Lecture 4. Companies have risk Manufacturing Risk - variable costs Financial Risk - Interest rate...
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Derivatives Lecture 4
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Transcript of Lecture 4. Companies have risk Manufacturing Risk - variable costs Financial Risk - Interest rate...
DerivativesLecture 4
Companies have riskManufacturing Risk - variable costsFinancial Risk - Interest rate changes
Goal - Eliminate risk
HOW?Hedging & Futures Contracts
Futures, Hedging & Risk Management
Kellogg’s produces cereal. A major input and variable cost is sugar. The price of a box of cereal is inflexible (i.e. it
has an elastic demand function). Kellogg’s is naturally “short” in sugar “short” = a requirement to buy the
commodity in the future.
Example – Cereal Production
Profit Scenario for Kellogg’s
Revenue-costs This is variable
Profits
Example – Cereal Production (continued)
Asset Price
Profit
Loss
• To hedge their natural position, Kellogg’s will enter into a long futures / forward contract
Short sugar Long Futures / Forward Contract
• Natural profit / loss position
Example – Cereal Production (continued)
Asset Price
Profit
Loss
NET POSITION
Example – Cereal Production (continued)
Asset Price
Profit
Loss
Farmer’s view
Short Forward / futures
Long sugarProfit Scenario for Farmer
Revenue This is variable -costs Profits
Example – Cereal Production (continued)
Together
Long Hedger
Natural position: Short sugar
Risk: Purchase price of sugar
Hedge: Long contract
Short Hedger
Natural position: Long sugar
Risk: Sales price of sugar
Hedge: Short contract
You are an Illinois farmer. You planted 100 acres of wheat this week, and plan on harvesting 20,000 bushels in March. If today’s futures wheat price is $1.56 per bushel, and you would like to lock in that price, what would you do?
Since you are long in Wheat, you will need to go short on March wheat. Since1 contract= 5,000 bushels, you should short four contracts today and close your position in March.
Example: Wheat Hedge
Example: Commodity Hedge
In June, farmer John Smith expects to harvest 10,000 bushels of corn during the month of August. In June, the September corn futures are selling for $2.94 per bushel (1K = 5,000 bushels). Farmer Smith wishes to lock in this price.
Show the transactions if the Sept spot price drops to $2.80.
Revenue from Crop: 10,000 x 2.80 28,000
June: Short 2K @ 2.94 = 29,400
Sept: Long 2K @ 2.80 = 28,000 .
Gain on Position------------------------------- 1,400
Total Revenue $ 29,400
Example: Commodity Hedge
In June, farmer John Smith expects to harvest 10,000 bushels of corn during the month of August. In June, the September corn futures are selling for $2.94 per bushel (1K = 5,000 bushels). Farmer Smith wishes to lock in this price.
Show the transactions if the Sept spot price rises to $3.05.
Revenue from Crop: 10,000 x 3.05 30,500
June: Short 2K @ 2.94 = 29,400
Sept: Long 2K @ 3.05 = 30,500 .
Gain on Position------------------------------- -1,100
Total Revenue $ 29,400
Fundamentals of Futures and Options Markets, 6th Edition,
Copyright © John C. Hull 20072.
11
Convergence of Futures to Spot Basis Risk
Time Time
(a) (b)
FuturesPrice
FuturesPrice
Spot Price
Spot Price
Basis Risk = Spread between the Futures Price and Spot Price
Fundamentals of Futures and Options Markets, 6th Edition,
Copyright © John C. Hull 2007
3.12
Convergence of Futures to Spot(Hedge initiated at time t1 and closed out at time t2)
Time
Spot Price
FuturesPrice
t1 t2
Basis Strengthens
Spread between spot price and futures price gets smaller
Basis Weakens
Spread between spot price and futures price gets larger
