price risk mgmt

7/29/2019 price risk mgmt

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Price Risk Management

Price Risk Management

using Hedging


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Agenda

Advance Concepts

Hedging

Optimal Hedging

Q & A


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Basis Risk

Basis is difference between the spot price of anassetand the futurespriceof thesameunderlyingasset

BasisRiskarisesduetouncertaintyinthedifferencebetweenspotandfuturesprice

Basis = Spot Price Futures Price

What is Positive and Negative Basis?


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To minimize basis risk, price correlation between spot

priceandfuturespriceshouldbehigh

Convergence ofFutureswithSpotpriceuponexpiryoffuturescontract

ResearchandAnalysisbeforehedging

Technical Analysis (Moving Average, RelativeStrengthIndex,Fibonacci,etc.)

FundamentalAnalysis(DemandSupply)

How to minimize Basis Risk?


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2004 Sep Oct Nov Dec 2005 Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec 2006 Feb Mar Apr May Jun Ju l Aug

100

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0.0%

23.6%

38.2%

50.0%

61.8%

100.0%

HG COPPER CONTINUOUS 25000 LBS [COMEX] (371.750, 374.350, 359.500, 362.450, -8.54999)

Correlation between MCX

Copper and COMEX

Copper is 99.70%

Hedging to Be Backed by Extensive Analysis: Technical &

Fundamental


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Stochastic Risk Variables:

Market prices of commodities

Interest rates

Exchange rates

other market variables

VolatilityLiquidity

Depth

Transparency

BenchmarkingMarket Patterns

Fundamental & Technical Analysis

Screen Reading

Trading Key


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ATTITUDE Game .!!!!!

How you be in market depends on your attitude

Love HateTake

Tackle Insure Minimize

Trade

Hedging Financial

Institutions

Diversification

costly

w/o derivatives


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Risk Profile of Market Participant

Risk Averse

Risk Seeker

Risk Neutral


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Fundamental Factors

Exchange

Rate

RBI

Intervention

Performance of

Equity Market

Policy

Decisions

Performance of

Other Asian

Currencies

PoliticalFactors

Capital

Flows

Fundamental

Factors

Uncertain

Events


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Basis in Contango and Backwardation


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When do we say that the basis is strengthening?

Whenthecashpriceofacommodityincreasesmorethanitsfuturesprices,thebasisisstrengthening.

When do we say that the basis is weakening?

When the futures price of a commodity increasesmorethanthecashprice,thebasisisweakening

Strengthening and Weakening of Basis


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When is the basis said to be narrowing?

Thebasisissaidtobenarrowingwhentheabsolutedifferencebetweenthespotandfuturespricereduces

When is the basis said to be widening?

Wideningofbasisoccurswhentheabsolutedifferencebetweenthespotandfuturespriceincreases

Narrowing and Widening of Basis


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In a contango market, who benefits when the basis narrows?

Inacontangomarket,wherethe futuresprice ishigherthanthespotprice,narrowingofbasisbenefitstheshorthedger (short hedger is onewho sells the futures andbuystheunderlyingcommodity)

In a contango market, who benefits when the basis widens?

Inacontangomarket,wideningofbasisbenefitsthelonghedger (longhedger is onewhobuys futuresandsells

underlyingphysicalcommodity)

Basis in a Contango Market


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In a backwardation market, who benefits when the basisnarrows?

In a backwardationmarket, where thespotprice ishigher than the futures price, narrowing of basisbenefitsthelonghedger

In a backwardation market, who benefits when the basiswidens?

In a backwardation market, widening of the basisbenefitstheshorthedger

Basis in a Backwardation Market


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Basis Risk to conduct extensive analysis and research

beforeenteringintohedgepositions

Physical assetdifferentfromunderlyingassetofthefuturesavailable for trading correlation of different asset pricesshouldbehightominimizebasisrisk

Unequal durationbetweenhedgeperiodandfuturescontracttradingcycle

Financing CostforMarktoMarketsettlementofthefuturesposition

Intricacies involved in Hedging and Solutions


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Pricing Commodity Futures

Relationship between the future and its underlying spot can be best

explained with the help ofCost of Carry Model

COST OF CARRY MODEL

Futures Price=Spot Price + Cost of Carry

Constituents of Cost of Carry:

- Cost of financing

- Cost of storage

- Cost of insurance


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Interest Rate Compounded Annually

F = S + C

Where

F= Future Price, S=Spot Price, C=Cost of Carry

Example:

Cost of 100 gms of gold in the spot market is 80,000

Cost of Carry = 12% p.a., compounded annually

The fair value of a 4 months future contract will be

F = 80,000 + 3200*

F = Rs. 83,200

* 80,000*12/100*4/12 = 3,200


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Interest Rate Compounded Continuously

F = Sern

Where

e = 2.71828 (exponential function)

Example:

Cost of 100 gms of gold in the spot market is 80,000

Cost of Carry = 12% p.a. compounded continuously,

The fair value of a 4 months future contract will be

F = 80,000*2.71828(0.12*0.333)

F = Rs. 83,265*

* 80,000*2.71828(0.04)

= 83,264.85


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HEDGING


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Derivatives Basics

Hedging

Hedging means taking a position in the future market that is opposite to

position in the physical market with a view to reduce or limit risk

associated with unpredictable changes in price

A long futures hedge is appropriate when you know you will purchase an

asset in the future and want to lock in the price

A short futures hedge is appropriate when you know you will sell anasset in the future & want to lock in the price

Types of Hedges

The profit(loss) in the cash position is offset by equivalent loss(profit) on

the futures position

Thi ki i t k t


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Thinking in two market

Hedgers must think in two markets:

FINANCIALrisk management tools workin parallelwith PHYSICAL

transaction.

PHYSICAL MARKET

1. Producers buy and sell theirphysical product.

2.The physical good is delivered to awarehouse or location.

3.Payment is made based on thevalue of the physical good at thevolume delivered.

FINANCIAL MARKET

1. Producers buy and sell contractsthat represent a physical good.

2. The physical good is not typicallydelivered, rather the papercontract are closed or offset.

3. Payment is made based on thedifference between the purchasevalue of the contract and thesold/offset value of the contract


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+ =Gains/Losses

in Cash Market

Gains/Losses

in Currency Futures Mitigate Risk

Cash Market Future Market


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Managing Commodity Risk

T f H d L h d


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Types of Hedge - Long hedge

Buying hedge mean buying a futures contract to hedge the cash position.

Its used by dealers, consumers, fabricators etc. who have or will be

having an exposure in the physical market.

Buying hedge is used in the following cases:

To protect against the possible rise in the prices of raw materials

Sh t h d


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Short hedge

Selling hedge/Short Hedge means selling a future contract to hedge a

cash position. Its used by dealers, consumers, fabricators etc. who have

or will be having an exposure in the physical market.

Selling hedge is used in the following cases:

To protect the price of the products for which sales are commitment

has been made.


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The ratio of number of futures contracts to be

purchased or sold, to the quantity of cash assetthat is required to be hedged

Hedge Ratio

Standard Deviation is a measure of the volatility or risk

Correlation provides the relationship between spot andfutures prices


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Hedge Ratio: Example

Copper Futures vs. Copper Spot

Correlation = 0.997547 (or 99.7547%)

Standard Deviation (Change in Spot Price) = 0.022178

Standard Deviation (Change in Futures Price) = 0.018966

Hedge Ratio = (0.997547)x(0.022178) = 1.1665(0.018966)

If exposure in physical copper market is 10 MT,

then the hedge quantity = 1.1665 x 10 = 11.665

12 futurescontracts

Based on actual Closing Prices

Determining Optimum Hedge Example


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Determining Optimum Hedge Example

3rd September - a gold jeweler buys 8 kgs of gold in the cash market as raw material, to

create jewelry and sell the same after 15 days. To manage his price risk he decides to hedge

by selling MCX Gold October Future contract. The CPof gold and FPof gold over the

15 days period is 1.17 and 0.62 respectively and the between the cash and future price of

gold for 15 days is 0.60.

Help the gold jeweler to determine the optimum hedge required to protect his exposure?

The optimal hedge ratio is 0.60*1.17/0.62 = 1.13

The gold jeweler should sell 1.13*8/1=9.04 kgs or 10 (always advisable to be over hedge

than under hedge) gold futures contracts to hedge the physical exposure of 8 kgs of gold.

Solution to the given problem


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Thank you

price risk mgmt

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