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Hedging Example - Sheet1

1. When hedging a physical commodity transaction, one exchanges exposure to the risk of fluctuations in the absolute or "flat" price of the underlying asset for "basis risk," which is the risk posed by the price difference between the physical commodity and hedging financial contract. 2. For example, a company that has agreed to deliver oil in 3 months could hedge by selling futures contracts now to lock in a sale price and protect against falling oil prices over that time period, in exchange taking on basis risk from potential divergence between the physical and futures prices. 3. Effectively, the hedge transforms flat price risk into a fixed profit by offsetting long physical exposure with a short financial position.

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Shaunny Bravo
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74 views1 page

Hedging Example - Sheet1

1. When hedging a physical commodity transaction, one exchanges exposure to the risk of fluctuations in the absolute or "flat" price of the underlying asset for "basis risk," which is the risk posed by the price difference between the physical commodity and hedging financial contract. 2. For example, a company that has agreed to deliver oil in 3 months could hedge by selling futures contracts now to lock in a sale price and protect against falling oil prices over that time period, in exchange taking on basis risk from potential divergence between the physical and futures prices. 3. Effectively, the hedge transforms flat price risk into a fixed profit by offsetting long physical exposure with a short financial position.

Uploaded by

Shaunny Bravo
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PDF, TXT or read online on Scribd
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1.

Flat price risk


exposed to the fluctuations in the absolute price of the underlying asset (eg. Brent, WTI, JKM, TTF)

2. Basis risk
exposed to the price difference between the price of the underlying asset (physical commodity) and the hedging instrument (financial contract)
eg. spread bw physical spot price and futures contract price used to hedge the position
there are many more examples of basis risk as you explore diff arbitrage opportunities (time spreads, index spreads, geo spreads)

So when you hedge you are basically


saying you no longer want to be
exposed to flat price risk and want to
hedge your physical commodity
transaction with financial contracts,
thereby exchanging flat price risk for
basis risk

What's happening with this example:

- you have an obligation to deliver/sell oil to a counterparty in 3 months time


- lets say current month is Oct and you need to sell in Jan

Physical:
- your physical cargo will be exposed to flat price risk as the price of Brent Jan-22 contract will keep fluctuating
- when we sell a physical commodity, we
want to sell as high as possible, so we want
prices to increase (but this is not in our
control obviously, prices can go up and
down)
- there is a risk the price goes up (sell as high as possible which is good) or price goes down (sell lower, less profit)

- to protect myself from this uncertainty of prices (flat price risk), I hedge this cargo exchanging flat price risk for basis risk

How? What is my hedge?


- do the opposite of what your physical tranaction is (which is we want prices to increase so that can sell high)
- so we need to be protected against a drop
in prices right (prices are too high now, will
drop so we go short on paper - sell now buy
later)
- on the paper side, we will sell the futures
contracts to be protected against a drop in
prices right (sell high, buy back lower)
Physical - by selling the paper we are essentially fixing a sale price for our cargo of $60
Sell Jan-22 55 - PL always positive
spread 1.5
PL 56.5

Financial
Sell Jan-22 contract 60
Buy back/settle Jan-22 contract 55
PL 5

Total PL Physical + Financial PL 61.5

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