Hedging Calculations
Hedging is based on the principle that cash prices and futures prices tend to move up and down together. Taking a position in the futures market opposite to the one taken in the cash market, offsets a hedger's risk of losses in one by ensuring gains in the other. In this manner, the investor is able to establish a price level for a cash market transaction that may not actually take place for several months and effectively protect himself from adverse price moves.

To review from an earlier chapter: buying a futures contract gives you a long futures position. A price increase would result in a futures gain. Selling a futures contract gives you a short futures position. A price decrease would result in a futures gain. There are two types of hedgers: the buyer or long hedger and the seller or short hedger.

Thus, there are effectively four scenarios for a hedge: it's either short or long, and the subsequent market price moves either down or up. Let's consider ethanol traded on the CBOT.

Net Result of Short Hedges
First, we'll look at the short hedge as prices decrease. It is May and an ethanol producer wants to hedge approximately 1.5 million gallons of his July production to guard against the possibility of falling prices. So he short hedges by selling 52 July ethanol futures contracts (a contract is for a railcar of 29,000 gallons on the CBOT) at $1.28/gallon. Both cash and futures prices have subsequently fallen. On July 1, when the producer sells physical ethanol to the local terminal, the price he receives is $1.15/gal. The producer simultaneously offsets his hedge, by purchasing July ethanol futures at $1.20. The transaction looks like this:


Cash Market
Futures Market
Basis
May
Receives cash forward (July) bid at $1.18/gal
Sells July ethanol futures at $1.28/gal
-.10
July
Sells cash ethanol at $1.15/gal in the spot
Buys July ethanol futures at $1.20/gal
-.05

As a result, the hedger sold ethanol for cash on the forward market at $1.15 (the July Cash Market box), gained 8 cents on the futures position (sold the future for $1.28 and bought it back for $1.20), so it was as if he sold the commodity for $1.23.

Remember, though, this was a hedge, not a primary position. Let's say the ethanol producer believed that prices would hold up through July, and perhaps gain a little. He would have been right. Let's say that this hedge represents only half his capacity of 3 million gallons/month. If he decided in May to sell the other half of his July run at market price, then the results are a little different. He would have gotten $1.15 on the cash market for half his stock. Average that out with the $1.23 for the hedged half, and he has an average sale price of $1.19/gallon.

Now let's look at a short hedge as the prices increase. Again it is May and our ethanol producer wants to hedge approximately 1.5 million gallons of his July production to guard against the possibility of falling prices. So he short hedges by selling 52 July ethanol futures contracts (a contract is for a railcar of 29,000 gallons) at $1.25/gallon. By the last week of June, both cash and futures prices have fallen. On July 1, when the producer sells physical ethanol to the local terminal, the price he receives is $1.15/gal. The producer simultaneously offsets his hedge, by purchasing July ethanol futures at $1.20. The transaction looks like this:


Cash Market
Futures Market
Basis
May
Receives cash forward (July) bid at $1.20/gal
Sells July Ethanol future at 1.25/gal
-.05
July
Sells cash ethanol at $1.25/gal
Buys July Ethanol futures at $1.35/gal
-.10
Change
$.05/gal gain
$.10/gal loss
.05 loss

As a result, the hedger sold ethanol for cash on the forward market at $1.25, lost 10 cents on the futures position, so it was as if he sold the commodity for $1.15.

Again, this was a hedge, not a primary position. Let's say the ethanol producer believed that prices would hold up through July, and perhaps gain a little. He would have been right. Again, he has another 1.5 million gallons/month of capacity. If he decided in May to sell the other half of his July run at market price, then the results are a little different. He would have gotten $1.25 on the cash market for half his stock. Average that out with the $1.15 for the hedged half, and he has an average sale price of $1.20/gallon.

It's not a coincidence that the average price per gallon in the first scenario and in the second scenario are so close: $1.19 versus $1.20. That's the whole point of the hedge: to eliminate downside risk while ensuring a reasonable net price. The trade-off is that it is as difficult to make a windfall as it is to lose one.

Net Result of Long Hedges
Now let's examine the other side – the long hedge. Again we'll look at the decreasing-price scenario first.

A gasoline refiner wants to hedge its anticipated July ethanol demand of 2.9 million gallons to protect against the possibility of increasing prices. Its trader enters into a hedge by buying 100 July ethanol futures contracts at $1.28/gallon in May, then both cash and futures prices fall. When the trader buys ethanol in the cash market for $1.05/gallon in July, the hedge is offset by selling July ethanol futures at $1.20.


Cash Market
Futures Market
Basis
May
Receives cash forward (July) offer
Buys July ethanol futures
-.10

from an ethanol marketing firm
at $1.28/gal


at $1.18/gal


July
Buys cash ethanol at $1.05/gal
Sells July ethanol futures
-.15


at $1.20/gal

Change
$.13/gal gain






As a result, the trader buys ethanol in July at $1.05, loses 8 cents in the futures market (buys at $1.28, sells at $1.20), so in effect has to pay $1.13/gallon. Bear in mind, this is still better than the $1.18 she would have paid on the cash market in May, although not as good as the $1.05 she could have paid in July.

Now let's consider a market with increasing prices. The refiner's trader wants to hedge her client's 2.9 million-gallon July ethanol demand against the possibility of increasing prices. She does this by buying 100 July ethanol futures at $1.25/gallon in May, then both cash and futures prices rise steadily. When the trader buys ethanol in the cash market for $1.20/gal in July, she simultaneously offsets the hedge by selling July ethanol futures at $1.35.


Cash Market
Futures Market
Basis
May
Receives cash forward (July) offer at $1.15/gal
Buys July ethanol futures at $1.25/gal
-.10
July
Buys cash ethanol at $1.20/gal
Sells July ethanol futures at $1.35/gal
-.15
Change
$.05/gal loss
$.10/gal gain
.05 cent gain

The trader bought the ethanol for $1.20 on the cash market, and realized a 10 cent gain in the futures market, so it was as if she paid only $1.10/gallon. By using the futures market, the refiner's trader was able to effectively lock in a July purchase price of $1.10/gal. In fact, the net purchase price again ended up being 5 cents better than was anticipated, due to the weakening basis.

Summary And Review

Related Articles
  1. Investing

    The Most "Wasteful" Industries

    Some industries require a lot more input to produce their product, and investors should be aware of the impact.
  2. Trading

    July's Tough, but These Stocks Tend to Do Well

    July isn't a great month for the stock market historically, but these stocks tend to perform well.
  3. Investing

    How Oil and Ethanol Combine to Make Valero Rich (VLO, PSX)

    Despite a lagging oil sector, Valero continues to have good results with its ethanol and oil refinery businesses.
  4. Trading

    3 Commodity ETFs to Watch in July

    These commodities have a tendency to rise or fall significantly in July, and they can be traded via ETF.
  5. Investing

    A Beginner's Guide To Hedging

    Hedging is a practice every investor should know about.
  6. Investing

    Are Hedge Funds Chasing Performance?

    Learn why hedge funds have performed worse than the S&P 500 Index in 2016, and why they may overweight equities to play catch-up in the second half of 2016.
  7. Investing

    Taking A Look Behind Hedge Funds

    Hedge funds can draw returns well above the market average even in a weak economy. Learn about the risks.
  8. Investing

    What Are Hedge Funds?

    Hedge funds may be similar to mutual funds in some ways, but they differ in other ways like fee structure. Is a hedge fund for you?
  9. Investing

    Who Are Exxon’s Main Competitors? (RDS.A, XOM)

    Learn about some of the main competitors to Exxon Mobil in the energy sector, and find out how their businesses are different from that of Exxon.
  10. Financial Advisor

    Why Hedge Funds Are Not Living Up to Return Hype

    Hedge funds are supposed to produce better returns while protecting your investments from the downside. Here's why they are not living up to their purpose.
Frequently Asked Questions
  1. How did the ABX index behave during the 2008 subprime mortgage crisis?

    Read about the disastrous performance of the various ABX indexes in the subprime mortgage crisis of 2008 during the middle ...
  2. How did moral hazard contribute to the 2008 financial crisis?

    Learn about moral hazard, how it can affect outcomes and how it contributed to the conditions that led to the 2008 financial ...
  3. Which mutual funds made money in 2008?

    Read about the only mutual fund that turned a profit in 2008. Learn about risk-averse investment strategies and the financial ...
  4. Were Collateralized Debt Obligations (CDO) Responsible for the 2008 Financial Crisis?

    Collateralized debt obligations are exotic financial instruments that can be difficult to understand, Learn the role they ...
Trading Center