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Commodity Hedging

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Mohsin Mohammad
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7 views

Commodity Hedging

Uploaded by

Mohsin Mohammad
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PPTX, PDF, TXT or read online on Scribd
You are on page 1/ 15

Hedging with

Soybean
Futures
Thai Ngo
Kamil Żygadło
Table of contents

01 Introduction

02 Practical Examples

03 Key Takeaways
0
1
Introduction
McDonald’s Chicken McNuggets

• In the 1980s, McDonald’s wanted to introduce chicken to their


menu... McDonald’s were one of two clients that Ray Dalio had at
the time. In an earth-shattering coincidence, Dalio's other client
was a chicken producer.
`
• Dalio mulled over the problem until he came to a realization:
Grown chicken = baby chick + corn + soymeal

• Chicks aren't a volatile commodity in and of themselves. What


producers had to worry about was the cost of the grains they
needed to feed them.

Dalio went to his chicken producer client with a proposition:


What if they entered into a forward contract with corn and soymeal
producers?
What is a Hedge?
• The primary objective is to mitigate the risk of adverse movements
in the price of the underlying asset (the desired price is secured)
• Greater stability for the parties involved (reduction in cash flow
fluctuations) which enables more accurate forecasts
• Allows the parties to prioritize their attention to their main
operations
Commodity hedging is done by taking a position in the futures market
that is opposite to the position in physical market (-1 correlation)
Market Participants
Hedgers are willing to make or take physical delivery because they are
producers or users of the commodity:
 Farmers, livestock producers
 Merchandisers, elevators
 Food processors, feed manufacturers
 Exporters
 Importers
Commodity Hedging Strategy
Short Hedge Long Hedge
Situation: Producers with a commodity to sell Situation: Processors need to buy raw
some time in the future. Hurt by a price materials some time in the future. Hurt by a
decline. price increase.

Actions: Sell the futures contract initially. Buy Actions: Buy the futures contract initially. Sell
the futures when settled (close-out/de-hedge) the futures when settled (off-set)

Example: Soybean producer expected to sell Example: Chicken producer expected will buy
25,000 bushels in November 50,000 bushels of corn in December

They are already long their positions (as they They are shorting their corn (as they will use
are ready producing soy). They need to create corn). They need to create an equal and
an equal and opposite position opposite position

 Sell 5 November soybean futures contracts  Buy 10 December corn futures contracts
(each contracts is 5,000 bushels) (each contracts is 5,000 bushels)
As prices increase (decline), the As prices Increase (decline), the
futures positions loses (gains) value -> futures positions gains (loss) value ->
Straddle Straddle
Disadvantages of hedging with futures

• Basis risk
• As futures are standardized, the exact requirements of a
party may not be satisfied (related to basis risk)
• The clearing house/exchange requires an initial margin and
can potentially issue margin calls
• Commissions/rolling costs
• Potential of lost profits
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2
Practical Examples
Perfect hedge (e.g. 90,000 bushels, soybeans
price ↓)bushels
1 contract = 5,000 Producer (possesses assets) Consumer (doesn’t possess assets)

Bushel spot price today $11.70 $11.70

Value of assets $1,053,000 (long) $1,053,000 (short)

Bushel futures price today $11.75 $11.75

Futures contract price $58,750 (short) $58,750 (long)

Bushel spot price later $10.80 $10.80

Value of assets $972,000 (short) $972,000 (long)

Assets profit/loss ($81,000) $81,000

Bushel futures price later $10.85 $10.85

Futures contract price later $54,250 (long) $54,250 (short)

Futures profit/loss $81,000 ($81,000)

Hedged profit/loss $0.00 $0.00


Perfect hedge (e.g. 90,000 bushels, soybeans
price ↑)bushels
1 contract = 5,000 Producer (possesses assets) Consumer (doesn’t possess assets)

Bushel spot price today $11.70 $11.70

Value of assets $1,053,000 (long) $1,053,000 (short)

Bushel futures price today $11.75 $11.75

Futures contract price $58,750 (short) $58,750 (long)

Bushel spot price later $12.10 $12.10

Value of assets $1,089,000 (short) $1,089,000 (long)

Assets profit/loss $36,000 ($36,000)

Bushel futures price later $12.15 $12.15

Futures contract price later $60,750 (long) $60,750 (short)

Futures profit/loss ($36,000) $36,000

Hedged profit/loss $0.00 $0.00


Good hedge (e.g. 90,000 bushels, soybeans
price ↑)bushels
1 contract = 5,000 Producer (possesses assets) Consumer (doesn’t possess assets)

Bushel spot price today $11.70 $11.70

Value of assets $1,053,000 (long) $1,053,000 (short)

Bushel futures price today $11.75 $11.75

Futures contract price $58,750 (short) $58,750 (long)

Bushel spot price later $14.70 $14.70

Value of assets $1,323,000 (short) $1,323,000 (long)

Assets profit/loss $270,000 ($270,000)

Bushel futures price later $14.76 $14.76

Futures contract price later $73,800 (long) $73,800 (short)

Futures profit/loss ($270,900) $270,900

Hedged profit/loss ($900) $900


Good hedge (e.g. 90,000 bushels, soybeans
price ↓)bushels
1 contract = 5,000 Producer (possesses assets) Consumer (doesn’t possess assets)

Bushel spot price today $11.70 $11.70

Value of assets $1,053,000 (long) $1,053,000 (short)

Bushel futures price today $11.75 $11.75

Futures contract price $58,750 (short) $58,750 (long)

Bushel spot price later $8.70 $8.70

Value of assets $783,000 (short) $783,000 (long)

Assets profit/loss ($270,000) $270,000

Bushel futures price later $8.76 $8.76

Futures contract price later $43,800 (long) $43,800 (short)

Futures profit/loss $269,100 ($269,100)

Hedged profit/loss ($900) $900


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3
Key Takeaways
What to remember
• The main purpose of hedging is to reduce the impact of price
volatility
• For short futures, if the underlying asset’s price decreases, then
the profit from the futures contract/-s offsets the cash loss and
vice versa
• Realistically, perfect hedges are uncommon therefore must be
vigilant
• A loss on a hedge is still a good hedge if compared to potential
outcomes

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