Hedging Futures

 

Hedging With Futures

July 17, 2004

 

1

Agenda 

Introduction



Hedging Strategies



Diversification Benefits



Practical Problems in Hedging

 

2

What is Risk? 

Exposure to market movement of prices 



In general, down side risk is what we mean by risk

Quantification Quantifica tion of of risk - the volatil volatility ity of the price price movements 

Volatility is nothing but the standard deviation (deviation from the mean prices)

 

3

What is Risk Management?  

No risk can be eliminated Risk Management 

Transferring the risk to some one who can handle

it better or  Transfer the risk to some one who has the appetite for risk 

Financial derivatives are used to hedge the exposure to market risk 

Hedgers transfer their risk to speculators who are willing to assume the risk

 

4

Risks faced by an entity Foreign exchange risk

•Commodity price risks include • Increase in purchase cost vis-à-vis

Interest rate risk

commitment on sales price • Change in value of inventory • Counterparty risk translating into

Commodity price risk

commodity price risk

Credit risk •Commodity futures

Operational risk

•Inventory hedging •Borrowings linked to commodity prices

 

5

What is a hedge? 



A hedge is a futures position that is roughly equal and opposite to the position the hedger has in the cash market A hedge is designed to reduce price risk.

The profit (loss) in the cash position is offset by equivalent loss (profit) on the futures position

 

6

What are the risks in commodities? Commodity enterprises face two classes of risk: 

Price risk – risk relati relating ng to movem movements ents in the the world price, the exchange rate and the basis between local and world prices)



Quantity risk (eg from weather)

Hedging may allow reduction in price and cost risk Insurance may be available for quantity risk

 

7

Vo Vola latil tilit ity y comp compar aris ison on - Su Summa mmary ry Average annual volatility 

Sensex or Nifty - 25-30%

 

Govt Sec Index - 5-10% Golld Go - 12-1 12-18 8%



Silver

- 15-25%



Cotton

- 10-12%



Oill se Oi seed eds s

- 15 15-2 -20% 0%



Commodities are less volatile compared to stock market



The determinants of volatility are different for capital market and commodity markets

 

8

Agenda 

Introduction



Hedging Strategies



Diversification Benefits



Practical Problems in Hedging

 

9

Commod ity pri price ce ris risk k - sig signif nifican icance ce Commodity Industry (data of 1500 companies)

Estimated Aggr. Turnover (Rs Cr.)

% of Raw Material cost to Aggr. Turnover 

Agro/ FMCG/ Edible Oils

65,000

70%

Auto/Auto Ancil.

35,000

90%

Chemicals Construction

5,000 10,000

65% 40%

Consumer Goods

3,000

50%

Engineering/Industrial G.

30,000

50%

Fertilizer/Pesticides

15,000

45%

Livestock/Leather 

2,000

65%

Metals/Mining/Steel

60,000

70%

Packaging

10,000

60%

3,00,000

85%

Sugar 

5,000

65%

Textiles

20,000

90%

Transport

2,000

40%

Oil/Petro/Refineries

Source of of data – ICICI Bank Bank Corporate Corporate Infobank Infobank

Industry in India today runs the raw material price risk, Going

Forward they can hedge this risk  

10

Commodity price risk & corporates 

Exposure to commodity price risk can do damage to the bottom line



Impact of commodity risk on profits is examined for three companies 

These companies are exposed to unique commodity price risk (Cotton, Aluminium and Copper)

 

Market leaders in their respective industry Impact on PBT if the companies had not hedged their commodity price risk

 

11

Co Commo mmodi dity ty pr pric ice e ris risk k – Imp Impac actt Amount in Rs crores Company Name

Sales

A Tex

1326.28

Raw Materia l 567.00

RM as % of sales

PBT

Price risk

Impact on PBT

% Impact

B Al

2639.55

1117.43

42.33

899.39

1.90%

(50.15)

(5.57)

C Cu

3406.48

2565.35

75.31

194.28

2.65%

(90.27)

(46.46)

42.75

129.00

1.30%

(7.37)

(5.71)

 

12

Commod modity ity Pri Price ce ris risk k – Imp Impact act on Com commodities 

Hedging can improve the profits



Impact depends on the raw materials intensity of the company





% of raw material expenditure on Sales



Value addition by the company

Is companies profits a function of the commodity prices? 

Textiles Texti les Industry Industry – Cott Cotton on price price increase increase cannot cannot be

passed down to the customers  Metal Proces Processing sing Industry Industry – Profi Profits ts are direct direct function function of the market prices of the commodities 

How does the share price of the company behave with the commodity price movements?

 

13

Co Comm mmod odit ity y Pric Price e Ris Risk k – Co Cotto tton n  6 0 0 0  

5000  4000  3000  2000  1000  0  1/01/01  

10/08/01  

C O T T O N P R IC E S  

7/15/02   C O M P A N Y A -S H A R E P R IC E

Increase in raw material cost means reduction in share

 

14

prices

Co Comm mmod odity ity Pr Price ice ris risk k – Al Alum umin inimu imum m   1800  1600  1400  1200  1000  800  600  400  1/01/01 

5 /2 1 /0 1

1 0 /0 8 /0 1

C O M P A N Y - B S H A R E P R IC IC E

2/25/02

A L U M I N I U M P R IC IC E

Share prices mimic the commodity price movements

 

15

Co Comm mmod odity ity Pr Price ice Ri Risk sk – Co Copp pper  er   

2000 

1600 

1200 

800 

400  1/01/01 

5/21/01 

10/08/01  

C O M P A N Y - C S H A R E P R IC E

2/25/02  C O P P E R P R IC E S  

Share prices mimic the commodity price movements

 

16

Types of Hedges 

Long Hedge  This requires taking a long position in the futures contract 

Appropriate when a certain asset or commodity would be purchased in the future and one is interested in locking in the price now

 

Textile Company would use a long hedge Short Hedge  



This involves a short position in the futures contract Applicable when a hedger already owns an asset and expects to sell it in the future The Aluminum producer would use a short hedge

 

17

Cross Hedge 

Cross Hedge is used to hedge price risk of different but economically related commodities 



Correlation analysis is used

Hedging and cross hedging should only be attempted if the price movements are similar and basis risk is acceptable to the hedger 

 

18

cotto A cot ton n hed hedge ge – an ex examp ample le 



Two varieties of cotton are available for trading on NCDEX NCDEX – J-3 J-34 4 (short (short stapl staple) e) and S-6 S-6 (long (long staple) Suppose, a farmer in Andhra Pradesh producing Buny / Brahma Brahma variety variety (extra long stapl staple) e) wishes wishes to hedge on NCDEX

 

19

Co Cott tton on hed hedge ge - co cont ntin inue ued d S-6 futures market

S-6 spot market

Buny / Brahma spot market

May 25, 2004

Sell one Aug futures (Rs. 6650 66 50//- pe perr quintal

Rs. 67 Rs. 6763 63//- pe perr quintal

Rs. 25 Rs. 2500 00//- pe perr quintal

August 20, 2004

Buy one Aug futures (Rs. 6550 65 50//- pe perr

Rs. 65 Rs. 6550 50//- pe perr quintal

Rs. 24 Rs. 2470 70//- pe perr quintal

Not relevant

Rs. (1620/-)

quintal Net gain (loss) Rs. 1870/-

Ne Nett gai gainn- Rs 18 1870 70-- Rs 16 1620 20= = Rs Rs 250 250

 

20

Co Cott tton on hed hedge ge - co cont ntin inue ued d 





Thus,, we se Thus see e that that the the far farme merr gain gains s Rs. Rs. 250/ 250/-- (p (per er contract) by hedging at NCDEX. 

The loss in the spot market is notional



The futures and spot price for S-6 should move together 



Also, the spot price for S-6 and Brahma / Buny

For hedging to be effective, two things are necessary.

should also move together.

Optimal hedge ratio

 

21

Unbalanced hedge 









The future contract standardized size units do not match the cash position quantity Use combination of regular sizeposition futures and mini acontracts to reach a futures as close as possible to the cash position An over hedged occurs when futures quantity exceeds the cash quantity An under hedged occurs when the cash position exceeds the future quantity The problem can be handled by trying to match quantities as closely as possible

 

22

Unbalanced hedge Cash

Futures

Sold two Buy

625000

Now

Sold Head at

607200

3 Months Later 

Loss

-17800

contracts Bought two contracts

629000 611200 17800

Cash from sale of Gold Cash from Futures

910,800 35,600

Total Cash

946,400

Per pound

630,933

 

23

Rolling Hedge 

When cash position is not known, then a process of hedging with the near contract and rolling the hedge is a common and accepted hedging practice

 

24

Dynamic Hedge 

Dynamic hedging is done on the basis of a price forecast



During periods when favorable price movement is expected, the hedge is held in abeyance



Hedge is entered into when adverse price



movement is expected Exposed to risk if price views turn out incorrect

 

25

Inter-commodity spread 

Price movements between related underlying instruments tend to correlate fairly well and such gains derivatives position may offset lossesininone a related instrument



Companies can hedge their input and output price risk 

Soya oil manufacturers--Soybean and Soya oil



Refiners—Crude and gasoline 



Crack Spread

Exchanges offer an inter-commodity spread discount on initial margin

 

26

Agenda 

Introduction



Hedging Strategies



Diversification Benefits



Practical Problems in Hedging

 

27

Index, Bullion Trends in Nifty, NSE G-Sec Index, 25.0

20.0

15.0

10.0

5.0

0.0

1/1/1997

1/1/1998 Gold/1000

1/1/1999

1/1/2000 NSE Nifty/100

1/1/2001

1/1/2002

G-Sec/10

1/1/2003 Silver/1000

1/1/2004

 

28

Correlation Correlation coefficients in Indian markets Gold Silver  Stocks Bonds

Go1l d

S0i.l0v8e9r 1

S0t.o2c ks 06 -0.099 1

B0.741 onds 0.146 0.112 1

Data: LBMA bullion prices, NSE Nifty, NSE G-Sec Index

Benefit of diversification can be seen from the

Risk Adjusted Returns  

29

Risk-Adjusted Returns Cumulative Returns

Portfolio structure  

100% Stock Portfolio ortfolio

73.70%

Risk of portfolio  

Risk Adjusted Return  

24.43%

47.80%

Stocks (50%) & Gold (50%) Portfolio Stocks (50%) & Silver (50%) Portfolio 100% Gold Portfolio 100% Silver Portfolio 100% 100 % Bonds Portfolio

 

3.017 3.326

14.37%

48.30%

3.634 13.29%

 

21.80% 22.90%

 

25.20%

7.92%

3.182

23.50%

8.79%

2.673

24.00%

6.58%

Bonds (50%) & Gold (50%) Portfolio Bonds (50%) & Silver (50%) Portfolio

2.001 1.742

 

3.647

 

30

Agenda 

Introduction



Hedging Strategies



Diversification Benefits



Practical Problems in Hedging

 

31

Costs of hedging 

There is a risk-return trade-off  



Lack of liquidity in the market resulting in impact cost 



Lower return due to lower risk

Low liquidity results in higher volatility

Margin finance 

Margins are based on volatility



The real cost of hedging is the finance cost of margins



Margins could range from 5% to 50%

 

32

Basis Risk 

Basis is defined as the difference between the cash price and futures price of a commodity. It can be either positive or negative 



Basis Bas is = Spot Spot price price – Fut Future ures s price price

The basis can improve or worsen the position of the hedger  



When a hedger is short futures, increases in the basis creates gains When a hedger is long futures, decreases in the basis creates gains

 

33

Cost of Physical Delivery 

Cost of dematerialization 



Cost of assaying 



Physical verification vs. scientific verification

Cost of accreditation of warehousing 



DP charges related to demat holdings

Own warehouse vs. accredited warehouse

Cost of handling, storage and transportation 

Own warehouse vs. transportation, storage and handling charges of accredited warehouse

 

34

Cost of Physical Delivery on NCDEX NCDEX - Indicati Indicative ve warehouse warehouse charges Commodity

Location

Warehouse

Delivery

Charges to be paid on deposit

Units

(in Rupees) Fixed charges@

Fixed

Warehouse

Testing charges to be paid

Charges Char ges - rate per unit unit per  per 

Directly to assayers (Rs)

Gold

Mumbai

Brinks

Kg

310*

55 per kg

0

260

Silver 

Delhi

Brinks

Kg

610**

1 per kg

0

560

Soy Bean

Indore

MPWLC

MT

110

13 per MT

650

60

Soya Oil

Indore

Jhawa Jhawarr ICS ICS

MT

110

30 per MT

1815

60

Mustard seed

Jaipur 

 ACE India

MT

110

18 per MT

900

60

Mustard oil

Jaipur 

 ACE India

MT

110

42 per MT

2285

60

RBD Palmolein

Kakinada

IMC

MT

110

26 per MT

1000

60

CPO

Kandla

CRPL

MT

110

25 per MT

1625

60

Cotton Cotton - long

 Ahmedabad

Gujcot

Bales

110

6 per Bale

2280

60

Cotton Cotton - medi medium um

Bathinda

PAFCO

Bales

110

6 per Bale

2280

60

Rubber  Rubber 

Kottayam Kochi

KSWC KSWC

MT MT

110 110

36 per MT 36 per MT

50 per MT (i) 50 per MT (i)

60 60

Pepper 

Kochi

KSWC

MT

110

22 per MT

20 per MT (ii)

60

Chana Chan a (Gra (Gram) m)

Delhi

Total Log

MT

110

37.5 per MT

1000

60

Chana Chan a (Gra (Gram) m)

Indore

MPWLC

MT

110

9 per MT

1000

60

Chana Chan a (Gra (Gram) m)

Indore

Jhawa Jhawarr ICS ICS

MT

110

10 per MT

1000

60

Jute Sacking Bags

Kolkata

Tewar Tew arii WH

Bales

110

6.25 per Bale

12 per Bale (iii)

60

Guar seeds

Jodhpur

VCO WH

MT

110

9 per MT

1000

60

 

35

Thank You

 

36

Short Hedge Example Short Hedge in Wheat Futures Cash Market 

Futures Market 

Wheat Price at

193

September 

Sell Wheat at

195

Sell Wheat at

172

April

Buy Wheat at

174

Opportunity loss

21

Gain

Net gain or loss =0

21

 

37

Long Hedge Example Long Hedge in Wheat Futures Cash Market 

Futures Market 

Wheat Price at

143

Buy Wheat at

155

Loss

13

Now

Buy Wheat at

148

3 Months Later  Sell Wheat at

161

Gain

Net gain or loss =0

13

 

38

Basis Example—Long Futures Cash Market 

Futures Market 

Wheat Price at

143

Now

Buy Wheat at

148

-5

Buy Wheat at

155

3 Months Later 

Sell Wheat at

163

-8

15

-3

Loss

12

Gain

Net gain or loss =3

Decrease in basis creates gains in case of a long hedge