VII: Futures 22: Hedging, Speculation, and Arbitrage.

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


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


Hedge

An investment that offsets this risk Short soybeans Short Soybean futures


Hedge Strategy

If soybean prices increase Long Spot J Short Futures L

If soybean prices decrease Long Spot L Short Futures J

K

K


Hedge Strategy

Use November Futures

November contracts deliver

plantOctober ?

harvest

SetHedge

Spot risk

LiftHedge

Offsetting futures risk


Set the Hedge

George sets the hedge in April Spot price: $4.20/bu Futures price: 431 Basis (spot-futures) = -11¢


Set the Hedge

Set the hedge in April

November contracts

deliver

$4.20

October ?harvest

431Lift

Hedge

-11¢


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


Scenario 1: Textbook Hedge

George harvests October 1 Spot price: $4.00/bu Futures price: 411 Basis (spot-futures) = -11¢


Lift Hedge


$4.00$4.20

411

-11¢

431

-11¢


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


Lift the Hedge

Textbook Hedge

Spot price: $4.20 $4.00

price: 431 price: 411


Scenario 2: Not quite a Textbook Hedge



Lift the Hedge


$5.00$4.20

508

-11¢

431

-8¢


George Q. Farmer


Margin:

Hedge is lifted


Margin:Profit:


Net Income:

Lift the Hedge


Lift the Hedge

Not quite a Textbook Hedge

Spot price: $4.20 $5.00



Hedge

Once the hedge is set George trades his Price Risk for Basis Risk


Scenario 3: Not quite a Textbook Hedge



Lift Hedge


$1.00$4.20

105

-11¢

431

-5¢


George Q. Farmer


Margin:

Hedge is lifted


Margin:Profit:


Net Income:

Lift the Hedge


Lift the Hedge

Trade Price Risk for Basis Risk

Spot price: $4.20 $1.00



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.


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


Set the Hedge

December contracts deliver

$2.00

+5¢

195


George Q. Farmer

Hedge is set

Set the Hedge


Lift the Hedge

In October Spot corn is /bushel December corn futures trade at


Set the Hedge

December contracts deliver

$2.00

+5¢

195


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


Set the Hedge


$2.00

+5¢

195

Futures II

VII: Futures 22: Hedging, Speculation, and Arbitrage.

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