in December of this year and Nestle will buy 50 tonnes of cocoa beans on December 1. Currently, the spot price of cocoa is US$2,800/tonne of beans and the futures price of a cocoa futures contract with a delivery period in January of the next year is US$2,700/tonne. |--------------------------------------------|----------------------------------| Today Hedge Termination date Delivery date of futures contract October December 1 January Risk If on December 1, the spot price of cocoa beans rises, Nestle will suffer an opportunity loss, because it will have to pay a greater amount to purchase cocoa beans. Hedge Nestle buys 50 cocoa futures contracts with a January delivery at a futures price of US$2,700/tonne. Outcome Scenario Spot price down Spot price up Spot price of cocoa beans on December 1 US$2,700 US$2,900 Futures price on December 1 US$2,625 US$2,775 Gain/loss on futures per tonne 2,625-2,700 = -US$75 2,775 – 2,700 = US$75 Effective price of cocoa beans = Spot price on December 1 -gain/ +loss on futures 2,700 + 75 = US$2,775 2,900 - 75 = US$2,825 Basis on December 1 2,700 – 2,625 = US$75 2,900 – 2,775 = US$125 Futures price today + basis on December 1 2,700 + 75 = US$2,775 2,700 + 125 = US$2,825
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