PSC Introduction to Financial Derivatives and Hedging Strategies

8/9/2019 PSC Introduction to Financial Derivatives and Hedging Strategies

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PROCUREMENT STRATEGY COUNCIL

Research Brief September 2008

2008CORPORATE EXECUTIVE BOARD

Introduction to Financial Derivatives and

Hedging StrategiesOVERVIEW

The recent rise in commodity price volatility has increased companies interest in implementing

a broader array of market-based derivatives to protect against future market increases whileenabling the company to take advantage of market declines. In a recent Council survey, almost

half of the respondents reported that they are investigating opportunities to use more financialderivatives to stem commodity price risk. This makes sense as respondents indicate that curren

commodity hedging only mitigates roughly 11% of the volatility experienced within the market

While there are many reasons why companies have not taken the next step to implementpotential financial hedges, a majority of companies cite a lack of the necessary infrastructure

and unfamiliarity with potential hedges as the primary reasons for not implementing these toolsTo help members better acquaint themselves with the most common financial instruments, theCouncil has developed this summary document outlining how each operates and the strengths

and weaknesses of each hedge.

43%

14%

6%3%

34%

Have no intention of exploring or expanding

Exploring potential hedging strategies

Relying MORE on hedging strategies

Relying LESS on hedging strategies

Continue using the same strategies

HEDGING STRATEGIES ON PROCUREMENTS RADAR

Percentage of Survey Respondents

n=35

Source: Procurement Strategy Council Research (2008)

27%

23%22%

17%

11%

Offset by Cost Reduction

Pass to Customer

Absorb in Lower Margin

Avoided by Long Term Contract

Avoided by Hedge

RESPONSE TO RAPID RISE IN COMMODITY PRICESPercentage of Survey Respondents

n=53

CONTENTS

OVERVIEW(Page 1)

DERIVATIVES:DEFINITION ANDTYPE(Page 2)

FORWARD CONTRACT(Page 2-3)

FUTURES CONTRACT(Page 3-4)

OPTION CONTRACT(Page 5-6)

SWAP CONTRACT(Page 6-7)

SUMMARY OF DERIVATIVES(Page 8)

HEDGING STRATEGIES(Page 9)

COLLAR HEDGE(Page 9)

BULL CALL SPREAD(Page 10)

SWAPTIONS(Page 10)

SUMMARY OF HEDGING

STRATEGIES(Page 12)

COMMON MISUNDERSTANDINGS(Page 13)

RESEARCH PROCESS IN BRIEF(Page 14)



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INTRODUCTION TO FINANCIAL DERIVATIVES AND HEDGING STRATEGIES PAGE 2

September 2008


Derivatives: Definition and Types

Derivatives are securities whose value is derived from an asset (referred to as an underlier

within the market) such as a commodity, currency, or a market basket of different assets1.

Following sections discuss details of four categories of derivatives

Forward Contracts - A private agreement between two parties to make payments for afuture delivery of the underlying commodity

Futures Contracts - An agreement made in an open commodities market to makepayments for a future delivery of the underlying commodity

Option Contracts - An agreement made through an open commodities exchangeproviding right to buy a commodity in the future at a predetermined price

Swaps - A contract enabling exchange of unpredictable cash flow, such as price paidfor heating oil based on index prices, for a predictable cash flow, such as fixed price ofheating oil.

FORWARD CONTRACT

A forward contract is

a customized

agreement between

two parties much likea standard sourcing

contract, the maindifference being that

complete advance

payment is made fora delivery in the

future2.

The trading parties

are either brought

together by an

intermediary (such asa brokerage firm or

financial institution)or have conducted

business in the past (as in supply contracts developed by Procurement). In this arrangement, the

price of the underlying asset, in whatever form, is paid before ownership of the asset changes.

The ability to hedge any commodity or product using forward contracts, and the availability of

long and short parties through diverse Over-the-Counter markets makes Forward Contracts

highly flexible agreements. The flexibility is further enhanced by ability to incorporate terms

and conditions agreeable to both trading parties. The process to negotiate a Forward Contract isvery similar to negotiating a normal sourcing contract (see the process map on next page). The

difference between sourcing and forward contract lies in invoicing, while payment is made after

delivery in sourcing contracts, forward contracts mandate payment before delivery. However

this flexibility also makes forward contracts the most vulnerable to default. In instances of

default, the long partys only recourse is suing the short party in open court.Forward Contract Applicability: Given the highly flexible nature of the contracts, forwards are

instruments of choice for buyers trying to hedge processed products with weak correlation to

exchange traded commodities. However, it is advisable to limit exposure to low quantities ordemand collateral as absence of a monitoring body increases risk of default.

Forward Contract Characteristics

Market Type Over-The-Counter (OTC)

ContractExecution

Physical Delivery

Pros

Terms are easily customized to meet theneeds of both the short and long parties

The future price is fixed for the long party Can provide coverage for commodities and

products without liquid marketplaces

Cons

The risk of the short party defaulting on theagreement increases during times of rapidinflation or supply disruptions

Long parties can find it difficult to forfeittheir right to participation if prices go down

(as the money has already been paid)

Complete payment required in advancewhich ties up working capital

Definition of Long And Short Parties

In each hedging arrangement, thereare two primary parties involved.

These parties are known as the LongParty and Short Party.

The Long Party is the organization orindividual that purchases the

contract or commodity

The Short Party is the organization or

individual that sells the contract orcommodity.

The Types of Commodity Markets

In most cases, commodity hedging is

conducted in one of two venues called markets.

Public Exchanges - A regulated

marketplace where short and longparties can trade a standardized setof market derivatives. In these

markets, most of the commoditycontracts are cash settled rather thansettled by final delivery of the physical

product to the long party. This meansthat at the end of these contracts,any differences between the currentvalue of the underlier and the originalcontract price is settled in cash.

This enables organizations to holdcommodities without needing to

manage warehouse and physicalinventory costs.

Private Over-The-Counter - A non-

regulated market place where twoparties come together or are brought

together by a mediator (usually abrokerage house or financialinstitution) to enter a derivatives

contract. Over-The-Countermarketplaces can be as easy as aforward contract between you and

your supplier, or, for moresophisticated trades, involved a bankas the mediator.

However, because these markets are

not regulated, the risk that either sidewill default on the trade is muchhigher as it wont result in exchange-

enforced penalties outside of a courtsetting.


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FUTURES CONTRACT

A futures contract is an

exchange traded,

standardized contract thatrepresents an agreement to

buy or sell a quantity of

asset at a predetermineddelivery date and fixed

price2.

To execute future contracts,

Procurement (long party)needs to establish a

relationship with a broker

registered with an

exchange that trades in the

desired commodity. Thisbroker then operates a

margin account on behalf

of Procurement through which future contracts offered by short parties can be bought. On anygiven day, the exchange may list a variety of contracts that vary in length, volume (quantity),

and settlement (a full list of contract terms is located on the following page). Procurement

organizations interested in using these derivatives must then patch together a series of contractsmeeting their needs.

The contracts are then settled each day based on the difference between the contract price and

the spot market price. The exchange marks all the contracts to market prices at the end of the

day. If the contract is out of money, meaning that a buyer struck a deal where the contract priceends up above the current spot price, the exchange may issue a margin call, a request to

deposit money in the margin account, to mitigate risk of default (see the process map below).

Futures Contract Characteristics

Market Type Public Exchanges

Contract

ExecutionCash settled

Pros

Mediation by exchange lowers risk of defaultby either party

Procurement only pays the complete contractat the end of the contract term (rather than

before as in a forward contract)

Cons

Structure prevents procurement from takingadvantage of market declines.

Can only be executed in exchanges that tradein the commodity Procurement wishes to

purchase

Long parties must set aside funds to pay formargin account

Procurement and SuppliersMeet to Negotiate Price of

Contract

Savings Relative to Spot Price

PROCESS MAP AND SAVINGS CHART FOR FORWARD CONTRACT

A simplified version of procedure to participate in Forward Contract market


Both Parties Enter a BindingLegal Contract to Trade aCommodity for Fixed Price

Both Parties Deposit aSecurity to Mediating Party

to Cover Risk of Default

Optional Step

Contract is Executed Either

by Cash Settlement orDelivery of

Commodity/Product

K

Long Party

(Procurement)

Short Party

(Supplier)Mediating Party

SupplierDelivers

ProcurementPays-20

-15

-10

-5

0

5

10

15

20

10 20 30 40

Spot Price

Savings

Legal Contract

K = Fixed Price

Margin

A margin is the collateral that shortand long parties must set aside tocover the credit risk for contracts thatrequire cash settlement sometime in

the future. The size of the margindepends on the size of the contract,

the partys bond rating, and itsrelationship with its counterparty (e.g.broker).

An account set up to handle these

cash settlements is considered amargin account. Once companiesset up these accounts with aparticular exchange, multiple futures

and options can be traded from asingle margin account with sufficientfunds to cover credit risk.


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Applicability: Futures contracts are suitable for companies that require commodities or near-commodities traded on an exchange at a predetermined fixed price. The exchange plays the role

of mediating party, lowering the risk of default significantly. Futures contracts lock the buyers

into a fixed price with potential loss of opportunity to save if the market prices fall.

A standard futures contract contains the following details

The underlying asset or instrument The type of settlement (cash settlement or physical settlement) The amount and units of the underlying asset per contract The currency in which the futures contract is quoted The grade of the deliverable. The delivery month The last trading date Other details such as the commodity tick, the minimum permissible price fluctuation

PROCESS MAP AND SAVINGS CHART FOR FUTURES CONTRACTA simplified version of procedure to participate in Futures Contract exchange

1

5.b

Each Day, if Market Moves

Up, Exchange DepositsMoney into Margin Account

If Commodity Prices

Moved Up, CompanyReceives Money

Procurement Provides

Hedging Requirements and

Margin Money toTreasury/Bank

Bank/Brokerage Firm Take

Long Position by Buying

Futures from Exchange

Each Day, if Market Moves

Down, Bank Deposits Margin

Money

Savings Relative to Spot Price

2 3.a

3.b

Expiry Date: Contracts are

Matched for Settlement

4If Commodity Prices

Moved Down, Company PaysMoney

5.a

K

BankProcurement Bank Exchange

Exchange

ExchangeBank

Bank

ExchangeShort Party Long Party

Procurement Short Party ProcurementExchangeExchange

-20

-15

-10

-5

05

10

15

20

10 20 30 40

Spot Price

Saving

s

Short Party

Note that the future behaves the same asa forward. The differences are in the risk of

default (lower with a future), and modes ofsettlement and delivery.

K = Fixed Price


Safer Than Forward

xchange mitigates risk of default viasue of margin call, making futuresontract a safer hedge compared to

orward contract


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September 2008


OPTIONS CONTRACT

An options contract provides

a Long Party a right- but not

an obligation- to buy or sell

an underlying asset offered

by a Short Party at apredetermined price within a

specified time period3.

In order to gain the luxury of

this flexibility, a Long Party

must pay a premium to theShort Party upfront in order

to hold the option for a

future purchase.

There are four basic trades in

Option Contracts 1.Long Call Long party

gains right to buy the

underlying commodity ata set price

2.Long Put Long Partygains right to sell the

underlying commodity ata set price

3.Short Call Short Party charges a premium for promising to sell the underlying commodity4.Short Put Short Party charges a premium for promising to buy the underlying commodity

The long party (buyer of an option) pays a premium. The short party (seller of an option) earns

a premium.

Most of the option contracts are cash settled like future contracts and include issuing margincalls to the appropriate party after each day of trading (also like future contracts). There are two

main styles of options 1.European an option that may only be exercised on expiration date of the option2.American an option that may be exercised on any trading day on or before expiration

date.

Calculating the Premium: The premium for options is based on two values the intrinsic value

of the contract and the time value of the contract. The intrinsic value of the contract is thedifference between spot price and the contract price included in the premium to cover the risk

short party takes in promising to trade at a price different from the market price. The time value

of the contract, calculated using annualized volatility, risk free interest rate, term of contract,and price of the contract, is included in the premium to cover the risk the short party takes in

promising to trade at a future date.

Applicability: Implementation of this hedge requires the buyer to pay a premium for the right to

execution. Premiums tend to discourage casual use of options contracts by Procurement; optionare a good choice when Procurement has access to sufficient upfront capital full support of

corporate Treasury or Finance.

Option Contract Characteristics

Market

TypeExchange Traded

Contract

Execution Cash settled

Pros

Mediation by exchange lowers risk ofdefault by either party

Provides Procurement an opportunity to takeadvantage of lower prices should thecommodity market decline

Cons

Can only be executed in exchanges that tradin the commodity Procurement wishes to

purchase

Commodities with low volatility may not beworth premium (whereas highly volatile

commodities may require hefty upfront riskpremiums)

Long parties must set aside funds to pay formargin account

Requires the upfront payment of a riskpremium

Definition of an Option Call and Put

Call An option that gives contractolder a right to buy the underlyingommodity at a specific price during a

pecific timeframe.

ut An option that gives contract

older a right to sell the underlyingommodity at a specific price during apecific timeframe.

Premiums

he premium is the upfront cost ofuying an option paid to the seller

whether it is exercised or not. The

remium represents the estimated riskaken on by the seller.


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SWAP CONTRACT

A swap contract is an agreementto exchange a fixed cash flow for

a floating cash flow, or visa

versa at a future time in fixedintervals4.

There are two types ofcommodity swaps

1. Fixed-Floating Swaps Afixed commodity based cash

flow is exchanged for a

floating cash flow (based onindex or price of traded

commodity)

2. Commodity-for-InterestSwaps - a total return on thecommodity is exchanged for

some money market rate

(plus a spread)

Swap contracts are traded over-the-counter and are usually offered by financial institutions thatwill seek out and connect interested parties. As with forward contracts, these arrangements are

highly customizable and can offer companies flexibility in arranging deals that help spread out

unique exposures to commodity markets.

Applicability: A swap contract enables a company to flatten the ups and downs in a commodity

market over the short term as it enables hedgers to get a fixed price from a financial institutionin exchange for an index-based price. Swap contracts are not suitable as a long term strategy in

volatile market places as prices will move away from fixed price significantly5.

Swap Contract Characteristics

Market Over-the-counter

Suitable

PeriodLong-term hedge

Pros

Terms are easily customized to meet theneeds of both the short and long parties

Can provide coverage for commoditiesand products without liquid marketplace

Help flatten volatile market prices socosts are more predictable

Cons

Financial institutions will extract heavypenalties if swaps are settled before

maturity

Commodity-index correlation mightbreak down in high volatility

Difficult to set-up and may requirestrong correlation proof for banks

PROCESS MAP AND SAVINGS CHART FOR OPTIONS CONTRACTA simplified version of the procedure to participate in an Options Contract exchange


If Commodity Prices Decline,Let the Contract Expire, and Buy

on the Spot Market

Savings Relative to Spot PriceWhen the Premium is 5.00

Procurement Provides

Hedging Requirements andPremium to Treasury/Bank

1Bank/Brokerage Firm Buys

Long Call by Paying aPremium

2Expiry Date: If Commodity

Prices Moved Up, ExerciseContract to Buy the

Commodity at a Savings

3.a

3.b

K

BankProcurement Bank Exchange

Exchange

ExchangeProcurement

Procurement-10

-5

05

10

15

20

25

30

10 20 30 40 50

Spot Price

Savings

Defining Swap Cash Flows

A cash flow, in context to commoditywaps, is a recurring payment to a

upplier for purchase of a commodity.

xed Cash Flow A fixed price due at a

uture date for the purchase of aommodity (e.g. the purchase of oil on

long term fixed contract).

oating Cash Flow A fluctuating price

ue at a future date for the purchase of commodity (e.g. the purchase of oilt index price).

K = Strike Price


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PROCESS MAP AND SAVINGS CHART FOR SWAP CONTRACT

A simplified version of procedure to participate in Swap Contract


Contract Period: If the IndexBased Prices are Above Fixed

Prices, Bank Pays

Company Trades Fixed CashFlow for Floating Cash Flow

Procurement ProvidesCommodity Requirements to

Treasury/Bank

If the Index Based Prices are

Below Fixed Prices, CompanyPays

BankProcurement

Fixed

FloatingBankProcurement

BankProcurement

BankProcurement

Savings Relative to Index Price

K

-20

-15

-10

-5

0

5

10

15

20

10 20 30 40

Index Price

Savings

K = Fixed Price

3.a

3.b


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September 2008


SUMMARY OF DERIVATIVES

The table below compares financial derivatives pros and cons discussed individually in earlier sections.

FEATURES OF DIFFERENT DERIVATIVES

A table providing snapshot of features of financial derivatives

Forward Contract Future Contract Option Contract Swap

ContractMarket

Type

Over-The-Counter Exchange Exchange Over-The-Counter

Contract

Type

Long party must take

delivery at expiration

Long party must settle

full contract in cash

Long party can settle the

contract in cash or cancel

Long party trades cash

flows as per agreement

Pros - Terms are easily

customized to meet theneeds of both the short

and long parties

- The future price is

fixed for the long party

- Can provide coveragefor commodities and

products without liquid

marketplaces

-Mediation by exchange

lowers risk of default byeither party

-Procurement only paysthe complete contract at

the end of the contract

term (rather than before

as in forward or optioncontracts)

-Mediation by exchange

lowers risk of default byeither party

-Provides Procurement anopportunity to take

advantage of lower prices

should the commodity

market decline

-Terms are easily

customized to meet theneeds of both the short

and long parties

-Can provide coverage for

commodities and products

without liquid

marketplaces

-Help flatten volatile

market prices so costs are

more predictable

Cons -The risk of the short

party defaulting on the

agreement increasesduring times of rapid

inflation or supply

disruptions

-Long parties can find it

difficult to forfeit theirright to participation if

prices go down (as the

money has already been

paid)

-Complete payment

required in advance

which ties up working

capital

-Structure prevents

procurement from takingadvantage of market

declines

-Can only be executed in

exchanges that trade inthe commodity

Procurement wishes topurchase

-Long parties must set

aside funds to pay for

margin account

-Can only be executed in

exchanges that trade inthe commodity

Procurement wishes to

purchase

-Commodities with lowvolatility may not be

worth premium (whereashighly volatilecommodities may require

hefty upfront risk

premiums)

-Long parties must set

aside funds to pay for

margin account; requires

the upfront payment of a

risk premium

- Financial institutions

will extract heavypenalties if swaps are

settled before maturity

-Commodity-index

correlation might breakdown in high volatility

-Can be difficult to set upas deals are heavily

customized and may

require strong market

correlations

Applicability Companies willing topay in advance and have

trustworthy sellers ofspecialized commodities.

Companies purchasingexchange-traded

commodities and do nothave a trustworthy

source to execute

forward contract.

Companies purchasingexchange-traded

commodities and willingto pay a premium for the

option to buy on the

spot market should pricesdecline

Companies purchasingcommodities from

suppliers demandingindex-based prices for

commodities not traded

on the open exchange



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HEDGING STRATEGIES

By using the above financial instruments in different combinations, companies can construct

mechanisms that both help limit downside risk without entirely losing the ability to takeadvantage of declining market prices. Common combinations are often referred to by name and

are treated as natural extensions of simple market derivatives.

COLLARHEDGE

A collar is formed when a partytakes both call and put position

in the market at prices equally

spread from the spot price.

A party sells a put at a price

lower than spot price and buys a

call at a price higher than spotprice. Both the contract prices

are placed equidistant from the

spot price and have sameexpiration date. The collar hedge

enables Procurement to pay the

spot price while capping the

upper and lower price (see the process map below)6.

Applicability: The difference between the premium received for selling a put and premium paidfor buying a call is negligible, making this strategy suitable for multiple hedging cycles in small

time period keeping the prices between a floor and ceiling.

Collar Characteristics

Underlying

DerivativeOption

Pros

Upper limit on price of commodity Low cost hedging strategy as cost of

margins are offset between the call and

the put

Cons

Limits savings to a lower limit if marketdecline, unlike a straight option where

the downward benefit is not limited Only available for those commodities

traded in a liquid market

Buy a Call by

paying a premium

Sell a Put and earn

a premium

Offset the

premium

At the endof term

Spot Price: $50Call Strike Price: $60

Spot Price: $50

Put Strike Price: $40

Spot Price < $40 Spot Price > $60

$40 < Spot Price < $60

Call expiresPut is executed

Buy commodity at $40

Both contracts expireBuy at spot price between

$40 and $60

Call is executedPut expires

Buy commodity at $60

PROCESS MAP FOR EXECUTING COLLAR HEDGEA simplified version of procedure to participate in CollarHedge


Limit Risk Spread

Collar hedge limits the risk of price rise

without complete loss of opportunity touy from market if price falls. However,also puts a lower price cap.


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Bull Call Spreads

A bull call spread is similar to

the collar in that it employs a

pair of options to create a low

risk, low reward strategy -- butit is different in that it is biased

to improve your reward upon

the assumption that the marketis more likely to rise than fall,

while it also allows you to fullybenefit from a drop in prices if

the market should happen tofall7.

In a market with an upward

outlook, the hedger can buy one call near the spot price and sell a second call further above.The difference between the premiums for the calls bought and sold is the maximum loss for the

hedge if the market falls, the calls are not exercised and only the premium costs remain. If the

market rises, the user now has the right to buy at the lower call price, generating savings, and ifthe market continues to rise the user has the obligation to sell at the higher call price, still

returning a profit but limiting the upside gain. In the case of commodities hedging rather than

speculation, this profit is then applied to buying the good in question, offsetting the rising price.

Applicability: This strategy is cheaper than buying just a call option, although it limits the

upside potential. The strategy is best when you expect a mild, but not a dramatic market rise.

Bull Call Spread Characteristics

Underlying

DerivativeOption

Pros

Limits upside price risk for thecommodity

Part of the premium cost is offset byselling as well as buying an option

Cons

The buyer still has to pay the remainingdifference on the premium if the market

drops and the calls arent exercised.

Only available for those commoditiestraded in a liquid market

Buy a Call bypaying a premium

Sell a Call and

earn a premium

Offset thepremium

At the endof term

Spot Price: $50Long Call Strike Price: $52

Spot Price: $50

Short Call Strike Price: $60

Spot Price < $52 Spot Price > $60

$52 < Spot Price < $60

Calls expire

Buy commodity at spotprice.

Exercise the low call

purchasing thecommodity at $52.

Both calls are executed:you buy at $52 and sell at$60, using the $8 gain tooffset the spot price for

your own purchasing.

PROCESS MAP FOR EXECUTING BULL CALL SPREADA simplified version of procedure to participate in Bull Call Spread


Medium Cost, Higher Benefit Hedge

A bull call spread enables a buyer touy and sell a pair of call options so

hat the premiums partially but notully offset each other. Unlike a collaredge, the buyer can still take fulldvantage of a drop in the market,

while also benefiting from a wider rangef gains assuming the market rises.


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September 2008


SWAPTIONS

A swaption is a combination of

swap and option which gives

buyer a right to enter a swap at

a future point in time.

A call swaption gives buyer a

right to swap a fixed cash flowfor a floating cash flow (such as

an index). A put swaption gives

buyer a right to swap a floating

cash flow for a fixed cash flow.

A hedger is interested in a put swaption as it provides right to exchange floating cash flow for afixed cash flow at predetermined rates at a future point in time8.

Applicability: Hedgers trying to gauge extent of volatility before entering a swap should use

Swaptions as the contract gives buyer the right to exchange a fixed cash flow for a floating cashflow at a future point in time.

Swaptions Characteristics

Underlying

DerivativeOption and Swap

Pros Fixed price for volatile commodities Large OTC market enables hedging of

products not traded on Exchanges

Cons Option to not enter swap in case of

market slide

Premium to buy right to swap

Buy an Option toenter Swap

Expiry dateof Option

Spot Price: $50Fixed Price Offered: $55

Market price fellSpot Price: $34

Market price roseSpot Price: $62

Swaption expires

Continue to buy at spot price

Execute swaptions contract

Receive $7 to compensate risein prices

PROCESS MAP FOR EXECUTING SWAPTIONA simplified version of procedure to participate in Swaption

End of 1stterm

Pay $3 to Swap writer frombudget

Buy commodity at $52 withremaining budget

Receive $13 to compensate risein prices

Market price roseSpot Price: $68

Market price fellSpot Price: $52


Premium to Swap

nlike most other Swaps, an option onwaps is bought by paying a premium.

Long Term View

may be worth purchasing a swaptionespite a short-term price fall not

upported by fundamental changes inupply; otherwise the buyer remainsxposed to higher prices in the long run.


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September 2008


SUMMARY OF HEDGING STRATEGIES

The table below compares hedging strategies pros and cons discussed individually in earlier

sections.

FEATURES OF HEDGING STRATEGIES

A table providing snapshot of features of hedging strategies

Collar Hedge Bull Call Spread Swaptions

Underlying

Derivative

Option Contracts Option Contracts Option on Swaps

Pros - Upper limit on

price of commodity

- Low cost hedging

strategy

- Limits upside price

risk for the

commodity

- Part of the

premium cost isoffset by selling as

well as buying anoption

- Optional fixed

price for volatile

commodities

- Large OTC market

enables hedging ofproducts not traded

on exchanges

Cons - Limits potential of

saving if prices

decline- Only applicable to

exchange-traded

commodities

- Buyer still has to

pay the remaining

difference on thepremiums.

- Only applicable to

exchange-tradedcommodities

- Premium required

to buy the contract

Applicability Companies looking

to evenly spreadupward and

downward risk of

buying exchange-

traded commodities

Companies looking

for a low-riskstrategy built on a

bias that the market

will move up during

the term of thehedge.

Companies trying to

convert index-basedprices into fixed

prices with the

option to observe the

market beforeentering the contract



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September 2008


COMMON MISUNDERSTANDINGS

The table below addresses common misunderstandings around hedging via financial derivatives

Myth Explanation

The premium charged for anoption contract is a true measure

of the expected volatility in themarket

The formula used to calculate the premium for an optioncontract takes into account volatility, spot and contract

prices, risk-free interest rates, and term of contract. Asthe calculation depends on various other factors, it doesnot directly correlate to expected volatility.

Financial derivatives are just

speculators tools and hedging onan open market is a risky gamble.

Financial derivatives markets were invented to protect

traders from unforeseen circumstances. While profit-seeking speculators participate and skew the market,

responsible use of financial derivatives can enableProcurement to secure predictable price ranges for

commodities.

If markets do not move, an optionbought with contract price below

the market price will enablesavings.

The intrinsic value embedded in the premium charged forthe option is equal to the difference between the spot and

contract price. Any savings made by execution of theoption will only offset the intrinsic part of the premium,making the landing cost of the commodity equal to the

market price plus time value embedded in the premium.



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September 2008


1 Durbin, Michael,All About Derivatives, New York: McGraw-Hill Companies, 2006, p. 1-42 Bansal, Manish, Navneet Bansal,Derivatives and Financial Innovations, New Delhi: Tata McGraw-Hill Companies,2007, p. 4933 Bansal, Manish, Navneet Bansal,Derivatives and Financial Innovations, New Delhi: Tata McGraw-Hill Companies,

2007, p. 4984 Durbin, Michael,All About Derivatives, New York: McGraw-Hill Companies, 2006, p. 31-365 Author Unknown, Some Basic Ideas About Commodity Swaps, The Financial Express,

http://www.financialexpress.com/news/Some-basic-ideas-about-commodity-swaps/201454/ (11 June 2007)6 Arunajith, Upul, The Zero Cost Collar Hedging Strategy, The Sunday Times Online,

http://sundaytimes.lk/070513/FinancialTimes/ft315.html (13 May 2007)7 optionsXpress, Bear Call Spread, http://www.optionsxpress.com/educate/strategies/bearcallspread.aspx8 Gilbert, Christopher L., Alexandra Tabova, Commodity Swaptions,

http://www.performancetrading.it/Documents/CgCommodity/CgC_Swaptions.htm

THE RESEARCH PROCESS IN BRIEF

Project Aims and Research Methodology

This document seeks to provide procurement executives with an overview of

financial instruments and hedging strategies. Because it employs an abbreviated

research process to maximize its timeliness, this project (by design) does not

provide an exhaustive evaluation of the problem or the practice. Looking forward,

the Procurement Strategy Council plans to periodically update this collection as new

practices and insights emerge.

While this report describes the opinions of experts and others regarding an issue of

key strategic concern, we cannot emphasize enough that (consistent with our

charter) we are not recommending any particular course of action.

This document is compiled from extensive primary and secondary research completed

by the Procurement Strategy Council.

Professional Services Note:

The Procurement Strategy Council has worked to ensure the accuracy of the information it provides

to its members. This project relies upon data obtained from many sources, however, and theProcurement Strategy Council cannot guarantee the accuracy of the information or its analysis in

all cases. Furthermore, the Procurement Strategy Council is not engaged in rendering legal,

accounting, or other professional services. Its projects should not be construed as professional

advice on any particular set of facts or circumstances. Members requiring such services are advised

to consult an appropriate professional. Neither Corporate Executive Board nor its programs are

responsible for any claims or losses that may arise from any errors or omissions in their reports,

whether caused by Corporate Executive Board or its sources.

Project Aims

ResearchMethodology

PSC Introduction to Financial Derivatives and Hedging Strategies

Documents

Transcript of PSC Introduction to Financial Derivatives and Hedging Strategies