VII: Futures

22: Hedging, Speculation, and Arbitrage

 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 © Oltheten & Waspi 2012
 Existing Risk: Long soybeans
Income

$240,000

$230,000

$220,000

$210,000

$200,000

$190,000

$180,000
36 0 380 400 420 440 46 0 480
Price (Soybeans Spot )

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 K
 If soybean prices decrease
 Long Spot L
 Short Futures J
K

Chapter 22: Hedges, Speculation, and Arbitrage © Oltheten & Waspi 2012
 Hedge Strategy
 Use November Futures

October ?
plant Spot risk harvest

Offsetting futures risk Lift November

Set Hedge contracts
Hedge deliver

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

October ?
$4.20 harvest

Lift November
431 Hedge contracts
deliver
-11¢

Chapter 22: Hedges, Speculation, and Arbitrage © Oltheten & Waspi 2012
 Set the Hedge
George Q. Farmer
Hedge is set

Long Position (spot)

Short Position
(futures)

Chapter 22: Hedges, Speculation, and Arbitrage © Oltheten & Waspi 2012
Income

$250,000

$200,000 Long
Position

$150,000

$100,000

$50,000
Short Position

$0
360 380 400 420 431 440 460 480
-$50,000
Price (Soybeans Spot )
 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 © Oltheten & Waspi 2012
 Lift Hedge

$4.20 $4.00

November
431 411 contracts
deliver
-11¢ -11¢

Chapter 22: Hedges, Speculation, and Arbitrage © Oltheten & Waspi 2012
 Lift the Hedge
George Q. Farmer
Hedge is set Sell 10 November futures @ 431
[10*5,000*431 = $215,500]
Margin:
Hedge is Buy 10 November futures @ 411
lifted [10*5,000*411 = $205,500]
Margin:
Profit:
Sell 50,000 soybeans spot @$4.00

Net Income:

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 © Oltheten & Waspi 2012
 Lift the Hedge

$4.20 $5.00

November
431 508 contracts
deliver
-11¢ -8¢

Chapter 22: Hedges, Speculation, and Arbitrage © Oltheten & Waspi 2012
 Lift the Hedge
George Q. Farmer
Hedge is set Sell 10 November futures @ 431
[10*5,000*431 = $215,500]
Margin:
Hedge is Buy 10 November futures @ 508
lifted [10*5,000*508 = $254,000]
Margin:
Profit:
Sell 50,000 soybeans spot @$5.00

Net Income:

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 © Oltheten & Waspi 2012
 Lift Hedge

$4.20 $1.00

November
431 105 contracts
deliver
-11¢ -5¢

Chapter 22: Hedges, Speculation, and Arbitrage © Oltheten & Waspi 2012
 Lift the Hedge
George Q. Farmer
Hedge is set Sell 10 November futures @ 431
[10*5,000*431 = $215,500]
Margin:
Hedge is Buy 10 November futures @ 105
lifted [10*5,000*105 = $52,500]
Margin:
Profit:
Sell 50,000 soybeans spot @$1.00

Net Income:

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 © Oltheten & Waspi 2012
 Set the Hedge

$2.00

December
195 contracts
+5¢ deliver

Chapter 22: Hedges, Speculation, and Arbitrage © Oltheten & Waspi 2012
 Set the Hedge
George Q. Farmer
Hedge is set

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 © Oltheten & Waspi 2012
 Set the Hedge

$2.00

December
195 contracts
+5¢ deliver

Chapter 22: Hedges, Speculation, and Arbitrage © Oltheten & Waspi 2012
 Lift the Hedge
George Q. Farmer
Hedge is set Sell 2 December futures @ 195
[2*5,000*195 = $19,500]
Margin:

Hedge is
lifted

Net Income:

Chapter 22: Hedges, Speculation, and Arbitrage © Oltheten & Waspi 2012
 Set the Hedge

$2.00

November
195 contracts
+5¢ deliver

Chapter 22: Hedges, Speculation, and Arbitrage © Oltheten & Waspi 2012
Futures II