Derivatives - Matt Will

Derivatives Lecture 4 Futures, Hedging & Risk Management Companies have risk Manufacturing Risk - variable costs Financial Risk - Interest rate changes Goal - Eliminate risk HOW? Hedging & Futures Contracts Example Cereal Production Kelloggs produces cereal. A major input and variable cost is sugar. The price of a box of cereal is inflexible (i.e. it has an elastic demand function).

Kelloggs is naturally short in sugar short = a requirement to buy the commodity in the future. Profit Scenario for Kelloggs Revenue -costs Profits This is variableThis This is variableis This is variablevariable Example Cereal Production (continued) Natural profit / loss position To hedge their natural position, Kelloggs will

enter into a long futures / forward contract Profit Short sugar Long Futures / Forward Contract Asset Price Loss Example Cereal Production (continued) NET POSITION

Profit Asset Price Loss Example Cereal Production (continued) Farmers view Profit Scenario for Farmer Profit Revenue This is variableThis This is variableis This is variablevariable -costs Profits

Short Forward / futures Long sugar Asset Price Loss Example Cereal Production (continued) Together Long Hedger Short Hedger

Natural position: Short sugar Natural position: Long sugar Risk: Purchase price of sugar Risk: Sales price of sugar Hedge: Long contract Hedge: Short contract Example: Wheat Hedge You are an Illinois farmer. You planted 100 acres of wheat this week, and plan on harvesting 20,000 bushels in March. If todays futures wheat price is $1.56 per bushel, and you would like to lock in that price, what would you do?

Since you are long in Wheat, you will need to go short on March wheat. Since1 contract= 5,000 bushels, you should short four contracts today and close your position in March. Example: Commodity Hedge In June, farmer John Smith expects to harvest 10,000 bushels of corn during the month of August. In June, the September corn futures are selling for $2.94 per bushel (1K = 5,000 bushels). Farmer Smith wishes to lock in this price. Show the transactions if the Sept spot price drops to $2.80. Revenue from Crop: 10,000 x 2.80

28,000 June: Short 2K @ 2.94 = 29,400 Sept: Long 2K @ 2.80 = 28,000 Gain on Position------------------------------Total Revenue . 1,400 $ 29,400 Example: Commodity Hedge In June, farmer John Smith expects to harvest 10,000 bushels of corn during the month of August. In June, the September corn futures are selling for $2.94 per bushel (1K = 5,000 bushels). Farmer Smith wishes to lock in this

price. Show the transactions if the Sept spot price rises to $3.05. Revenue from Crop: 10,000 x 3.05 30,500 June: Short 2K @ 2.94 = 29,400 Sept: Long 2K @ 3.05 = 30,500 Gain on Position------------------------------Total Revenue . -1,100 $ 29,400 Convergence of Futures to Spot Basis Risk Basis Risk = Spread between the Futures Price and Spot Price

Futures Price Spot Price Spot Price Futures Price Time (a) Time (b) Fundamentals of Futures and Options Markets, 6th Edition, Copyright John C. Hull 2007

2.11 Convergence of Futures to Spot (Hedge initiated at time t1 and closed out at time t2) Basis Strengthens Futures Price Spread between spot price and futures price gets smaller Basis Weakens Spot Price Spread between spot price and futures price gets larger Time

t1 t2 Fundamentals of Futures and Options Markets, 6th Edition, Copyright John C. Hull 2007 3.12

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