Effectve #-- EDGE pearect AND INT - ge sf dort and Jong nee by the niga mill and oases 10 the SDE e sly, the hedging inated OF the sugar nities venice! plant respec velys nd losses in the futures and Le ae ‘ical contract offers & roche! * Fite in exact offsoltoe oe ct hedge. It was not so for Petrochem; itions in the physical market and the futures ae ‘te, and therefore the gains or losses with the changing prices See also be opposite. The hedge where Joss in the physical market is fully of the gains in the position in the futures market and vice versa is Talbiea, perfect hedge as depicted in Figure 3.1. as ct hedge because the price under the forw; ard 'A forward contract is a perfe contract is fitm. The hedge with futures market is rarely perfect. The effe 7 lective price under futures hedge would be close to the futures contract pric e when Scanned with CamScanner‘Commodity Futures 69 initial position is set up. The gains or losses in the futures do m: Wot exactly offset the lose/gnins in the phyateal market because of the following rene 1, The exposure in the underlying und fututes market is not on the identical asset of same quality and therefore changes in the prices iq in two markets are not identical. + The value of exposure in the underlying and the futures do not match exactly because size of the futures contract is standardized, The time of maturity of the futures contract is not same as the time of exposure in the physical position because maturities of futures contract are specific. ‘Short on underlying Gi Long on futures: ain Gain in physical , market Loss in futures market Loss | The Perfect Hedge Mismatch of Asset and Quality Futures hedge is It is not necessary that the futures contract on same asset on which price risk imperfect dueto is to be covered, is available. For example, a sugarcane grower cannot cover mismatch of 4 Price risk of his produce ifthe futures contract on siigarcane is not available. It inpleme does not mean to suggest that no hedging is possible under the situation of inthe physical NON-availability of the futures contract on the commodity. One has to find a and futures commodity that is available through futures, and has a positive or negative Position. correlation with the prices of the commodity to be hedged. The effectiveness of the hedge will depend upon the degree of correlation in Prices of the com- modity and the futures contract. If correlation between the two commodities is perfect, the hedge could be perfect. In the case of the sugarcane grower the hedge is possible through the futures contract available on sugar, as prices of sugarcane aind sugar go hand in hand. A hedge executed through a futures contract on an asset different than the underlying asset is referred to as cross hedge. Scanned with CamScanner70 Derivatives and Risk Management The mismatch in assets also covers the differences in quality of commodities. Different qualities of sugar are sold with different prices, and futures contracts on all qualities may not be available. However, as long as there is a correlation of prices there is no cause to worry and an effective hedge can be set up. Mismatch of Quantities Another reason that leads to deviations from a perfect hedge is the inability to cover the exact quantity of the asset to be hedged. As is known, futures contracts are standardized in terms of quantity. For example, one standard contract of sugar futures is of 10 MT. Quantity that is not a multiple of 10 MT cannot be hedged exactly. If the sugar mill wanted to hedge 95 MT it had a choice of booking either 9 or 10 contracts for hedging. It would either be underhedged or overhedged. Even if the price changes are identical, the hedge may be sub-optimal because the exposures in two markets do not match. Mismatch of Period of Hedging Since the futures contracts are also standardized with respect to the delivery dates the exact matching of period to hedge cannot be achieved except by coincidence. For example, if the sugar mill wanted to hedge against the price risk till 30 April, it cannot do so because the April contract expires on 20 April. The sugar mill may have the choice to book a futures contract for April or May, which may expire on 20 May, or take position on April futures contract. If it books April contract the position remains exposed for the period from 20 to 30 April. By booking May contract the period of exposure in the assets is covered. But while exiting the May contract the convergence of prices in the physical and financial markets would not be happening, leaving losses and gains unequal in the two markets. Also, beyond the date of liquidation of asset on 30 April and continuing to keep the position in futures open ‘amounts to speculation. iste Despite imperfect hedge in futures and perfect hedge in forwards, is it necessary that forward hedge be preferred over futures hedge? The evalus- tion needs to be based on costs and benefits of each. The transaction cost in futures is extremely nominal and transparent. It offers flexibility of entry and exit at any time with ease, On the other hand, forward contracts have larger “transaction cost in the. form of bid-ask, spread, and are non-transparent as * they change from customer to. customer, and do not offer convenient entry and exit from the hedge. Scanned with CamScannerstatic and Dynamic Hedging a caeee 69 Hedging could be either static or dynamic, In static hedging, the company that Is Dee asain would enter the futures market and keep the contract til ite maturity if the end fa ty same 96 the maturity ofthe futures-—or close to the end-of exposure date-—if the sounenity fli thar sndror cabosure date, The main idea in static hedging is to hedge the price risk s0 cae flow are certain. Static hedgers do not worry about possible losses they may have made eee However? dina pastes ned8ing the original hedge would be undertaken fo a given maturity a . as time passes by, the he. {fie presumptions about es ‘dger will observe the price movements and make specifi bai aa wrouiidl tale the future price movements on the basis of dereagl av supply, market conditions, ee and woul oat deeper calcally a8 to how long the position needs to be hedged and the extent sha trey inooree sare annul hedged. In dynamic hedging, the hedge position eas chenge over time. Thi i ‘h We te aedaer has sophisticated knowledge ofthe stderiyin seat mr ket, Dynamalc hedging Is mucl "skier than static hedging, butt the hedge the hedges such t is knowledgeable about the market, they may be able to time hat hedging losses can be minimized, 6.10 Strip Hedges and Stack Rolling Hedges Ahedger may have commit; example, WIPRO might be this case, WIPRO will ente expiry every month. This i periodic amounts and hed; ‘ments to either buy or sell a commodity at different tines daring she yee zor ceiving USD 200,000 at the end of every month for the next six months. * into elther a forward contract or a futures contract for USD 200,000, with * Known as strip hedging. The total amount for the whole yeat is stripped into 'ging is done for each stripped amount. Scanned with CamScannerIna stack rolling hedge, the whole exposure will be hedged using the near-month contract. For exam, ple, WIPRO will hedge the total amount of USD 1,200,000 that will be received over the next six months with a forward or a futures contract with expiry in one month. When this contract expires, TPR i roll over the remaining hedge amount of USD 1,000,000 with a forward or a futures contrac! With expiry in one month. Since the amount hedged is different from the amount of exposurt bt ty fat Month, WIPRO is subject to basis risk if it follows a stack rolling hedge. A stack rolling he a viturtty of the nas when the hedging horizon is larger than, or the end-of-exposure date is after, a contracts available. Scanned with CamScanner