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FIN+4414+-+Managing+Risk+-+Chapter+23

FIN+4414+-+Managing+Risk+-+Chapter+23 - Managing Risk...

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Managing Risk
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Terminology : Basic definition. Comparison to options. Escrow, margin, and payment. Ability to earn interest on commodity/security price. Futures and Forward Contracts
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“Marked-to-market” and daily profit and loss Dividends and Interest payments. Forward contracts. Futures and Forward Contracts
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Example: A wheat farmer expects to harvest wheat in August. The current price in March is $2.73 per bushel, which will cover the cost of production and give the farmer a fair rate of return. Hedging: Commodity Futures
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The farmer can not be sure what wheat will sell for in August when the crop is harvested, but notices that September wheat futures are selling for $2.82 per bushel. How does the farmer hedge? Hedging: Commodity Futures
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If the farmer is willing to settle for $2.73 per bushel, then, to hedge this price, the farmer should sell September wheat futures in March. In August, when the wheat is harvested, the price will be locked, given that spot and futures prices will, in general, move together. Hedging: Commodity Futures
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August Outcome 1 : Harvest is large so spot price drops to $2.66 per bushel and September futures drops to $2.75. Hedging: Commodity Futures
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Cash Market Futures Market Sells wheat for Buys September $2.66 futures for $2.75 Result Result Loss of $0.07 Gain of $0.07 per per bushel bushel Hedging: Commodity Futures
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Outcome : $2.66 = per bushel cash income .07 = per bushel cash gain from futures hedge $2.73 = per bushel realized price Hedging: Commodity Futures
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August Outcome 2 : Harvest is small so spot price rises to $2.94 per bushel and September futures increase to $3.03. Hedging: Commodity Futures
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Cash Market Futures Market Sells wheat for Buys September $2.94 futures for $3.03 Result Result Gain of $0.21 Loss of $0.21 per per bushel bushel Hedging: Commodity Futures
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Outcome : $2.94 = per bushel cash income - .21 = per bushel cash loss from futures hedge $2.73 = per bushel realized price Hedging: Commodity Futures
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Problems : The prior example was not a perfect hedge, since the wheat was harvested and sold in August, while the futures contract matured in September. Hedging: Commodity Futures
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We had assumed that the spot- futures spread remained constant over time. This may or may not happen and exposes the farmer to what is called “spread variation risk”.
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