EXAMPLE 3.

3 Long hedge
Today is 24 March. Arefinery needs 1075 barels of crude oil in the month of September. The current price of crude oil is 23000
per barrel. September tutures contracts at MCX are trading at 3200. The firm expects the price to go up further, and even beyond
T3200 in September. It has the option of buying the stock now. Aternatively, it can hedge through a futures contract. The size of
futures contract is 100 barrels.
(a) If the cost of capital, insurance, and storage is 15% p.a., examine whether it is beneficial for the firm to buy now.
(b) Instead, if the upper limit to buying price is (3200, what strategy can the firm adopt?
(c) If the firm decides to hedge through futures, find out the effective price it would pay for crude oilif at the time of lifting the
hedge the spot and futures prices are () *2900 and 2910, respectively. (iü) 23300 and *3315, respetively.
Solution
(a) If the cost of carry (including interest, insurance, and storage) is 15%, the fair price of the futures contract is
S, e =s000 e o15 = 3233.65. It implies that if the firm buys crude oil today to be used after six months, it would
effectively cost 3233.65 per barrel.
(b) Since futures are trading at t3200, it can lockin the price of around 3200 through along hedge. Under a long hedge, the firm
would buy the futures on crude oil today and selit six months later, while simultaneously meeting the physical requirements
r
from the market at the price prevailing at that time. Irrespective of the price six months later, the firm would end up paying a
price of around 3200.
(c) IH the firm adopts the strategy mentioned in (b), the effective price to be paid by the firm in the two cases of rise and fall in
spot values is calculated as follows:
Quantity of crude oil to be hedged = 1,075 barrels
Size of one futures contract =100 barrels
Number of futures contracts bought 1,075/100 = 11 contracts
Futures price =73,200
Value of futures bought = 3,200 >x 11 x 100 =35.20,000
Six months later, the firm would unwind its futures position and buy its requirement from the spot market.

Futures sold at price 2,910 3,315

Value of futures sold 32,01,000 36,46,500
Gain/Loss on futures -3,19,000 1,26,500
Spot price 2,900 3,300
Actual cost of buying 1,075 barrels 31,17,500 35,47,500
Efective cost of buying 34,36,500 34,21,000
Etfective pricé 3,197 3,182
EXAMPLE 3.4 Basis risk
What
From the data of Example 3.3, the effective price worked out to 3197 and 3182 as against the target price of 3200.
you attribute to each
are the reasons for variation in the actual price paid and the target price, and how much variation would
reason?
Solution
The difference between the target price and the price actually paid is due to basis, which is attributable to (a) mismatch of assets,
(b) mismatch of timing, and (c) mismatch of quantity in the futures market and the spot market.
Mismatch of asset quality There is no mismatch of assets, as a futures contract on crude oil was available and the same was
and the futures market.
required in the spot market. Therefore, there is no mismatch of quality of the asset in the spot market
same time,
Mismatch of timing If the futures contract was maturing and the asset was to be bought in the physical market at the
have been zero. Due to mismatch of
then the prices in the spot and the futures would have been identical, i.e., basis would then
to mismatch of timing is:
timing, the prices would differ by the amount of basis at the end of the hedge. The price differential due
Effective price paid = S, + Fo-F=Fo-(F- S,) = Fo-basis when hedge is lited
When price declined =3,200-(2,910 - 2,900) =R3,190 per barrel
When price increased =3200 (3,315 3,300) =3,185 per barrel
attributable to mismatch of quantity. The
Mismatch of quantity The remaining difference between the spot and forwards prices is
in the futures was 1100 barrels, ie.. 11 contracts
actual requirement of quantity was 1075 barrels, whereas the position taken
of 100 barrels each.
 Ity utureS

EXAMPLE 3.5 Cross hedge and hedge ratio

Asugarcane trader is expecting a stock of 200 MT from various farmers to be available to him
after three months,
the normal course, the prices of sugarane in the month of April remain at 80 per quintal (3800MT). As a burnpernext April. In
Crop is anticipated, he is woried about a fall in prices. Futures contracts in sugarcane are not available. However, sugarcane
futures in
sugar are available, and 3-m contracts of 10 MT each are selling for 800 per quintal (R8000/MT). How can the trader hedge his
position using futures contracts in sugar, assuming the prices of sugar and sugarcane are perfectly and positively
correlated?
Solution
Hedging strategy
Futures contracts in sugarcane are not available. Hence, the trader has to hedge his position by using a cross hedge. He can
hedge bytaking an opposite position in futures. Since the trader is long on thêasset, he has to go shorton iuturès. Therefore, the
trader sells the 3-m futures contracts on sügar now andbüys the samie contracts back after three months, just prior to maturity.
The number of contracts to be traded willdepend upon the hedge ratio or the sensitivitj of prices of the asset to be hedged to
the prices of the futures contract.
When the prices of sugarcane and sugar change equally, then
Value to be hedged 200 X 800
Number of contracts to be sold on
Value of future contract 10 × 8,000
The prices of sugarcane and sugar are perfectly positively correlated. Changes in sugarcane prices will be just as much as
1
changes in sugar prices. The price of sugarcane, therefore, must beof
10
sugar, i.e., Z88 per quintal (*880 per tonne)/ 72 per
quintal (720 per tonne) for a 10% change in the price of sugar. The hedging outcome for 10% increase/decrease in prices is
as below:
Prices rise by 10%, 7 Prices fal by 10%,3
Value of futures contracts sold 1,60,000 v 1,60,000
Value of futures contracts bought 1,76.000 1,44,000 V
Profitloss on the futures market -16,000 +16,000
Spot sale of sugarcane (quantity × price) = 200 X 880 1,76,000
200 × 720 1,44,000
Total value realized 1,60,000 1,60,000
EXAMPLE 3.6 Cross hedge and hedge ratio
strategy change if (a) the price of sugarcane changes by half as much as that of
Refer to Example 3.5. How would the hedging much as that of sugar?
by twice as
sugar, and (b) the price of sugarcane changes in price?
How can the trader immunize himself from the changes
Solution
(a) Hedging strategy:
When the price of sugarcane changes by half of that of sugar
No. of contracts to be sold - 0.5 x value to be hedged or
Value of future contract
0.5 X 200 × 800
10 X 8,000
The prices of sugarcane and sugar are positively correlated. The change in the sugarcane price will be half as much as the
change in the sugar price. The price of sugarcane, therefore, must be 5% moreless than expected, i.e, 784 per quintal (*840
per tonne)/ 76 per quintal (*760 per tonne) for a 10% change in the price of sugar. The hedging out come is as below:
Prices rise by 10%, 7Prices fall by 10%,7
Value of futures contracts sold 80,000 80,000
Value of futures contracts bought 88,000 72,000
Profit/loss on the futures market -8,000 +8,000
Spot sale of sugarcane (quantity X price) 200 X 840 1,68,000
=200 X 760 1,52,000
Total value realized 1,60,000 1,60,000
(b) When the price of sugarcane is twice that of sugar
No. of contracts to be sold 2 X value to be hedged or.
Value of future contract
2x 200 800
10 x 8,000
The prices of sugarcane and sSugar are positively
as the change in the sugar price. The price of
correlated. The change in the sugarcane price wil be twice as much
quintal (3960 per sugarcane, therefore, must be 20% more/less than expected, i.e., 796 per
tonne)/Z64
per quintal (*640 per tonne) for a 10% change in the price of
is as below: sugar. The hedging out com

Value of futures contracts sold Prices rise by 10%, ? Prices fall by 10%,?
Value of futures contracts bought 3,20,000 3,20,000
Profit/loss on the futures market 3.52,000 2,88,000
Spot sale of sugarcane (quantity X price) = -32,000 +32,000
200 x 960 1,92,000
200 × 640
Total value realized 1.28.000
1,60,000 1,60,000
Note that when sugarcane price
change only half
contracts to one contract. When sugarcane price as much as that of sugar the
changed twice as much, the hedgehedge ratio dropped to half from two
ratio doubled from two to four.
SOLVED PROBLEMS
SP 3.1: Short hedge with commodity futures
of jute is 1900 per ka
Ajute packaging unit has planned production of 4300 kg of jute to be sold six months later. The spot price
and a 6-m futures on the same is trading at 1850 per kg. The prices are expected to fall as low as ?1700/kg six months later.
What can the jute packaging unit do to mitigate its risk of reduced profit? If it decides to make use of the futures market, what
would the eftective realized price for the sale of jute be when the spot and futures prices were 1750 and *1755, respectively?
Assume size of futures contract as 200 kgs.
Solution
In order to hedge. the firm would go short on futures at the current futures price of R1850. By doing so the firm ensures a price
realization of around ?1850 per kg irrespective of the spot price prevailing at the end of six months.
Quantity of jute to be hedged 4300 kg
Size of one futures contract 200 kg
No. of futures contracts sold 4300 200 22 contracts
Futures price =1850
Value of futures sold 1850 × 22 X 200
=81,40,000
6&7 Souce: Business Line, 29 September 2005.
 Commodity Futures 81

Six months later, the firm would unwind its futures position by buying the futures contract back and selling the goods in the spot
market.

Futures bought at price 1755

Amount bought for 22 contracts 77,22,000
Gain/losS on futures 4,18,000
Spot price 1750
Actual cost of selling 4300 kg 75,25,000
Total value realised after hedge 79,43,000
Elfective price realised 1847

SP 3.2: Speculation with commodity futures

on sugar with three months to maturity is
Atrader in sugar is extremely bullish wth the current price at 25 per ka. Afutures contract
trading at 28 per kg. One contract in sugar is for 1000 kg, with a 10% margin.
expected to rise by 20% in three months?
(a) With funds of 1,00,000 available, what could the strategy of the trader be if the price is the strategy be more profitable?
(b) At what minimum expected price after three months of taking a position in futures would
(c) What happens if the price of sugar actually fell to 24 per kg?
Solution
(a) buy sugar in the spot market, store, and sell after three
Since the prices of sugar are likely to go up, the trader has two options months later.
months at a higher price, (b) buy sugar futures now and sell them three
Spot - 25.00 Futures = 128.00
(a) Price now: Futures= Spot = 30.00
Price three months later Spot 730.00
Dealing in the spot market: = 4000 kg
Amount of stock of sugar that can be bought = 1,00,000/25
= 20% x 1,00,000 =20,000
Profit at the end of three months
Dealing with futures market: = 28.000
= 28 X 1000
Value of one contract = 0.10 >X 28,000 = 2800
Margin required = 1,00,000/2800 35 (rounded off)
No. of contracts that can be bought =35,000 kg
Exposure in sugar = (30-28) × 35 × 1000 70,000
Profit on 35 contracts with price rise of 20% and
kg at 25 while a futures position is 35,000 kq at 28. With cash
b) With the same amount of funds, the cash position is 4000 the following
in futures position to exceed the cash position,
futures price equal at the end of three months at X, for the profit
must hold:
(X-28) X 35,000 (X-25) X 4000
X> 28.39
the expected price must exceed R28.39/ka.
For a speculative position to be more profitable,
c) If the price actually fell to 24
= 1X 4000 = 74000
Loss in cash position = 4 X 35,000 = 1,40,000
Loss in futures position
SP 3.3: Calendar spread with commodity futures 3200,
crude oil is Z3000 per barrel. In the futures market, 3-m and 6-m contracts are trading at 3125 and
Tne spot price of the following:
insurance, is 15% p.a. If the cost of carry model applies, find
Tespectively. The cost of carry inclusive of storage and in this situation?
price of the futures contracts for three months and six months. What action can an artbitrageur take
(a) Fair would the profit to the
end of three months the spot price were 3500 and the futures market stood corrected, what
0) at the
arbitrageur be? would the profit to the
end of three months the soot price were 2700 and the futures market stood corrected, what
(C) I at the
arbitrageur be?
82 Derivatives and Risk Managemnent

Solution
(a) The fair price of 3-m and 6-m futures with cost of carry of 15% and spot value of 3000 is
F S, x e= 3000x e15 x312 = 3114.64 Actual pice = 3125 ~
Fs = S, x e=3000 x 15 x612 = R3233.65 Actual price = *3200
An arbitrageur would act as follows:
() The 3-m futures are overvalued and must be sold.
(ü) The 6-m futures are undervalued and must be bought.
(b) futures
If at thewould
end ofbethree months the spot price increased to *3500 and the future prices stand corrected, then the fair values of
3500 and 73634 at which the arbitrageur squares off. His position would be
Original 3-m futures
Sold at 3125 Bought at 73500 Profit/loss -*375
Original 6-m futures
Bought at T3200 Sold at 73634 Profit/loss +7434
Net profit on the calendar spread 759
(c) If at the end of three months the spot price decreased to 2700 and the future prices stand corrected, then the fair values of
futures would be 2700 and R2803, at which the investor squares off. The position of the investor would be:
Original 3-m futures
Sold at 73125 Bought at 2700 Profit/loss +7425
Original 6-m futures
Bought at 73200 Sold at
Net profit on the calendar spread 28
2803 Profitloss 397