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Chapter 4 1

CHAPTER 4Using Futures Markets

In this chapter, we discuss the different ways that futures markets serve different members of society. This chapter is organized into the following sections:

1. Price Discovery

2. Speculation

3. Hedging

Chapter 4 2

Price Discovery

Because the futures market incorporates the collective opinion of many buyers and sellers, the futures market can be used to reveal information about future spot prices.

The usefulness of forecasting future spot prices, based on current futures prices, depends upon three factors:

1. Information: the need for information about future spot prices.

2. Accuracy: the accuracy of the futures market forecasts of those prices.

3. Performance: the performance of futures market forecasts relative to alternative forecasting techniques.

Chapter 4 3

Information

Interest Rates and Home Buying

You are in the market for a new home and you want to have an idea of how interest rates will behave in the next year. By examining the WSJ, you can discover what the market as a whole thinks about the future course of interest rates. If the interest rate (yield) on bonds to be delivered in six months is three percentage points lower than current interest rates, then there is good reason to expect that interest rates will fall over the next six months.

Furniture Manufacturer

A furniture manufacturer needs to print its catalog for the next year and needs to include prices. Furniture prices will depend in part upon next year’s lumber prices. The furniture manufacturer can review the lumber futures market to estimate the costs of the wood.

The person using the futures market to estimate the future course of interest rates or the future course of lumber prices is using the futures market for its price discovery benefit.

Chapter 4 4

Accuracy

We would like the estimator of the expected future spot price to be accurate. If it is not accurate, its usefulness is limited. A forecast estimate is unbiased if, on average, the forecast is correct. However, even if a forecast estimate is unbiased, the range might be so wide that its usefulness is limited.

Example

I predict that the points scored by the winner in the NBA finals game will be between 50 and 150 points. On average, I might be right, but the range is so wide that it not particularly useful.

Futures prices sometimes have large errors and these may differ across commodities.

Chapter 4 5

Performance

Evidence suggests that while futures markets have large errors, they are generally better at predicting the future than any other available methods of forecasting.

Because of this property, military researchers have suggested using futures contracts to predict terrorist attacks.

Chapter 4 6

Forecasting Oil Prices A Case Study

Table 4.1 illustrates a case of a large forecast error.

Table 4.1

Forecast Errors for Alternative Forecasts Commodity Horizon

Futures Error

No--Change Error

Crude Oil 1 Month

.0148

.0268

2 Month

.0268

.0499

3 Month

.0456

.0720

6 Month

.1057

.1469

Heating Oil 1 Month

.0074

.0085

2 Month

.0182

.0196

3 Month

.0284

.0305

6 Month

.0628

.0553

Leaded Gasoline 1 Month

.0129

.0155

2 Month

.0261

.0281

3 Month

.0397

.0440

6 Month

.0956

.0893

Source: Cindy W. Ma, “Forecasting Efficiency of Energy Futures Prices,” The Journal of Futures Markets, 9:5, October 1989, pp. 393-419.

Chapter 4 7

Forecasting Performance for Different Commodities

Quality of forecasts differ across commodities.

Table 4.2

Forecasting Power of Commodity Futures Forecasting Power for All Maturities

No Forecasting Power

Broilers Hogs Eggs Oats

Forecasting Power for Most Maturities

Cattle Soybeans Pork bellies Soymeal

Forecasting Power for Some Maturities

Orange juice Plywood

Lumber Copper Soyoil Cotton Cocoa Gold Corn Platinum Wheat Silver Coffee

Source: Eugene F. Fama and Kenneth R. French, ‘Commodity Futures Prices: Some Evidence on Forecast Power, Premiums, and the Theory of Storage,” Journal of Business, 60:1, 1987, pp. 55-73.

Chapter 4 8

Speculation

A speculator is a trader who enters the market to profit from short term price changes. In doing so, he/she assumes risk that other individuals are trying to dispose of.

Most individuals have no heavy exposure in the futures market. As such when they enter the futures market it is for speculation.

There are three kind of speculators:

1. Scalpers

2. Day Traders

3. Position Traders

Chapter 4 9

Scalpers

A scalper is an individual that enters the futures market to profit from very short term price movements. A scalper is generally trying to guess the short term psychology of the market.

How Long of Intervals?

– From the next few seconds to the next few minutes.

– Requires the scalper to be in the trading pit to observe the behavior of other buyers and sellers.

– Generally involves a great many trades earning a small profit on each trade. One study shows that scalpers make about 70 trades per day.

By trading very frequently, scalpers provide liquidity to the market.

Chapter 4 10

Scalpers’ Behavior Study

Table 4.3

Mr. X's Trades Over 31 Trading Days Total Transactions 2,106 Number of Contracts Traded 2,178 (Round turns-buy and sell 1 contract)

Number of Trades 729 (Zero net position to a zero net position) Profitable 353 (48%) Unprofitable 157 (22%) Scratch 219 (30%) Source: William L. Silber, “Marketmaker Behavior in an Auction Market: An Analysis of Scalpers in Futures Market,” Journal of Finance, September 1984, 39:4, pp. 937B953.

Chapter 4 11

Services Provided by Scalpers

1. Provide a party willing to take the opposite side of a trade for an off-the-floor trader.

2. Actively trade, thereby generating price quotations and allowing the market to discover prices more effectively.

3. By competing for trades, help to close the bid-asked spread, thereby reducing execution costs for other traders.

4. Attract hedging activity, because hedgers know their orders can be executed.

Chapter 4 12

Day Traders

Day traders attempt to profit from trades that occur during a single trading day.

Day traders close all of their positions before the end of the trading day. As such, day traders have no position in the futures market overnight.

By closing all of their positions at the end of the day, day traders are able to reduce their risk. Holding a position overnight is a risky proposition as the supply of many commodities is driven by weather.

Example: orange juice concentrated

Traded by the Citrus Associates of NY Cotton Exchange Florida.

Weather is crucial to orange juice prices.

In November, a trader holds a short position in orange juice futures. The trader checks the Florida Weather two days before trading closes, and no evidence of damaging weather exists, so the trader holds his position overnight. Overnight, a strong cold front damages a large portion of the orange crop. This trader suffers a large loss.

Chapter 4 13

Position Traders

A position trader is a speculator that holds a position overnight. Sometimes they may hold them for weeks or months.

There a two types of position traders:

– Outright Position

– Spread Position

These two types of trades will be discussed in turn.

Chapter 4 14

Outright Positions

This is simply taking a naked position in a commodity. For example, a trader thinks that long-term interest rate will increase, and consequently futures prices for bonds will fall. Therefore, the trader sells a futures contract on U.S. Treasury bonds.

If long-term interest rates rise as the trader expected, the trader will earn a profit.

The risk is that the long-term interest rate will decline rather than increase. In which case the position trader will lose money.

Chapter 4 15

Spread Positions

Spread positions involve trading multiple contracts on the same or related commodities.

The idea is to profit when the difference in prices between the two related commodities changes.

There are two basic types of spreads:

1. Inter-commodity spread

In an inter-commodity spread, a trader takes a position in two or more different but related commodities.

2. Intra-commodity spread

In an intra-commodity spread, a trader takes a position in two or more maturity months for the same good.

Example:

Wheat and corn are substitutes for each other for certain uses (e.g., ethanol production and cattle feed). Therefore, we would expect a certain relationship to exist between the prices of the two commodities. That is, the prices of these two commodities should follow some pattern.

Chapter 4 16

Spread Position Inter-Commodity Case

Table 4.5 illustrates the case of a spread speculator who believes that the difference between futures price of wheat and corn is too high.

Table 4.5

An Inter-Commodity Spread The wheat and corn contracts are both for 5,000 bushels. Date

Futures Market

February 1 Sell 1 JUL wheat contract at 329.50 cents per bushel. Buy 1 JUL corn contract at 229.00 cents per bushel.

June 1 Buy 1 JUL wheat contract at 282.75 cents per bushel. Sell 1 JUL corn contract at 219.50 cents per bushel.

Corn Loss:

B$.095 per bushel x 5,000 bushels = B$475.00

Wheat Profit:

$.4675 per bushel x 5,000 bushels = $2,337.50

Total Profit: $1,862.50

Notice that the spread has narrowed as expected resulting in a profit on the transactions.

Chapter 4 17

Spread Position Inter-Commodity Case

Insert figure 4.1 and 4.2 below

Chapter 4 18

Spread Position Intra-Commodity Case

Tables 4.6 and 4.7 will be used to illustrate a more complex spread, “the butterfly spread.”

Table 4.6

Copper Futures Prices on November 10 Delivery Month (of following year)

Price

(cents per pound) JUL

67.0

SEP

67.5 DEC

70.5

Chapter 4 19

Spread Position Intra-Commodity Case

Table 4.7

A Butterfly Spread in Copper The copper contract trades on the Commodity Exchange, Inc., a division of the New York Mercantile Exchange (NYMEX). Each contract is for 25,000 pounds. Date

Futures Market

November 10 Sell 1 JUL copper contract at 67 cents per pound. Buy 2 SEP copper contracts at 67.5 cents per pound. Sell 1 DEC copper contract at 70.5 cents per pound.

April 15 Buy 1 JUL copper contract at 65 cents per pound. Sell 2 SEP copper contracts at 67 cents per pound. Buy 1 DEC copper contract at 68.5 cents per pound.

Profits and Losses:

JUL: +$.02 x 25,000 pounds = +$500 SEP: -$.005 x 2 contracts x 25,000 pounds =

-$250 DEC: +$.02 x 25,000 pounds = +$500

Total Profit: $750

Chapter 4 20

Speculative Profits

Evidence suggests that some individuals earn good returns by speculating but many do not. When you incorporate the value of your time as well as the opportunity cost of funds that you invest, many positive returns disappear.

Table 4.8

Evidence on Speculative Profits Study

Key Results

Stewart (1949) 75% of speculators lost money.

Houthakker (1957) Small speculators lost in grains, but made profits in cotton.

Rockwell (1967) Small speculators lose consistently after con-sidering transaction costs.

Ross (1975) Speculators made money before commis-sions and lost money including commissions.

Chang and Stevenson (1985) Small speculators make profits.

Hartzmark (1987) Leuthold, Garcia, and Lu (1994)

Large speculators do not earn significant profits; large hedgers do not have significant losses. Large reporting traders in frozen pork bellies earn significant profits.

Chapter 4 21

Technical Trading Systems

Technical analysis is a method of analyzing markets that uses only market data (price, volume, open interest, etc) to predict future price movements.

Table 4.9

Evidence on Technical Trading Systems Study

Key Results

Tomek and Querin (1984) The chance for a technical trading rule to work is small.

Neftci and Policano (1984) Some predictive power for T-bills, gold, and soybeans, but none for copper.

Lukac, Brorsen, and Irwin (1988a)

Examination of 12 different technical trading systems found that 7 generate profits, thus providing some support for technical analysis.

Lukac, Brorsen, and Irwin (1988b)

Technical trading systems are similar, and generate trading signals at similar times.

Lukac, Brorsen, and Irwin (1989) Trading systems require users to specify parameters, but past data do not help choose best parameters.

Chapter 4 22

Commodity Funds

A commodity fund is a financial institution that accepts funds from a variety of participants and uses those funds to speculate in the futures market. To succeed, commodity funds must be able to earn speculative profits, presumable through technical trading systems.

Table 4.10

Studies of Commodity Funds Study

Key Results

Irwin and Brorsen (1985) Returns vary widely by year; interest earnings are a large part of total earnings; 65% of funds lost money; including funds in a stock and bond portfolio reduced portfolio risk.

Cornew (1986) Funds only use 20% of total funds as margin de-posits; 80% of funds earn interest.

Murphy (1986) Performance of technically oriented funds is inferior to stocks and TBbills; adding funds to stock and bond portfolios reduces overall risk; no evidence that funds outperform a buyBandBh-old strategy.

Irwin and Brorsen (1985) Funds place 28% of equity in margins.

Elton, Gruber, and Rentzler (1987)

Overall performance is not attractive alone or as an addition to a stock and bond portfolio; past performance is not a good guide to future performance.

Edwards and Ma (1988) Pre-public trading results reported in fund prospectuses do not help predict subsequent fund performance and are substantially greater than post-public performance.

Chapter 4 23

Hedging

A hedger is an individual who enters the futures market in order to reduce a preexisting risk.

A preexisting position might include:

1. A commodity that you own: you have a silver mining company and have silver stored. You own the commodity.

2. An anticipatory hedge: a commodity that you will acquire in the future. If you are a new silver mining company and just have initiated mining operations. You expect to acquire/have silver in the future.

3. An anticipatory hedge: a commodity that you will need in the future. You are a manufacturer of film, and silver is an essential input for film production. You will need to acquire silver to produce the film for next year sales.

Each of these positions can be hedged.

Chapter 4 24

Hedging Horizon

The hedge horizon is the amount of time that you need to protect the price (hedge) for.

In some instances, you will have a predefined hedging horizon. The silver mining company has just started mining the silver ore. The process of going from mining to refined silver takes 15 months. The silver mining company may wish to hedge until the silver is mined and refined.

In other instances, there will be no specific hedging horizon.

Chapter 4 25

A Long Hedge

A long hedge involves purchasing a futures contract.

Example

A film manufacturing company that needs silver in the future would purchase a futures contract for silver. By doing so, the company will know with certainty how much it will have to pay for the silver in the future. Thus the firm has reduced its risk.

Suppose that the film manufacturer needs 50,000 troy ounces of silver in two months. The silver prices are as follows:

Table 4.12

Silver Futures Prices on May 10 The COMEX division of NYMEX trades a silver contract for 5,000 troy ounces. Contract

Price

(cents per troy ounce) Spot

1052.5

JUL

1068.0 SEP

1084.0

Chapter 4 26

A Long Hedge

The film manufacturer estimates that to pay higher than 1068.0 cents per ounce could jeopardize profitability. Thus, the company enters the futures market to hedge against the possibility of higher silver prices. The transactions are as follows:

Table 4.13

A Long Hedge in Silver Date

Cash Market

Futures Market

May 10

Anticipates the need for 50,000 troy ounces in two months and expects to pay 1068 cents per ounce, or a total of $534,000.

Buys ten 5,000 troy ounce JUL futures contracts at 1068 cents per ounce.

July 10

The spot price of silver is now 1071 cents per ounce. The manufacturer buys 50,000 ounces, paying $535,500.

Since the futures contract is at maturity, the futures and spot prices are equal, and the ten contracts are sold at 1071 cents per ounce.

Opportunity loss: -$1,500

Futures profit: $1,500

Net Wealth Change = 0

Chapter 4 27

A Short Hedge

A short hedge involves selling a futures contract to reduce risk.

You ,a silver mine owner, are concerned about future silver prices and its impact on your company’s profitability. You may want to sell a futures contract to reduce risk.

By doing so, you will know exactly how much your company will receive. Thus, you have reduced risk.

Suppose that you expect to have 50,000 troy ounces of sliver in two months. The silvers prices are as follows:

Table 4.12

Silver Futures Prices on May 10 The COMEX division of NYMEX trades a silver contract for 5,000 troy ounces. Contract

Price

(cents per troy ounce) Spot

1052.5

JUL

1068.0 SEP

1084.0

Chapter 4 28

A Short Hedge

You estimate that a price of 1068.0 cents per ounce satisfies your company’s profitability goals. Thus, the company enters the futures market to hedge against the possibility of lower silver prices. The transactions are as follows:

Table 4.14

A Short Hedge in Silver Date

Cash Market

Futures Market

May 10 Anticipates the sale of 50,000 troy ounces in two months and expects to receive 1068 cents per ounce, or a total of $534,000.

Sells ten 5,000 troy ounce July futures contracts at 1068 cents per ounce.

July 10

The spot price of silver is now 1071 cents per ounce. The miner sells 50,000 ounces, receiving $535,500.

Buys 10 contracts at 1071.

Profit $1,500

Futures loss: -$1,500

Net Wealth Change = 0

Chapter 4 29

Do Hedgers Need Speculators?

Hedgers, as a group, need speculators to take positions and bear risk only for the mismatch in contracts demanded by long and short hedgers.

If long and short hedgers had exactly offsetting needs, hedgers would not need speculators.

Chapter 4 30

Cross-Hedging

In many cases, there will not be a futures contract available that exactly matches our needs. In this case, we need to engage in a cross-hedge.

A cross-hedge is needed when the characteristics of the spot and futures positions do not match perfectly.

Some of the mismatches are:

– Maturity: the hedging horizon may not match the futures expiration date.

– Quantity: the quantity to be hedged may not match the futures contract quantity.

– Quality: the physical characteristics of the commodity to be hedged may differ from the characteristics required for futures contract.

Chapter 4 31

Cross-Hedging

Maturity

Futures contracts may not mature at exactly the time that you need delivery of the good. The film manufacturer needs silver almost continuously. However, COMEX silver futures trade only for delivery in February, April, May, Jul, September and December. Thus, the futures expiration dates and the hedging horizon don’t match perfectly.

Quantity

COMEX silver contracts are for 5,000 troy ounces. However, a film manufacturer may only need 7,500 ounces. This company has a problem selecting the number of contracts it needs for its production line.

Quality

For film manufacturing, silver needs to be in pellet form and it does not need to be as pure as silver bullion. COMEX silver contracts specifies that deliverable silver must be 1,000 ounce ingots that are 99.9 percent pure, not exactly the silver quality that the film manufacturer needs.

Chapter 4 32

Micro-Hedging versus Macro Hedging

Micro-Hedging

Micro-hedging occurs when a futures position is matched against a specific asset or liability item on the balance sheet.

Example: a bank hedging rates on one-year certificates of deposits from the liability side of its balance sheet.

Macro-Hedging

Macro-hedging occurs when a hedge is structured to offset the net risk associated with the hedger’s overall asset/liability mix.

Example: a bank that uses interest rates to equate the interest rate exposure of its assets with the interest rate exposure of its liabilities.

Chapter 4 33

Stack Hedges versus Strip Hedges

Strip Hedge

Strip hedging occurs when a trader enters the futures market and takes a series of futures positions of successively longer expirations.

Stack Hedge

Stack hedging occurs when a trader enters the futures market and takes a number of positions that can be stacked in the front month and then rolled forward.

Chapter 4 34

Risk-Minimization Hedging

Sometimes we wish to minimize our risk, but do not have a specific time horizon.

In other situations, we may need to cross-hedge.

In either case, purchasing one future for each position in the cash market may not perfectly get rid of risk.

That is, the futures contract that we are using to hedge may not move exactly with our cash position.

In this case, we may want to compute the risk-minimizing hedge ratio.

Chapter 4 35

Risk-Minimization HedgingSoybeans Case

Figure 4.3 shows 300 days of historical soybean cash prices.

Insert Figure 4.3 below

Chapter 4 36


Suppose that you are a soybean meal processor. You hold soybeans for regular use in your business. From this inventory, you purchase soybeans and sell soybeans to your customers.

You have an ongoing inventory of 1,000,000 bushel of soybeans. Suppose the cash price of soybeans is currently $7.19 (or 719.5 cents/bushel). As such, the inventory is currently valued at $7,190,000.

You wish to minimize the price risk associated with holding the inventory. You realize that if the price of soybeans were to drop substantially, you would experience a loss in value on the soybeans that you have in inventory. Such a loss would be devastating to your profits. You wish to hedge the price risk of the inventory that you hold.

Because the inventory is an ongoing asset, the processor does not have a specified horizon. As such, the processor wishes to engage in a risk-minimizing hedge.

Chapter 4 37


Since you have the asset (you own the soybeans), the hedge would involve selling futures contracts.

As soybeans futures trade in 5,000 bushel contracts, the temptation is to sell 200 contracts, to match your inventory on a 1:1 basis.

This approach might not be the risk-minimizing hedge. To calculate the risk-minimizing number of contracts to sell, we must compute the Hedge Ratio (HR).

Hedge Ratio (RH)

The number of futures contracts to hold for a given position in a commodity.

PositionMarket Cash Position Futures

HR

Chapter 4 38


To minimize your risk, you should trade HR futures contracts.

The profits or losses on a portfolio for a day are:

Where

Pt+1 = The value of the portfolio at time t+1Pt = The value of the portfolio at time tSt+1 = The value of the spot position at time t+1St = The value of the spot position at time tFt+1 = The value of the future position at time t+1Ft = The value of the futures position at time t

tttttt FFHRSSPP 111

Chapter 4 39


The variance of a portfolio of one unit of the spot asset and one unit of a futures contract can be computed as follows:

FSSFFSP HRHR 22222

Where:

t2 P portfolio on the VarianceP

t2 S of VarianceS

t2 F of VarianceF

tt F and Sbetween t coefficienn CorrelatioSF

Chapter 4 40


The trader minimizes the variance on the portfolio by selecting a hedge ratio as follows:

22F

SF

F

FSSFRM

COVHR

Where:

COVSF= The covariance between the stock price and the exercise priceHRRM = Risk-minimizing hedge ratio

The easiest way to compute the hedge ratio is by estimating the following regression:

ttttt FFSS )()( 11

Where

α = the constant regression parameter

β = the slope parameter

εt = random error term with mean = 0 and standard deviation = 1

Chapter 4 41


the risk-minimizing hedge ratio

This regression will output:

2R a measure of hedging effectiveness

10 2 RWhere

The closer to 1 the better the chance that the hedge will work.

There are at least 3 candidate measures of St and Ft that can be used in the above regression:

Price level

Price change

Percentage price changes

It is recommended that price change and percentage price change be used.

Chapter 4 42


Step 1: estimate the price change and percentage price changes for the soybean using the previous 60 days daily data of soybean prices.

Day Cash (S) Future (F) Chg (S) Chg (F)1 890327 7552 890328 749.5 1 -5.53 890329 747.5 1 -24 890330 725 1 -22.55 890331 723 1 -26 890403 697.5 72 -25.57 890404 702 1 4.58 890405 702 1 09 890406 701 1 -1

10 890407 699 1 -211 890410 707 3 812 890411 708 1 113 890412 715.5 1 7.514 890413 716 1 0.515 890414 722.5 1 6.516 890417 736 3 13.517 890418 738.5 1 2.518 890419 737.5 1 -119 890420 741 1 3.520 890421 754.5 1 13.5

. . . . .

. . . . .59 890616 717.5 1 060 890619 733 3 15.5

Where :Chg (S) = change in cash priceChg (F) = change in futures price

Chapter 4 43


Step 2: run a regression analysis in Excel (recall that to do this in Excel you need to go to “Tools”, “Data Analysis”, “Regression”. The Y variable will be the change in the commodity price. The X variable will be the change in the futures price.

SUMMARY OUTPUT

Regression StatisticsMultiple R 0.11726695R Square 0.013751537Adjusted R Square -0.003551067Standard Error 15.62544125Observations 59

ANOVAdf SS MS F Significance F

Regression 1 194.0458 194.0458 0.794767 0.376411Residual 57 13916.8 244.1544Total 58 14110.85

Coefficients Standard Error t Stat P-value Lower 95%Upper 95%Lower 95.0%Upper 95.0%Intercept 4.879820628 2.035745 2.397068 0.019828 0.803311 8.95633 0.803311 8.95633X Variable 1 -0.185935589 0.208566 -0.891497 0.376411 -0.603581 0.23171 -0.603581 0.23171

Chapter 4 44


Step 3: interpret the results.

From the above regression, we have:

0103.0

5159.0

Results: in order to complete the risk-minimizing hedge, we should sell 0.5159 bushel of soybean futures contracts for each bushel that we have in inventory. Since we have 1,000,000 bushel of soybeans in inventory, we should sell:

0.5159 X 1,000,000 = 515,900 bushel of soybeans in the futures market.

4758.02 R

Chapter 4 45


Soybeans are traded in 5,000 bushel futures contracts, we should sell:

Quantity Contract Hedged Be ToAmount # Contracts

You should sell 103 Soybean Contracts.

18.1035000

900,515# Contracts

Chapter 4 46


Step 4: evaluate the performance of the hedge. Figure 4.4 shows the wealth change from day 61 forward.

Insert Figure 4.4 Here

Comparing the unhedged and the hedged strategies, both strategies lost money. However, the hedged strategy loss was lower.

Recall that the regression in this case accounted for only 47.58 percent of the variance in the cash price (R2 = 0.4758)

Chapter 4 47

Hedging and Quantity Risk

Quantity Risk

In the case of a soybean farmer, the size of the futures position used in the hedge depends on the farmer’s expectations on the size of the crop.

Crop size can be affected by elements outside the control of the farmers (e.g., weather).

Chapter 4 48

Costs and Benefits of Hedging

There are six market imperfections that make hedging important and that can impose real costs to companies, including:

1. Taxes

2. Costs of financial distress

3. Transaction costs of hedging

4. Principal-agent problems

5. Costliness of diversification

6. Differences between internal and external financing costs

Chapter 4 49

Taxes

Suppose that you own a gold mine. You expect to mine 1,000 ounce of gold.

Your cost of producing the gold is $300/oz.

The futures price for gold is $400/oz, which is your expected sales price.

The actual price could be $300 or $500 with equal probability.

Your tax rate is 20% and your company has a $20,000 tax credit that can be used to offset income taxes.

Table 4.15 shows the impact of taxes if your company is unhedged or hedged.

Chapter 4 50

Taxes

Table 4.15

How Taxes Provide an Incentive to Hedge

Unhedged Firm

Hedged Firm

Sale Price of Gold

$300

$500

$300

$500 Gold Revenue

$300,000

$500,000

$300,000

$500,000

Futures Result

0

0

+100,000

-100,000 Less Production Cost

-300,000

-300,000

-300,000

-300,000

Pre-Tax Profit

0 $200,000

$100,000

$100,000

Tax Obligation

0

-40,000

-20,000

-20,000 Add Tax Credit (if applicable)

0

+20,000

+20,000

+20,000

Net Income

0 $180,000

$100,000

$100,000

Expected AfterBTax Net Income

$90,000

$100,000

By hedging, the gold mine company was able to use the $20,000 tax credit.

Empirical evidence on taxes and hedging is mixed. Some argue that taxes do affect hedging decisions. Others argue that hedging allows firms to increase their debt capacity and acquire tax credits.

Chapter 4 51

Cost of Financial Distress

The costs associated with bankruptcy and financial distress may motivate firms to hedge. Bankruptcy and financial distress costs include:

1. Accountant and lawyers fees

2. Loss of customers

3. Exit of lines of business

4. Loss of tax shields

Hedging can reduce the probability of financial distress.

Chapter 4 52

Transaction Costs of Hedging

Selling a futures contract will add costs to the company. Thus, these costs are a disincentive to hedge. A company might simply take the risk rather than paying the cost of selling the futures contract.

Chapter 4 53

Principal-Agent Problems

Managers and shareholders often have conflicting interest.

Managers tend to be more risk averse than shareholders. They have much of their wealth tied up in an individual firm while the owners might hold a portfolio containing the stocks of several firms.

As such, managers might tend to hedge more than what the shareholders would like them to.

Chapter 4 54

Costliness of Diversification

Many business owners have much or all of their personal wealth tied up in a single business. This is commonly the case among farmers.

In this case, they become much like managers in the sense that they are risk averse. This lack of diversification on the part of the owner can create an incentive to hedge.

Chapter 4 55

Differences Between Internal and External Financing Costs

External financing refers to borrowing or issuing new securities.

Internal financing refers to retained earnings and cash reserves.

Obtaining external financing is generally more expensive than using internal financing.

Without hedging companies may be forced to seek external financing to solve their cash flow shortages.