How to Master Hedging

How to Master Hedging
and Pass the Series 3 Exam

A significant portion of the series 3 exam will be focusing on how to use futures contracts to hedge risk. . This article, which was produced from material contained in our series 3 textbook, will help you master the material so that you pass the series 3 exam.

Hedging

Hedgers are always the users or producers of a commodity who are seeking to reduce or eliminate business risk that can result from an adverse change in the price of the commodity. The hedger is not seeking to profit outright from a position in a futures contract. Any profit on the futures contract will be used to offset the negative impact of an adverse price movement in the underlying commodity. Hedgers take futures positions that are opposite to their position in the underlying cash commodity. There are two types of hedgers, long hedgers and short hedgers. The type of hedger gets their name from the position that they take in the futures market to hedge their risk in the cash market. A long hedger will purchase futures to protect from the risk of the price of the commodity going up. A long hedger is someone who uses the commodity or who is contractually obligated to deliver the cash commodity but who does not own the cash commodity. If a business has a need for or an obligation to deliver the physical commodity, they are considered to be short the cash commodity or short the basis. Any increase in the price of the cash commodity will have a negative impact on their business, will reduce their profits, or may cause the business to suffer a loss.

Case Study: Long Hedger

A large jewelry company knows that it will need a substantial amount of gold to produce the class rings that are ordered in the spring of each year. Competition for the class?ring contracts is significant and as a result pricing power is limited. The company fears that if the price of gold increases it will not be able to pass along the increased gold price to the buyers of the rings. In October gold is selling in the spot market at 1,425 per troy ounce and the company knows it will need 5,000 troy ounces to fill the orders it traditionally receives in April. To meet its demand for gold in April the company may elect to purchase the 5,000 ounces in the spot market and accept delivery. This would require the company to lay out a tremendous amount of cash and pay for storage and insurance of the commodity for the next six months. If the company did not have sufficient cash to pay for the gold in full and used a credit facility to finance the purchase, the company’s cost would be increased further by paying interest on the borrowed funds. The company also may elect to take no action at this time. This however will leave the company exposed to increased prices and losses should the price of gold rally in the next six months. Alternatively and perhaps the best choice is for the jewelry company to purchase gold futures for April delivery. The jewelry company can hedge their need for 5,000 ounces of gold by purchasing 50 April gold contracts. Since each gold contract is for 100 troy ounces, the company has completely hedged their need for gold and is now in a position to accept delivery at the time they begin to receive orders. If spot gold in October is selling at 1425 and the April gold contract is selling for 1435, the company has locked in their delivery price for April at 1435 and can accept delivery to meet its demand. This is a perfect hedge: the number of units needed and the delivery month meets the need of the user. Let’s look at the same scenario, except the need for the gold is in March and the company hedges the price of gold in October with April gold futures

Time Gold Cash/Spot Price April Gold Futures Price October 1425 1435 March 1440 1447.50 Change +15 (increased cost) +12.50 (profit on long futures)

In March, the price of spot gold has increased $15 from $1,425 to $1,440 per ounce. During the same time the price of the April gold futures contract has increased from $1,435 to $1,447.50, an increase of $12.50. The jewelry company will now purchase 5,000 ounces of gold in the spot market at $1,440 and will offset the hedge by selling 50 April gold contracts at $1,447.50. In this case the company hedged $12.50 of the $15 price increase in gold. As a result of the hedge the company’s effective cost for the 5,000 ounces of gold is $1,427.50 per ounce. The effective cost of $1,427.50 is found as follows: price of spot gold in March $1440 $12.50 profit on the futures contract equals $1,427.50. A short hedger will sell futures to protect from the risk of the price of the commodity falling. A short hedger is someone who produces the commodity or who owns the cash commodity. If a business produces the commodity or owns the physical commodity, they are considered to be long the cash com- modity or long the basis. Any fall in the price of the cash commodity will have a negative impact on their business, will reduce their profits, or may cause the business to suffer a loss.

Case Study: Short Hedger

A famer in Iowa is operating a third?generation family farm. The main crop for the farm over the last 30 years is corn. With demand for corn strong and prices at historically high levels, the farmer decides to plant substantially more corn this crop year. In April the farmer plants an additional 100 acres of corn, increasing his production by 25% to 500 total acres. As a result of the increased production the farmer is taking on significantly higher expenses in the form of seed, watering, and fertilization costs. The farmer is concerned that the price of corn may fall between the planting season in April and the time when the corn is harvested in mid?September as corn farmers ramp up production to take advantage of the historically high corn price. Due to the unusually high demand forecast, the September futures contract is trading at a premium to cash corn in April, which is trading at 5.10 per bushel and September corn futures are trading at 5.40. The farmer expects to grow 150 bushels per acre for a total of 75,000 bushels of corn (500 acres 150 bushels per acre). To hedge his crop production the farmer sells 15 September corn futures contracts at 5.40. Since each corn contract represents 5,000 bushels of corn, the farmer has hedged his entire crop production. When the farmer harvests his crop in September he will deliver the crop production of 75,000 bushels of corn against his 15 short futures contracts and will have locked in the sale price of $5.40 per bushel. This is another example of a perfect hedge. The number of units and the contract delivery month coincided perfectly with the harvest period and with the size of the crop production. Let’s look at the same scenario, except let’s now place the farmer in part of Iowa where the crop is harvested later, in mid?October. With no corn contracts trading in April for October delivery the farmer must sell December futures contracts to hedge his October crop production and delivery. With cash corn trading at 5.10 and corn futures for December delivery trading at 5.50, the farmer sells 15 December corn futures contracts at 5.50.

Time Corn Cash/Spot Price December Corn Futures Price April 5.10 5.50 October 4.90 5.32 Change 0.20 (loss on commodity) ?0.18 (profit on short futures)

In October the price of spot corn has fallen by 20 cents from $5.10 to $4.90 per bushel. During the same time the price of the December corn futures contract has fallen from $5.50 to $5.32, a decline of 18 cents. The farmer will now sell 75,000 bushels of corn in the spot market at $4.90 and will offset the hedge by purchasing 15 December corn contracts at $5.32. In this case the farmer hedged all but 2 cents of the 20?cent price decline in corn. As a result of the hedge the farmer’s effective selling price for the 75,000 bushels of corn is $5.08 per bushel. The effective selling price of $5.08 is found as follows: price of spot corn in October plus profit per bushel on the futures contract ($4.90 + 18 cents $5.08).

How To Manage An Imperfect Hedge

There are a number of factors that can cause a hedge to be less than perfect. In fact, in most cases the hedge is imperfect. Some of the factors that can impact the effectiveness of a hedge are:

• The number of units covered by the futures contract are more or less than the units to be hedged.
• The futures delivery months do not line up with the producer’s harvest or production cycle.
• The futures delivery months do not line up with the user’s demand cycle.
• The change in the price of the underlying commodity and the change in the price of the futures contract are not perfectly correlated.

While the prices of the commodity and the futures contract converge as the delivery period approaches, a price change in the commodity will not always be completely reflected in the price change of the futures contract and vice versa. As a result, a hedge traditionally will not offset 100 percent of the losses or 100 percent of a price increase. When hedging it is important to select the delivery month that always equals or exceeds the month during which the commodity will be produced or needed. We saw in our second example with the corn farmer that no corn futures contract was trading in April for October delivery. The farmer had to use either the September or December contract. The farmer properly selected the December contract, which exceeded his delivery in October. Had the farmer selected the September contract, the delivery period would have passed and the contract would have expired and left the farmer completely unhedged for weeks into his October harvest and sale. Another challenge can occur when the units to be hedged do not meet the number of units in an even number of contracts. There are no half lots or half contracts in futures. If our corn farmer was predicting that his crop would yield 77,000 bushels of corn it could not be perfectly hedged using corn contracts covering 5,000 bushels of corn. 77,000 bushels ÷ 5000 bushels per contract would require 15.4 corn contracts to hedge the entire crop. Since the farmer cannot sell 15.4 contracts, he must select either 15 contracts or 16 contracts to hedge his crop. The correct choice for the exam in this type of scenario would be to sell 15 contracts. The Series 3 exam does not want a hedger to over hedge the position. If the farmer sold 16 contracts covering 80,000 bushels, the farmer would have hedged his production and would be speculating on an additional 3,000 bushels.