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Hedging&FuturesTodayWewillreturntoCapitalBudgeting&Financing.Wewilldiscusshowtoreducerisk.TopicsHowtoeliminateriskincapitalbudgeting.(i.e.variablecosts)Howtoeliminateriskinfinancing(erestratefluctuations)HOW?ByHedging&FuturesContractsHedging&FuturesToday1Ex-CerealProductionEx-Kelloggproducescereal.Amajorcomponentandcostfactorissugar.Forecastedincome&salesvolumeissetbyusingafixedsellingprice.Changesincostcanimpacttheseforecasts.Tofixyoursugarcosts,youwouldideallyliketopurchaseallyoursugartoday,sinceyouliketoday’sprice,andmadeyourforecastsbasedonit.But,youcannot.Youcan,however,signacontracttopurchasesugaratvariouspointsinthefutureforapricenegotiatedtoday.Thiscontractiscalleda“ForwardContract.”Thistechniqueofmanagingyoursugarcostsiscalled“Hedging.”Ex-CerealProductionEx-Kel2TypeofContracts1-SpotContract-AKforimmediatesale&deliveryofanasset.2-ForwardContract-AKbetweentwopeopleforthedeliveryofanassetatanegotiatedpriceonasetdateinthefuture.3-FuturesContract-AKsimilartoaforwardcontract,exceptthereisanintermediarythatcreatesastandardizedcontract.Thus,thetwopartiesdonothavetonegotiatethetermsofthecontract.TheintermediaryistheCommodityClearingCorp(CCC).TheCCCguaranteesalltrades&“provides”asecondarymarketforthespeculationofFutures.TypeofContracts1-SpotContr3TypesofFuturesCommodityFutures-Sugar -Corn -OJ-Wheat -Soybeans -PorkbelliesFinancialFutures-Tbills -Yen -GNMA-Stocks -EurodollarsIndexFutures-S&P500 -ValueLineIndex-VanguardIndexTypesofFuturesCommodityFutu4FuturesContractConceptsNotanactualsaleAlwaysawinner&aloser(unlikestocks)Kare“settled”everyday.(MarkedtoMarket)Hedge-KusedtoeliminateriskbylockinginpricesSpeculation-KusedtogambleMargin-notasale-postpartialamountHogK=30,000lbsTbillK=$1.0milValuelineIndexK=$indexx500FuturesContractConceptsNota5Ex-Settlement&SpeculateYouarespeculatinginHogFutures.YouthinkthattheSpotPriceofhogswillriseinthefuture.Thus,yougoLongon10HogFutures.Ifthepricedrops.17centsperpound($.0017)whatistotalchangeinyourposition?30,000lbsx$.0017lossx10Ks=$510.00lossSinceyoumustsettleyouraccounteveryday,youmustgiveyourbroker$510.0050.6350.80-$510centsperlbsEx-Settlement&SpeculateYou6YouareanIllinoisfarmer.Youplanted100acresofwinterwheatthisweek,andplanonharvesting5,000bushelsinMarch.Iftoday’swheatpriceis$1.56perbushel,andyouwouldliketolockinthatprice,whatwouldyoudo?SinceyouarelonginWheat,youwillneedtogoshortonMarchwheat.Since1K=5,000bushels,youshouldshortonecontractandcloseyourpositioninMarch.Ex-CommodityHedgeYouareanIllinoisfarmer.Y7Ex-CommodityHedge
realworldInJune,farmerJohnSmithexpectstoharvest10,000bushelsofcornduringthemonthofAugust.InJune,theSeptembercornfuturesaresellingfor$2.94perbushel(1K=5,000bushels).FarmerSmithwishestolockinthisprice.ShowthetransactionsiftheSeptspotpricedropsto$2.80.RevenuefromCrop:10,000x2.80 28,000June:Short2K@2.94=29,400Sept:Long2K@2.80=28,000.GainonPosition-------------------------------1,400TotalRevenue$29,400Ex-CommodityHedge
realworl8Ex-CommodityHedge
realworldInJune,farmerJohnSmithexpectstoharvest10,000bushelsofcornduringthemonthofAugust.InJune,theSeptembercornfuturesaresellingfor$2.94perbushel(1K=5,000bushels).FarmerSmithwishestolockinthisprice.ShowthetransactionsiftheSeptspotpricerisesto$3.05.RevenuefromCrop:10,000x3.05 30,500June:Short2K@2.94=29,400Sept:Long2K@3.05=30,500.LossonPosition-------------------------------(1,100)TotalRevenue$29,400Ex-CommodityHedge
realworl9
Ex-CommoditySpeculation
realworldNov:Short3MayK(.4400x38,000x3)= +50,160Feb:Long3MayK(.4850x38,000x3)= -55,290 Lossof10.23%= -5,130YouhavelivedinNYCyourwholelifeandareindependentlywealthy.Youthinkyouknoweverythingthereistoknowabotporkbellies(uncurredbacon)becauseyourbutlerfixesitforyoueverymorning.Becauseyouhavedecidedtogoonadiet,youthinkthepricewilldropoverthenextfewmonths.OntheCME,eachPBKis38,000lbs.Today,youdecidetoshortthreeMayKs@44.00centsperlbs.InFeb,thepricerisesto48.5centsandyoudecidetocloseyourposition.Whatisyourgain/loss?Ex-CommoditySpeculation
re10MarginTheamount(percentage)ofaFuturesContractValuethatmustbeondepositwithabroker.SinceaFuturesContractisnotanactualsale,youneedonlypayafractionoftheassetvaluetoopenaposition=margin.CMEmarginrequirementsare15%Thus,youcancontrol$100,000ofassetswithonly$15,000.MarginTheamount(percentage)11
Ex-CommoditySpeculation
realworld-withmarginNov:Short3MayK(.4400x38,000x3)= +50,160Feb:Long3MayK(.4850x38,000x3)= -55,290 Loss= -5,130Loss 5130 5130 Margin 50160x.15 7524YouhavelivedinNYCyourwholelifeandareindependentlywealthy.Youthinkyouknoweverythingthereistoknowabotporkbellies(uncurredbacon)becauseyourbutlerfixesitforyoueverymorning.Becauseyouhavedecidedtogoonadiet,youthinkthepricewilldropoverthenextfewmonths.OntheCME,eachPBKis38,000lbs.Today,youdecidetoshortthreeMayKs@44.00centsperlbs.InFeb,thepricerisesto48.5centsandyoudecidetocloseyourposition.Whatisyourgain/loss?
------------=-------------------- =------------=68%lossEx-CommoditySpeculation
re12FinancialFuturesGoal(Hedge)-Tocreateanexactlyoppositereactioninpricechanges,fromyourcashposition.Commodities-Simplebecauseassetstypesarestandard.Financials-Difficultbecauseassetstypesareinfinte.-Youmustattempttoapproximateyourpositionwithfuturesvia“HedgeRatios.”
FinancialFuturesGoal(Hedge)13Example-Hedge
CashPosition FuturesPositionNov Long$1,000 Short1K@$970March Sell@$930 Long1K@$900 loss$70 gain$70
Netposition=$0
Ex-FinancialFuturesExample-HedgeEx-Financial14Example-HedgeReality
CashPosition FuturesPositionNov Long$1,000 Short1K@$970March Sell@$930 Long1K@$920 loss$70 gain$50
Netposition=$20loss
Ex-FinancialFuturesExample-HedgeRealityEx-Fi15Ex-FinancialFuturesYouarelongin$1milofbonds(15yr8.3125%bonds)ThecurrentYTMis10.45%andthecurrentpriceis82-17.Youwanttocashoutnow,butyouraccountantwantstodeferthetaxesuntilnextyear.TheMarchBondKissellingfor80-09.SinceeachKis$100,000,youneedtoshort10MarchKs.InMarchyoucashoutwiththeBondprice=70-26andtheKprice=66-29.Whatisthegain/loss?Ex-FinancialFuturesYouare16Ex-FinancialFuturesYouarelongin$1milofbonds(15yr8.3125%bonds)ThecurrentYTMis10.45%andthecurrentpriceis82-17.Youwanttocashoutnow,butyouraccountantwantstodeferthetaxesuntilnextyear.TheMarchBondKissellingfor80-09.SinceeachKis$100,000,youneedtoshort10MarchKs.InMarchyoucashoutwiththeBondprice=70-26andtheKprice=66-29.Whatisthegain/loss?
Cash Futures BasisNov $825,312 $802,812 +(2-8)March $708,125 $669,062 +(3-29)Gain/Loss ($117,187) $133,750 +(1-21)NetGain=$16,563(=1-21x$1mil)Ex-FinancialFuturesYouare17FinancialFuturesTheartinFinancialfuturesisfindingtheexactnumberofcontractstomakethenetgain/loss=$0.ThisiscalledtheHedgeRatio#ofKs=----------------------------------XHedgeRatio
$FaceValueCash$FaceValueofFuturesKHRGoal-Findthe#ofKsthatwillperfectlyoffsetcashposition.FinancialFuturesTheartinFi18HedgeRatioDetermination1-TheDurationModel2-NaiveHedgingModel3-ConversionFactorModel4-BasisPointModel5-RegressionModel6-YieldForecastModelHedgeRatioDetermination1-T19SwapsAnagreementbetweentwofirmsinwhicheachfirmagreestoexchange(orSwap)the“interestratecharachteristics”oftwodifferentfinancialinstrumentsofidenticalprincipal.TypesInterestRateSwapsCurrencySwapsSwapsAnagreementbetweentwo20Ex-InterestRateSwapsAaaCorp BaaCorpL.T.FixedLoan 10% 11.5%S.T.VariableLoan 7.25% 7.50%SwapAaaCorpBorrows$1milfixedloan@10%BAACorpBorrows$1milvariableloan@7.5%Aaaassumespmtsonvariableloanat7.5%Baaassumespmtsonfixedloan@10.75%Ex-InterestRateSwapsAaaCo21AaaBenefit BaaBenefitPayL.T.@ -10.00% PayS.T.@ -7.50%GetL.T.@ +10.75% GetS.T.@ +7.50%PayS.T.@ -7.50% PayL.T.@ -10.75%S.T.Sav@ +7.25% L.T.Sav@ +11.50%NetBenefit +.50% NetBenefit +.75%Ex-InterestRateSwapsAaaCorp BaaCorpL.T.FixedLoan 10% 11.5%S.T.VariableLoan 7.25% 7.50%AaaBenefit BaaBenefitEx-22Hedging&FuturesTodayWewillreturntoCapitalBudgeting&Financing.Wewilldiscusshowtoreducerisk.TopicsHowtoeliminateriskincapitalbudgeting.(i.e.variablecosts)Howtoeliminateriskinfinancing(erestratefluctuations)HOW?ByHedging&FuturesContractsHedging&FuturesToday23Ex-CerealProductionEx-Kelloggproducescereal.Amajorcomponentandcostfactorissugar.Forecastedincome&salesvolumeissetbyusingafixedsellingprice.Changesincostcanimpacttheseforecasts.Tofixyoursugarcosts,youwouldideallyliketopurchaseallyoursugartoday,sinceyouliketoday’sprice,andmadeyourforecastsbasedonit.But,youcannot.Youcan,however,signacontracttopurchasesugaratvariouspointsinthefutureforapricenegotiatedtoday.Thiscontractiscalleda“ForwardContract.”Thistechniqueofmanagingyoursugarcostsiscalled“Hedging.”Ex-CerealProductionEx-Kel24TypeofContracts1-SpotContract-AKforimmediatesale&deliveryofanasset.2-ForwardContract-AKbetweentwopeopleforthedeliveryofanassetatanegotiatedpriceonasetdateinthefuture.3-FuturesContract-AKsimilartoaforwardcontract,exceptthereisanintermediarythatcreatesastandardizedcontract.Thus,thetwopartiesdonothavetonegotiatethetermsofthecontract.TheintermediaryistheCommodityClearingCorp(CCC).TheCCCguaranteesalltrades&“provides”asecondarymarketforthespeculationofFutures.TypeofContracts1-SpotContr25TypesofFuturesCommodityFutures-Sugar -Corn -OJ-Wheat -Soybeans -PorkbelliesFinancialFutures-Tbills -Yen -GNMA-Stocks -EurodollarsIndexFutures-S&P500 -ValueLineIndex-VanguardIndexTypesofFuturesCommodityFutu26FuturesContractConceptsNotanactualsaleAlwaysawinner&aloser(unlikestocks)Kare“settled”everyday.(MarkedtoMarket)Hedge-KusedtoeliminateriskbylockinginpricesSpeculation-KusedtogambleMargin-notasale-postpartialamountHogK=30,000lbsTbillK=$1.0milValuelineIndexK=$indexx500FuturesContractConceptsNota27Ex-Settlement&SpeculateYouarespeculatinginHogFutures.YouthinkthattheSpotPriceofhogswillriseinthefuture.Thus,yougoLongon10HogFutures.Ifthepricedrops.17centsperpound($.0017)whatistotalchangeinyourposition?30,000lbsx$.0017lossx10Ks=$510.00lossSinceyoumustsettleyouraccounteveryday,youmustgiveyourbroker$510.0050.6350.80-$510centsperlbsEx-Settlement&SpeculateYou28YouareanIllinoisfarmer.Youplanted100acresofwinterwheatthisweek,andplanonharvesting5,000bushelsinMarch.Iftoday’swheatpriceis$1.56perbushel,andyouwouldliketolockinthatprice,whatwouldyoudo?SinceyouarelonginWheat,youwillneedtogoshortonMarchwheat.Since1K=5,000bushels,youshouldshortonecontractandcloseyourpositioninMarch.Ex-CommodityHedgeYouareanIllinoisfarmer.Y29Ex-CommodityHedge
realworldInJune,farmerJohnSmithexpectstoharvest10,000bushelsofcornduringthemonthofAugust.InJune,theSeptembercornfuturesaresellingfor$2.94perbushel(1K=5,000bushels).FarmerSmithwishestolockinthisprice.ShowthetransactionsiftheSeptspotpricedropsto$2.80.RevenuefromCrop:10,000x2.80 28,000June:Short2K@2.94=29,400Sept:Long2K@2.80=28,000.GainonPosition-------------------------------1,400TotalRevenue$29,400Ex-CommodityHedge
realworl30Ex-CommodityHedge
realworldInJune,farmerJohnSmithexpectstoharvest10,000bushelsofcornduringthemonthofAugust.InJune,theSeptembercornfuturesaresellingfor$2.94perbushel(1K=5,000bushels).FarmerSmithwishestolockinthisprice.ShowthetransactionsiftheSeptspotpricerisesto$3.05.RevenuefromCrop:10,000x3.05 30,500June:Short2K@2.94=29,400Sept:Long2K@3.05=30,500.LossonPosition-------------------------------(1,100)TotalRevenue$29,400Ex-CommodityHedge
realworl31
Ex-CommoditySpeculation
realworldNov:Short3MayK(.4400x38,000x3)= +50,160Feb:Long3MayK(.4850x38,000x3)= -55,290 Lossof10.23%= -5,130YouhavelivedinNYCyourwholelifeandareindependentlywealthy.Youthinkyouknoweverythingthereistoknowabotporkbellies(uncurredbacon)becauseyourbutlerfixesitforyoueverymorning.Becauseyouhavedecidedtogoonadiet,youthinkthepricewilldropoverthenextfewmonths.OntheCME,eachPBKis38,000lbs.Today,youdecidetoshortthreeMayKs@44.00centsperlbs.InFeb,thepricerisesto48.5centsandyoudecidetocloseyourposition.Whatisyourgain/loss?Ex-CommoditySpeculation
re32MarginTheamount(percentage)ofaFuturesContractValuethatmustbeondepositwithabroker.SinceaFuturesContractisnotanactualsale,youneedonlypayafractionoftheassetvaluetoopenaposition=margin.CMEmarginrequirementsare15%Thus,youcancontrol$100,000ofassetswithonly$15,000.MarginTheamount(percentage)33
Ex-CommoditySpeculation
realworld-withmarginNov:Short3MayK(.4400x38,000x3)= +50,160Feb:Long3MayK(.4850x38,000x3)= -55,290 Loss= -5,130Loss 5130 5130 Margin 50160x.15 7524YouhavelivedinNYCyourwholelifeandareindependentlywealthy.Youthinkyouknoweverythingthereistoknowabotporkbellies(uncurredbacon)becauseyourbutlerfixesitforyoueverymorning.Becauseyouhavedecidedtogoonadiet,youthinkthepricewilldropoverthenextfewmonths.OntheCME,eachPBKis38,000lbs.Today,youdecidetoshortthreeMayKs@44.00centsperlbs.InFeb,thepricerisesto48.5centsandyoudecidetocloseyourposition.Whatisyourgain/loss?
------------=-------------------- =------------=68%lossEx-CommoditySpeculation
re34FinancialFuturesGoal(Hedge)-Tocreateanexactlyoppositereactioninpricechanges,fromyourcashposition.Commodities-Simplebecauseassetstypesarestandard.Financials-Difficultbecauseassetstypesareinfinte.-Youmustattempttoapproximateyourpositionwithfuturesvia“HedgeRatios.”
FinancialFuturesGoal(Hedge)35Example-Hedge
CashPosition FuturesPositionNov Long$1,000 Short1K@$970March Sell@$930 Long1K@$900 loss$70 gain$70
Netposition=$0
Ex-FinancialFuturesExample-HedgeEx-Financial36Example-HedgeReality
CashPosition FuturesPositionNov Long$1,000 Short1K@$970March Sell@$930 Long1K@$920 loss$70 gain$50
Netposition=$20loss
Ex-FinancialFuturesExample-HedgeRealityEx-Fi37Ex-FinancialFuturesYouarelongin$1milofbonds(15yr8.3125%bonds)ThecurrentYTMis10.45%andthecurrentpriceis82-17.Youwanttocashoutnow,butyouraccountantwantstodeferthetaxesuntilnextyear.TheMarchBondKissellingfor80-09.SinceeachKis$100,000,youneedtoshort10MarchKs.InMarchyoucashoutwiththeBondprice=70-26andtheKprice=66-29.Whatisthegain/loss?Ex-FinancialFuturesYouare38Ex-FinancialFuturesYouarelongin$1milofbonds(15yr8.3125%bonds)ThecurrentYTMis10.45%andthecurrentpriceis82-17.Youwanttocashoutnow,butyouraccountantwantstodeferthetaxes
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