Commodity assignment help study about that derivatives are being used to hedge different types of risks faced by the individuals and firms. Commodity risk can also be hedged using both futures and option.Futures and options have different characteristics in terms of hedging and this can be explain in the following paragraphs.
The example to explain the hedging using the futures is NSW wheat. Its futures trade on the Australian Stock Exchange Account. When the assignment was started the NSW wheat price was ranging from AUD $250.00 to $300 (for the APW wheat in different regions of New South Wales). Intention is to purchase 20 ton of wheat in July 14. The following chart shows the price of the July14 future price of NSW wheat.
Following chart was available for July’14 futures of NSW wheat:
The quotation tick size is Australian $0.1 per tonne and it need to be settles as physical delivery. This is Australian grade wheat and is a minimum of GTA Wheat Standard APW1.
Commodity risk is faced by both seller and buyer of the commodity if the transaction has to be taken in the future. Seller faces the risk that the price will go down in the future than the current price. Buyer faces the risk that the price will go up in the future and thus he may be need to pay more than the current price. Futures fall under two categories, forwards and futures.
This is over the counter contract and it happens between two parties outside the exchange.A contract where a buyer and a seller agree upon a specified price, quantity and date of an asset. Here there is a risk for either of a party defaulting as there is no regulating party between them (Shimko, 1994).
They are similar to forwards trade which will be settled in future is called a Future. They are traded on stock exchanges and are guaranteed by exchange. Futures eliminate counter-party risk, such as the one in forward rate agreement. Some of the popular terminologies used in futures contract are:
- Spot price and future price difference is called as basis.
- Future price is price at which future contract trades in futures market.
- Tenure is the life time for which a future is traded.
- Expiry date is the date of settlement of future contract.
Here too the commodity risk can be hedged using the futures or forward contract. To use a forward contract the investor needs to go bank or go to the counter-party. However as mentioned as it is not regulated there is a risk that the counter-party may default.
Hence the investor can use the futures to hedge its trade. If it hedges using the futures then he needs to abide the settlement terms of the exchange. In the futures contract the contract size, date of settlement is fixed. Also the type of commodity which can be delivered is also fixed. Many of the exchanges settle for physical delivery while other settles in cash. Here the commodity chosen is NSW wheat and it type is APW. There are certain specifications which need to be followed while delivering the commodity.
To hedge using the future contract for wheat, the current price as mentioned above ranged from 250 to 300 and the future price was 311.8. Hence using this price the investor can lock into the price of wheat. If the investor is using futures for hedging then the future movement of the futures does not affect the investor as the loss made on the spot price will be offset by the gains on the future. The same is applicable for the reverse movement of the spot. Also the volatility of the futures matches exactly with the spot (Büyükşahin & Robe, 2013).
There are some risks which the investor faces when he uses futures to hedge its risk. Following are some risks:
Basis Risk – Futures have standard expiry date. For wheat there is expiry for five months (January, March, May, July, and September) on the third Thursday of that month. If the investor have to make a deal on a date which is away from the expiry date then the investor faces the basis. On the settle the future and spot price converge. It may diverge in before the maturity however just before the maturity it converges to spot. But they do not always move in sync. Hence the investor may suffer loss as the spot and future may move in different direction or may not move is similar ratio. Longer the time gap between the transaction and the expiry it will be more risky for the investor. The investor will be left with only futures position if the transaction takes place before the expiry date or will be left with only the spot commodity if the transaction is to happen after the expiry (Hull, 1999).
Over hedging risk – The contract size of the futures is fixed and it may not match with the quantity to be sold or bought. Hence the investor needs to over hedge its position. This can be risky for the investor as the movement of the future may not be in favor of the investor and this will lead to losses. If the investor wants to buy 20.5 tons of the wheat then he may over hedge or under hedge 0.5 tons of the wheat as partial contract cannot be bought. Thus the investor in exposed to risk of the open position.
Proxy Risk – Sometimes investor use another commodity to hedge its risk. Not all commodities have futures. An investor may use wheat futures to hedge its barley exposure. Hence in this scenario the investor faces the cross hedging if the two commodities move in different ratios as compared to their historical values.
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Investor can also use options to hedge its position. There are two typed of options:
Call Option – It gives the right but not obligation to the buyer of the call option to buy the underlying.
Put Option – It gives the right but not the obligation to the buyer to the put of the option to sell the underlying.
Difference between option and future is that the buyer of the option may or may not exercise the option depending on the market price. If the investor has to buy wheat is the case here then he may use a call option to hedge its position. If the price of the wheat rises in the spot market then he may use the call option to buy the underlying at the strike price which is fixed at the time of buying the option. The difference will be profit for the investor. However if the spot price decreases then the investor may not exercise the option and can buy the wheat from the market at a lower price. To buy the option the investor needs to pay a premium upfront. The premium paid is determined by the option pricing formula (Moschini & Lapan, 1995).
Similar is the case with the put option. If the price of the wheat falls below the strike price then the investor will sell at the strike price. If the price of the wheat is above the strike price then investor will sell at the market rate.
An option contract specifies strike price, time to maturity, contract size.
Following table gives the prices of call and put options for different strike
prices for the NSW wheat:
|Call Price||Exercise Price||Put Price|
Source: ASX website
It is visible that the price of call and put follow the reverse trend as the strike price increases or decreases. If the strike price increases the call option price decreases whereas for the put option it increases (Stoll & Whaley, 1987).
An investor depending on his risk appetite and the profit margin may but option of different strike price. If the investor can buy the wheat at 340 and still remain profitable then he may choose a higher strike option whereas some other investor would but a lower strike option. Here the buyer of the option doesn’t have face any risk except the fact that he may lose the premium paid on the option. In futures the investor has to make the transaction irrespective of the current spot price. However future does not require payment of premium and both the counter-party bear equal risk. In options the seller of the option bears all the risk. He takes the premium for the risk which he will take while selling the option (Russo, 1983).
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An investor can also use option trading strategies to maximize the profit. If the investor feels that the price of the wheat will rise above 320 but will not rise above 340. Then he may but 320 call option and sell 340 call option. Thus his profit will be capped but he can save on the cost by selling the option. This is call spread strategy. Thus other strategies like put spread, covered call, strangle can be used to hedge the exposures.
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NSW Wheat Futures. Available at http://www.asx.com.au/products/agricultural-derivatives/nsw-wheat-futures.htm. [Accessed on 08th March 2014].
Büyükşahin, B., & Robe, M. A. (2013). Speculators, commodities and cross-market linkages. Journal of International Money and Finance.
Stoll, H. R., & Whaley, R. E. (1987). Expiration day effects of index options and futures (No. 3). Salomon Brothers Center for the Study of Financial Institutions, Graduate School of Business Administration, New York University.