Hedging With Futures
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July 17, 2004
Agenda
Introduction Hedging Strategies Diversification Benefits Practical Problems in Hedging
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What is Risk?
Exposure to market movement of prices
In general, down side risk is what we mean by risk
Quantification of risk - the volatility of the price movements
Volatility is nothing but the standard deviation (deviation from the mean prices)
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What is Risk Management?
No risk can be eliminated Risk Management
Transferring the risk to some one who can handle it better or Transfer the risk to some one who has the appetite for risk
Financial derivatives are used to hedge the exposure to market risk
Hedgers transfer their risk to speculators who are willing to assume the risk
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Risks faced by an entity
Foreign exchange risk Interest rate risk Commodity price risk Credit risk Operational risk
•Commodity price risks include • Increase in purchase cost vis-à-vis commitment on sales price • Change in value of inventory • Counterparty risk translating into commodity price risk
•Commodity futures •Inventory hedging •Borrowings linked to commodity prices
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What is a hedge?
A hedge is a futures position that is roughly equal and opposite to the position the hedger has in the cash market A hedge is designed to reduce price risk.
The profit (loss) in the cash position is offset by equivalent loss (profit) on the futures position
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What are the risks in commodities?
Commodity enterprises face two classes of risk: Price risk – risk relating to movements in the world price, the exchange rate and the basis between local and world prices) Quantity risk (eg from weather)
Hedging may allow reduction in price and cost risk Insurance may be available for quantity risk
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Volatility comparison - Summary
Average annual volatility Sensex or Nifty - 25-30% Govt Sec Index - 5-10% Gold - 12-18% Silver - 15-25% Cotton - 10-12% Oil seeds - 15-20% Commodities are less volatile compared to stock market The determinants of volatility are different for capital market and commodity markets
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Agenda
Introduction Hedging Strategies Diversification Benefits Practical Problems in Hedging
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Commodity price risk - significance
Industry (data of 1500 companies) Agro/ FMCG/ Edible Oils Auto/Auto Ancil. Chemicals Construction Consumer Goods Engineering/Industrial G. Fertilizer/Pesticides Livestock/Leather Metals/Mining/Steel Packaging Oil/Petro/Refineries Sugar Textiles Transport Estimated Aggr. Turnover (Rs Cr.) 65,000 35,000 5,000 10,000 3,000 30,000 15,000 2,000 60,000 10,000 3,00,000 5,000 20,000 2,000 % of Raw Material cost to Aggr. Turnover 70% 90% 65% 40% 50% 50% 45% 65% 70% 60% 85% 65% 90% 40%
Source of data – ICICI Bank Corporate Infobank
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Industry in India today runs the raw material price risk, Going Forward they can hedge this risk
Commodity price risk & corporates
Exposure to commodity price risk can do damage to the bottom line Impact of commodity risk on profits is examined for three companies
These companies are exposed to unique commodity price risk (Cotton, Aluminium and Copper) Market leaders in their respective industry Impact on PBT if the companies had not hedged their commodity price risk
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Commodity price risk – Impact
Amount in Rs crores Company Name A Tex Sales 1326.28 Raw Materia l 567.00 RM as % of sales 42.75 PBT 129.00 Price risk 1.30% Impact on PBT (7.37) % Impact (5.71)
B Al
2639.55
1117.43
42.33
899.39
1.90%
(50.15)
(5.57)
C Cu
3406.48
2565.35
75.31
194.28
2.65%
(90.27)
(46.46)
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Commodity Price risk – Impact on commodities
Hedging can improve the profits Impact depends on the raw materials intensity of the company
% of raw material expenditure on Sales Value addition by the company
Is companies profits a function of the commodity prices?
Textiles Industry – Cotton price increase cannot be passed down to the customers Metal Processing Industry – Profits are direct function of the market prices of the commodities
How does the share price of the company behave with the commodity price movements?
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Commodity Price Risk – Cotton
6000
5000
4000
3000
2000
1000
0 1 /0 1 /0 1
1 0 /0 8 /0 1
7 /1 5 /0 2
C O M P A N Y A -S H A R E P R IC E
C O T T O N P R IC E S
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Increase in raw material cost means reduction in share prices
Commodity Price risk – Aluminimum
1800
1600
1400
1200
1000
800
600
400 1 /0 1 /0 1
5 /2 1 /0 1
1 0 /0 8 /0 1
2 /2 5 /0 2
C O M P A N Y - B S H A R E P R IC E
A L U M IN IU M P R IC E
Share prices mimic the commodity price movements
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Commodity Price Risk – Copper
2000
1600
1200
800
400 1 /0 1 /0 1
5 /2 1 /0 1
1 0 /0 8 /0 1
2 /2 5 /0 2
C O P P E R P R IC E S
C O M P A N Y - C S H A R E P R IC E S H A R E P R IC E (X 5 )
Share prices mimic the commodity price movements
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Types of Hedges
Long Hedge This requires taking a long position in the futures contract Appropriate when a certain asset or commodity would be purchased in the future and one is interested in locking in the price now Textile Company would use a long hedge Short Hedge This involves a short position in the futures contract Applicable when a hedger already owns an asset and expects to sell it in the future The Aluminum producer would use a short hedge
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Cross Hedge
Cross Hedge is used to hedge price risk of different but economically related commodities
Correlation analysis is used
Hedging and cross hedging should only be attempted if the price movements are similar and basis risk is acceptable to the hedger
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A cotton hedge – an example
Two varieties of cotton are available for trading on NCDEX – J-34 (short staple) and S-6 (long staple) Suppose, a farmer in Andhra Pradesh producing Buny / Brahma variety (extra long staple) wishes to hedge on NCDEX
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Cotton hedge - continued
S-6 futures market May 25, 2004 Sell one Aug futures (Rs. 6650/- per quintal Buy one Aug futures (Rs. 6550/- per quintal S-6 spot market Rs. 6763/- per quintal Buny / Brahma spot market Rs. 2500/- per quintal
August 20, 2004
Rs. 6550/- per quintal
Rs. 2470/- per quintal
Net gain (loss) Rs. 1870/-
Not relevant
Rs. (1620/-)
Net gain- Rs 1870- Rs 1620= Rs 250
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Cotton hedge - continued
Thus, we see that the farmer gains Rs. 250/- (per contract) by hedging at NCDEX.
The loss in the spot market is notional
For hedging to be effective, two things are necessary.
The futures and spot price for S-6 should move together Also, the spot price for S-6 and Brahma / Buny should also move together.
Optimal hedge ratio
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Unbalanced hedge
The future contract standardized size units do not match the cash position quantity Use a combination of regular size futures and mini contracts to reach a futures position as close as possible to the cash position An over hedged occurs when futures quantity exceeds the cash quantity An under hedged occurs when the cash position exceeds the future quantity The problem can be handled by trying to match quantities as closely as possible
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Unbalanced hedge
Cash Futures Sold two contracts Bought two contracts
Buy
625000
Now
629000
Sold Head at Loss
607200 -17800
3 Months Later
611200 17800
Cash from sale of Gold Cash from Futures Total Cash Per pound
910,800 35,600 946,400 630,933
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Rolling Hedge
When cash position is not known, then a process of hedging with the near contract and rolling the hedge is a common and accepted hedging practice
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Dynamic Hedge
Dynamic hedging is done on the basis of a price forecast During periods when favorable price movement is expected, the hedge is held in abeyance Hedge is entered into when adverse price movement is expected Exposed to risk if price views turn out incorrect
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Inter-commodity spread
Price movements between related underlying instruments tend to correlate fairly well and such gains in one derivatives position may offset losses in a related instrument Companies can hedge their input and output price risk
Soya oil manufacturers--Soybean and Soya oil Refiners—Crude and gasoline
Crack Spread
Exchanges offer an inter-commodity spread discount on initial margin
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Agenda
Introduction Hedging Strategies Diversification Benefits Practical Problems in Hedging
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Trends in Nifty, NSE G-Sec Index, Bullion
25.0
20.0
15.0
10.0
5.0
0.0
1/1/1997
1/1/1998
Gold/1000
1/1/1999
1/1/2000
NSE Nifty/100
1/1/2001
1/1/2002
1/1/2003
Silver/1000
1/1/2004
G-Sec/10
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Correlation
Correlation coefficients in Indian m arkets Gold Silver Stocks Bonds Gold 1 0.089 0.206 0.741 Silver 1 -0.099 0.146 Stocks 1 0.112 Bonds 1
Data: LBMA bullion prices, NSE Nifty, NSE G-Sec Index
Benefit of diversification can be seen from the
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Risk Adjusted Returns
Risk-Adjusted Returns
Portfolio structure 100% Stock Portfolio Stocks (50% ) & Gold Portfolio Stocks (50% ) & Silver Portfolio 100% Gold Portfolio 100% Silver Portfolio 100% Bonds Portfolio Bonds (50% ) & Gold Portfolio Bonds (50% ) & Silver Portfolio (50% ) (50% ) Cumulative Returns 73.70% 47.80% 48.30%
13.29%
Risk of portfolio
24.43% 14.37%
Risk Adjusted Return 3.017 3.326 3.634 2.001 1.742 3.182 2.673 3.647
(50% ) (50% )
21.80% 22.90% 25.20% 23.50% 24.00%
7.92% 8.79% 6.58%
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Agenda
Introduction Hedging Strategies Diversification Benefits Practical Problems in Hedging
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Costs of hedging
There is a risk-return trade-off Lower return due to lower risk Lack of liquidity in the market resulting in impact cost
Low liquidity results in higher volatility
Margin finance
Margins are based on volatility The real cost of hedging is the finance cost of margins Margins could range from 5% to 50%
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Basis Risk
Basis is defined as the difference between the cash price and futures price of a commodity. It can be either positive or negative
Basis = Spot price – Futures price
The basis can improve or worsen the position of the hedger
When a hedger is short futures, increases in the basis creates gains When a hedger is long futures, decreases in the basis creates gains
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Cost of Physical Delivery
Cost of dematerialization
DP charges related to demat holdings
Cost of assaying
Physical verification vs. scientific verification
Cost of accreditation of warehousing
Own warehouse vs. accredited warehouse
Cost of handling, storage and transportation
Own warehouse vs. transportation, storage and handling charges of accredited warehouse
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Cost of Physical Delivery on NCDEX
NCDEX - Indicative warehouse charges Commodity Location Warehouse Delivery Units Fixed charges@ Gold Silver Soy Bean Soya Oil Mustard seed Mustard oil RBD Palmolein CPO Cotton - long Cotton - medium Rubber Rubber Pepper Chana (Gram) Chana (Gram) Chana (Gram) Jute Sacking Bags Guar seeds Mumbai Delhi Indore Indore Jaipur Jaipur Kakinada Kandla Ahmedabad Bathinda Kottayam Kochi Kochi Delhi Indore Indore Kolkata Jodhpur Brinks Brinks MPWLC Jhawar ICS ACE India ACE India IMC CRPL Gujcot PAFCO KSWC KSWC KSWC Total Log MPWLC Jhawar ICS Tewari WH VCO WH Kg Kg MT MT MT MT MT MT Bales Bales MT MT MT MT MT MT Bales MT 310* 610** 110 110 110 110 110 110 110 110 110 110 110 110 110 110 110 110 Charges to be paid on deposit (in Rupees) Warehouse Charges - rate per unit per 55 per kg 1 per kg 13 per MT 30 per MT 18 per MT 42 per MT 26 per MT 25 per MT 6 per Bale 6 per Bale 36 per MT 36 per MT 22 per MT 37.5 per MT 9 per MT 10 per MT 6.25 per Bale 9 per MT Testing charges to be paid Directly to assayers (Rs) 0 0 650 1815 900 2285 1000 1625 2280 2280 50 per MT (i) 50 per MT (i) 20 per MT (ii) 1000 1000 1000 12 per Bale (iii) 1000 260 560 60 60 60 60 60 60 60 60 60 60 60 60 60 60 60 60 Fixed
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Thank You
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Short Hedge Example
Short Hedge in Wheat Futures
Cash Market Wheat Price at Sell Wheat at Opportunity loss 193 172 21 September April Futures Market Sell Wheat at Buy Wheat at Gain 195 174 21
Net gain or loss =0
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Long Hedge Example
Long Hedge in Wheat Futures
Cash Market Wheat Price at Buy Wheat at Loss 143 155 13 Now 3 Months Later Futures Market Buy Wheat at Sell Wheat at Gain 148 161 13
Net gain or loss =0
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Basis Example—Long Futures
Cash Market Wheat Price at Buy Wheat at Loss 143 155 12 Now 3 Months Later Futures Market Buy Wheat at Sell Wheat at Gain 148 163 15 -5 -8 -3
Net gain or loss =3
Decrease in basis creates gains in case of a long hedge
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