Post on 22-Dec-2015
VII: Futures
22: Hedging, Speculation, and Arbitrage
Chapter 22: Hedges, Speculation, and Arbitrage © Oltheten & Waspi 2012
Futures
Hedge use futures to reduce risk on an existing
position Speculate
use futures to take on risk in the hope of making a profit
Arbitrage Use the difference between spot and futures
prices to generate risk-free profit
Chapter 22: Hedges, Speculation, and Arbitrage © Oltheten & Waspi 2012
Hedge
Identify the existing risk 50,000 bushels of
soybeans growing in the fields
The current price of $4.20/bushel can change before George can harvest & sell
Chapter 22: Hedges, Speculation, and Arbitrage
Existing Risk: Long soybeans
$180,000
$190,000
$200,000
$210,000
$220,000
$230,000
$240,000
360 380 400 420 440 460 480Price (Soybeans Spot)
Inco
me
© Oltheten & Waspi 2012
Chapter 22: Hedges, Speculation, and Arbitrage © Oltheten & Waspi 2012
Hedge
An investment that offsets this risk Short soybeans Short Soybean futures
Chapter 22: Hedges, Speculation, and Arbitrage © Oltheten & Waspi 2012
Hedge Strategy
If soybean prices increase Long Spot J Short Futures L
If soybean prices decrease Long Spot L Short Futures J
K
K
Chapter 22: Hedges, Speculation, and Arbitrage © Oltheten & Waspi 2012
Hedge Strategy
Use November Futures
November contracts deliver
plantOctober ?
harvest
SetHedge
Spot risk
LiftHedge
Offsetting futures risk
Chapter 22: Hedges, Speculation, and Arbitrage © Oltheten & Waspi 2012
Set the Hedge
George sets the hedge in April Spot price: $4.20/bu Futures price: 431 Basis (spot-futures) = -11¢
Chapter 22: Hedges, Speculation, and Arbitrage © Oltheten & Waspi 2012
Set the Hedge
Set the hedge in April
November contracts
deliver
$4.20
October ?harvest
431Lift
Hedge
-11¢
Chapter 22: Hedges, Speculation, and Arbitrage © Oltheten & Waspi 2012
George Q. Farmer
Hedge is set
Set the Hedge
Long Position (spot)
Short Position (futures)
431
-$50,000
$0
$50,000
$100,000
$150,000
$200,000
$250,000
360 380 400 420 440 460 480
Price (Soybeans Spot)
Inco
me
Short Position
Long Position
Chapter 22: Hedges, Speculation, and Arbitrage © Oltheten & Waspi 2012
Scenario 1: Textbook Hedge
George harvests October 1 Spot price: $4.00/bu Futures price: 411 Basis (spot-futures) = -11¢
Chapter 22: Hedges, Speculation, and Arbitrage © Oltheten & Waspi 2012
Lift Hedge
November contracts deliver
$4.00$4.20
411
-11¢
431
-11¢
Chapter 22: Hedges, Speculation, and Arbitrage © Oltheten & Waspi 2012
George Q. Farmer
Hedge is set Sell 10 November futures @ 431[10*5,000*431 = $215,500]
Margin:
Hedge is lifted
Buy 10 November futures @ 411[10*5,000*411 = $205,500]
Margin:Profit:
Sell 50,000 soybeans spot @$4.00
Net Income:
Lift the Hedge
Chapter 22: Hedges, Speculation, and Arbitrage © Oltheten & Waspi 2012
Lift the Hedge
Textbook Hedge
Spot price: $4.20 $4.00
price: 431 price: 411
Chapter 22: Hedges, Speculation, and Arbitrage © Oltheten & Waspi 2012
Scenario 2: Not quite a Textbook Hedge
George harvests October 1 Spot price: $5.00/bu Futures price: 508 Basis (spot-futures) = -8¢
Chapter 22: Hedges, Speculation, and Arbitrage © Oltheten & Waspi 2012
Lift the Hedge
November contracts deliver
$5.00$4.20
508
-11¢
431
-8¢
Chapter 22: Hedges, Speculation, and Arbitrage © Oltheten & Waspi 2012
George Q. Farmer
Hedge is set Sell 10 November futures @ 431[10*5,000*431 = $215,500]
Margin:
Hedge is lifted
Buy 10 November futures @ 508[10*5,000*508 = $254,000]
Margin:Profit:
Sell 50,000 soybeans spot @$5.00
Net Income:
Lift the Hedge
Chapter 22: Hedges, Speculation, and Arbitrage © Oltheten & Waspi 2012
Lift the Hedge
Not quite a Textbook Hedge
Spot price: $4.20 $5.00
price: 431 price: 508
Chapter 22: Hedges, Speculation, and Arbitrage © Oltheten & Waspi 2012
Hedge
Once the hedge is set George trades his Price Risk for Basis Risk
Chapter 22: Hedges, Speculation, and Arbitrage © Oltheten & Waspi 2012
Scenario 3: Not quite a Textbook Hedge
George harvests October 1 Spot price: $1.00/bu Futures price: 105 Basis (spot-futures) = -5¢
Chapter 22: Hedges, Speculation, and Arbitrage © Oltheten & Waspi 2012
Lift Hedge
November contracts deliver
$1.00$4.20
105
-11¢
431
-5¢
Chapter 22: Hedges, Speculation, and Arbitrage © Oltheten & Waspi 2012
George Q. Farmer
Hedge is set Sell 10 November futures @ 431[10*5,000*431 = $215,500]
Margin:
Hedge is lifted
Buy 10 November futures @ 105[10*5,000*105 = $52,500]
Margin:Profit:
Sell 50,000 soybeans spot @$1.00
Net Income:
Lift the Hedge
Chapter 22: Hedges, Speculation, and Arbitrage © Oltheten & Waspi 2012
Lift the Hedge
Trade Price Risk for Basis Risk
Spot price: $4.20 $1.00
price: 431 price: 105
Chapter 22: Hedges, Speculation, and Arbitrage © Oltheten & Waspi 2012
Hedge
George also grows corn (10,000 bushels) Futures contracts defined as
5,000 bushels Cents per bushel Corn futures deliver March, May, July,
September, & December.
Chapter 22: Hedges, Speculation, and Arbitrage © Oltheten & Waspi 2012
Set the Hedge
In April Spot corn is $2.00/bushel December corn futures trade at 195 Margin requirements at $400 and $300 per
contract
Chapter 22: Hedges, Speculation, and Arbitrage © Oltheten & Waspi 2012
Set the Hedge
December contracts deliver
$2.00
+5¢
195
Chapter 22: Hedges, Speculation, and Arbitrage © Oltheten & Waspi 2012
George Q. Farmer
Hedge is set
Set the Hedge
Chapter 22: Hedges, Speculation, and Arbitrage © Oltheten & Waspi 2012
Lift the Hedge
In October Spot corn is /bushel December corn futures trade at
Chapter 22: Hedges, Speculation, and Arbitrage © Oltheten & Waspi 2012
Set the Hedge
December contracts deliver
$2.00
+5¢
195
Chapter 22: Hedges, Speculation, and Arbitrage © Oltheten & Waspi 2012
George Q. Farmer
Hedge is set Sell 2 December futures @ 195[2*5,000*195 = $19,500]
Margin:
Hedge is lifted
Net Income:
Lift the Hedge
Chapter 22: Hedges, Speculation, and Arbitrage © Oltheten & Waspi 2012
Set the Hedge
November contracts deliver
$2.00
+5¢
195
Futures II