VI I : Futures

22: Hedging, Speculation, and Arbitrage

Chapter 22: Hedges, Speculation, and Arbitrage Oltheten & Waspi 2012
Futures
Hedge
use futures to reduce risk on an existing
position
Speculate
use futures to take on risk in the hope of
making a profit
Arbitrage
Use the difference between spot and futures
prices to generate risk-free profit
Chapter 22: Hedges, Speculation, and Arbitrage Oltheten & Waspi 2012
Hedge
Identify the existing risk
50,000 bushels of
soybeans growing in
the fields
The current price of
$4.20/bushel can change
before George can
harvest & sell
Chapter 22: Hedges, Speculation, and Arbitrage
Existing Risk: Long soybeans
$180,000
$190,000
$200,000
$210,000
$220,000
$230,000
$240,000
360 380 400 420 440 460 480
Price (Soybeans Spot )
I
n
c
o
m
e
Oltheten & Waspi 2012
Chapter 22: Hedges, Speculation, and Arbitrage Oltheten & Waspi 2012
Hedge
An investment that offsets this risk
Short soybeans
Short Soybean futures
Chapter 22: Hedges, Speculation, and Arbitrage Oltheten & Waspi 2012
Hedge Strategy
If soybean prices increase
Long Spot J
Short Futures L
If soybean prices decrease
Long Spot L
Short Futures J

K
K
Chapter 22: Hedges, Speculation, and Arbitrage Oltheten & Waspi 2012
Hedge Strategy
Use November Futures
November
contracts
deliver
plant
October ?
harvest
Set
Hedge
Spot risk
Lift
Hedge
Offsetting futures risk
Chapter 22: Hedges, Speculation, and Arbitrage Oltheten & Waspi 2012
Set the Hedge
George sets the hedge in April
Spot price: $4.20/bu
Futures price: 431
Basis (spot-futures) = -11
Chapter 22: Hedges, Speculation, and Arbitrage Oltheten & Waspi 2012
Set the Hedge
Set the hedge in April
November
contracts
deliver
$4.20
October ?
harvest
431
Lift
Hedge
-11
Chapter 22: Hedges, Speculation, and Arbitrage Oltheten & Waspi 2012
George Q. Farmer
Hedge is set


Set the Hedge
Long Position (spot)
Short Position
(futures)
431
-$50,000
$0
$50,000
$100,000
$150,000
$200,000
$250,000
360 380 400 420 440 460 480
Price (Soybeans Spot )
I
n
c
o
m
e
Short Position
Long
Position
Chapter 22: Hedges, Speculation, and Arbitrage Oltheten & Waspi 2012
Scenario 1: Textbook Hedge
George harvests October 1
Spot price: $4.00/bu
Futures price: 411
Basis (spot-futures) = -11
Chapter 22: Hedges, Speculation, and Arbitrage
Lift Hedge
November
contracts
deliver
$4.00
$4.20
411
-11
431
-11
Oltheten & Waspi 2012
Chapter 22: Hedges, Speculation, and Arbitrage Oltheten & Waspi 2012
George Q. Farmer
Hedge is set Sell 10 November futures @ 431
[10*5,000*431 = $215,500]
Margin:
Hedge is
lifted
Buy 10 November futures @ 411
[10*5,000*411 = $205,500]
Margin:
Profit:
Sell 50,000 soybeans spot @$4.00
Net Income:
Lift the Hedge
Chapter 22: Hedges, Speculation, and Arbitrage Oltheten & Waspi 2012
Lift the Hedge
Textbook Hedge
Spot price:
$4.20
$4.00
price: 431
price: 411
Chapter 22: Hedges, Speculation, and Arbitrage Oltheten & Waspi 2012
Scenario 2: Not quite a Textbook Hedge
George harvests October 1
Spot price: $5.00/bu
Futures price: 508
Basis (spot-futures) = -8
Chapter 22: Hedges, Speculation, and Arbitrage
Lift the Hedge
November
contracts
deliver
$5.00
$4.20
508
-11
431
-8
Oltheten & Waspi 2012
Chapter 22: Hedges, Speculation, and Arbitrage Oltheten & Waspi 2012
George Q. Farmer
Hedge is set Sell 10 November futures @ 431
[10*5,000*431 = $215,500]
Margin:
Hedge is
lifted
Buy 10 November futures @ 508
[10*5,000*508 = $254,000]
Margin:
Profit:
Sell 50,000 soybeans spot @$5.00
Net Income:
Lift the Hedge
Chapter 22: Hedges, Speculation, and Arbitrage Oltheten & Waspi 2012
Lift the Hedge
Not quite a Textbook Hedge
Spot price:
$4.20 $5.00
price: 431
price: 508
Chapter 22: Hedges, Speculation, and Arbitrage Oltheten & Waspi 2012
Hedge
Once the hedge is set George trades his
Price Risk for Basis Risk
Chapter 22: Hedges, Speculation, and Arbitrage Oltheten & Waspi 2012
Scenario 3: Not quite a Textbook Hedge
George harvests October 1
Spot price: $1.00/bu
Futures price: 105
Basis (spot-futures) = -5
Chapter 22: Hedges, Speculation, and Arbitrage
Lift Hedge
November
contracts
deliver
$1.00
$4.20
105
-11
431
-5
Oltheten & Waspi 2012
Chapter 22: Hedges, Speculation, and Arbitrage Oltheten & Waspi 2012
George Q. Farmer
Hedge is set Sell 10 November futures @ 431
[10*5,000*431 = $215,500]
Margin:
Hedge is
lifted
Buy 10 November futures @ 105
[10*5,000*105 = $52,500]
Margin:
Profit:
Sell 50,000 soybeans spot @$1.00
Net Income:
Lift the Hedge
Chapter 22: Hedges, Speculation, and Arbitrage Oltheten & Waspi 2012
Lift the Hedge
Trade Price Risk for Basis Risk
Spot price:
$4.20
$1.00
price: 431
price: 105
Chapter 22: Hedges, Speculation, and Arbitrage Oltheten & Waspi 2012
Hedge
George also grows corn (10,000 bushels)
Futures contracts defined as
5,000 bushels
Cents per bushel
Corn futures deliver March, May, July,
September, & December.

Chapter 22: Hedges, Speculation, and Arbitrage Oltheten & Waspi 2012
Set the Hedge
In April
Spot corn is $2.00/bushel
December corn futures trade at 195
Margin requirements at $400 and $300 per
contract
Chapter 22: Hedges, Speculation, and Arbitrage
Set the Hedge
December
contracts
deliver
$2.00
+5
195
Oltheten & Waspi 2012
Chapter 22: Hedges, Speculation, and Arbitrage Oltheten & Waspi 2012
George Q. Farmer
Hedge is set



Set the Hedge
Chapter 22: Hedges, Speculation, and Arbitrage Oltheten & Waspi 2012
Lift the Hedge
In October
Spot corn is /bushel
December corn futures trade at
Chapter 22: Hedges, Speculation, and Arbitrage
Set the Hedge
December
contracts
deliver
$2.00
+5
195
Oltheten & Waspi 2012
Chapter 22: Hedges, Speculation, and Arbitrage Oltheten & Waspi 2012
George Q. Farmer
Hedge is set Sell 2 December futures @ 195
[2*5,000*195 = $19,500]
Margin:
Hedge is
lifted
Net Income:
Lift the Hedge
Chapter 22: Hedges, Speculation, and Arbitrage
Set the Hedge
November
contracts
deliver
$2.00
+5
195
Oltheten & Waspi 2012
Futures I I