Derivatives and Risk Management

Copyright © Oxford University Press By Rajiv Srivastava

 Commodity futures have commodities as
underlying assets.
 Futures on commodities help mitigate price
risk.
 Trading in forward and futures on
commodities is not new. It has been in vogue
for more than 100 years.

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 Futures on commodities due to its possible use
as a speculative product are often thought as
unwarranted and as a disservice to society.
 Futures contracts on commodities result in
 price discovery,
 reducing seasonal price variations,
 efficient dissemination of information,
 reduced cost of credit, and
 more efficient physical markets.

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 The usual tools of containing the volatility in
the commodity prices like buffer stocks,
controlled and phased release of commodities,
minimum support price etc have either failed
or have proved too expensive for the economy.
 Commodity futures trading in developing
country can contribute a lot to the stability of
fiscal management, increasing the
effectiveness of price protection at national
level and improving the efficiency of social
programmes.
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 Stability to Government’s Revenue
Government budget, developmental expenditure,
and position of balance of payment are crucially
dependent upon prices of commodities. Volatility in
commodity prices causes volatility in budgetary
provisions and government’s developmental
expenditure. Therefore at national level there is a
need to reduce the volatility.
 Eliminating Minimum Support Price and Subsidy
Commodity futures trading helps smooth out the
variability in government’s revenue and transfers
the price risk management from government to
private participants.
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 Futures contracts on commodities differ
significantly from those on financial assets in terms
of quality specifications and delivery mechanism.
 The consumption value makes valuation of futures
contracts on commodities difficult.
 Quality of underlying asset is immaterial in case of
financial products, whereas there is ample scope of
controversy over quality in case of commodity futures.
 Commodity futures are governed by seasons and
perishable nature of the underlying asset.
 Commodities (the agricultural products) is confined to
the harvesting period while the consumption is uniform
throughout the year.
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 The pricing of futures contracts commodities
cannot use “no arbitrage argument” due to
convenience yield attached with commodities.
 Cash and carry arbitrage stipulates the
following:
F ≥ (S0 + s) ert
 Due to consumption value of the asset the
reverse cash and carry implying shorting the
asset and buying futures is not feasible.
Therefore, we only have an upper bound to the
futures price as below:
F ≤ (S0 + s) ert

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 Assume that spot price of cardamom is Rs 714 per kg. If
financing cost are 10% per annum with continuous
compounding what should be the price of the 3-m
futures contract on cardamom? If warehousing and
insurance cost are placed at 1% what would be the fair
value of the 3-m futures contract?
Solution
 The fair value of futures contract is given only as upper
bound
F1 ≤ S0 x ert , F1 ≤ 714 x e0.10 x 3/12 = Rs 732.07 per kg
 Warehousing and insurance cost would be added to the
financing cost for determining the upper bound of fair
value of the futures
F1 ≤ S0 x ert ,
F1 ≤ 714 x e0.11 x 3/12 = Rs 733.91 per kg
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 Long and Short Positions
Hedging Principle
Short Hedge
Long Hedge

Copyright © Oxford University Press

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 Long and Short Positions
 When one holds the underlying asset he is said to
be long on the asset. For example a jeweller
holding gold or silver is long on the asset.
 The one who requires the asset in future is said
to be short. For example a tea exporter needs
stock of tea to execute the pending orders is
short on tea.
 Similarly in the futures market
 if one buys a futures contract he is said to be
long, and
 if one sells the futures contract he is said to be
short.
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 To execute a hedge following steps are taken:
 One who is long on the asset, goes short on the
futures market, and the one who is short on
underlying goes long in the futures market.
 At an appropriate time one can neutralise the
position in the futures market, i.e. go long on
futures if one was originally short and go short on
futures if one was originally long, and receive/pay
the difference of prices.
 Sell or buy the underlying asset in the physical
market at prevailing price.

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 When one has long position in the asset he
needs to take a short position in futures to
hedge. It is referred as short hedge.
 For example, a sugar mill would go short on
the futures contract on sugar to hedge
against the fall in price.
 If prices fall the short position in futures
would yield profit compensating for the loss
due to reduced realized value of sugar in the
spot market.

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 Consider a sugar mill. It is expected to produce 100
MT of sugar in the month of April. The current price
today (the month of February) is Rs 22 per Kg. April
futures contract in sugar due on 20th April is trading
at Rs 25 per Kg. The sugar mill apprehends that the
price lesser than Rs 25 per Kg will prevail in April due
to excessive supply then.
 How can the sugar mill hedge its position against
the anticipated decline in sugar prices in April?
 To execute the hedging strategy the sugar mill takes
opposite position in the futures market.
 The sugar mill is long on the asset in April. Therefore it
needs to sell the futures contract today.

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If price falls to Rs 22 per Kg. Cash flow (Rs per Kg.)
 Sold futures contract in February + 25.00
 Bought futures contract in April - 22.00
Gain in the futures market + 3.00
 Price realised in the spot market +22.00
 Effective price realised Rs 25.00 per Kg.
Here the loss of Rs 3 (Rs 25 – Rs 22) in the spot market
is made up by an equal gain in the futures market.

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If price rises to Rs 26 per Kg. Cash flow (Rs/Kg.)
 Sold futures contract in February + 25.00
 Bought futures contract in April - 26.00
Loss in the futures market - 1.00
 Price realised in the spot market +26.00
 Effective price realised Rs 25.00 per Kg.
Here the gain of Rs 1 (Rs 26 – Rs 25) in the spot
market is offset by the equal loss in the futures
market.

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 When one has short position in the asset he
needs to take a long position in futures to
hedge. It is referred as long hedge.
 For example, an importer of oil would go
long on the futures contract on oil to hedge
against the rise in price.
 If prices indeed rise the long position in
futures would yield profit compensating for
the loss due to increased price of oil in the
spot market.

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A perfect hedge is one where loss on the
physical position is exactly offset by gain in
the financial position and vice-versa.
The Perfect Hedge

Short on underlying
Gain Long on Futures
Gain in
physical market
Price
Loss in
futures market
Loss

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 Except by coincidence futures hedge is
imperfect. The gains/losses in the futures do not
exactly offset the loss/gains in the physical
position because:
 the exposure in the underlying and futures market is
not on the identical asset of same quality,
 the value of exposure in the underlying and the
futures are not same because futures contract have
fixed size.
 the time of maturity of the futures contract is not
same as the time of exposure in the physical position
because maturities of futures contract are specific.

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 Basis is difference of futures price, F and
spot price, S. It declines as time to maturity
approaches.
 Basis at the beginning is B0 = F0 – S0
 Basis at the end is B1 = F1 – S1
 With futures hedge we have opposite
positions in physical and futures markets.
 Gain/loss in the spot market = S1 – S0
 Gain/loss in the futures market = F0 – F1

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 In a hedged portfolio consisting of long/short
position in the spot and short/long position in
futures we have net gain/loss on the portfolio
= S1 – S0 + F0 – F1 = (F0 – S0) – (F1 – S1)
= B 0 – B1
 The risk in the hedged portfolio would be
equal to the difference of basis at start and
end of hedge.
 Hedging risk with futures is not perfect. Price
risk gets replaced by much smaller basis risk.

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 Hedge ratio is the number of futures contract to
have minimum risk. It depends upon the risks in
the spot prices, futures prices and the co-
efficient of correlation between the two.
σs
h* = ρ
σf
Where h* = Optimum Hedge Ratio
ρ = Correlation coefficient of spot and futures price
σs, σf = Standard deviations of spot & futures prices
respectively

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 Futures can also be used for hedging against
the quantity uncertainties as price and
quantity have inverse relationship.
 Hedge ratio for quantity hedging depends upon
the ratio of covariance of revenue and
variance of price.

Covariance of revenue with price

Quantity for hedging =
Variance of price

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 Futures can be used for speculation if the
estimate of future spot price is different
than the futures price.
 To speculate on the prices of commodities
one has to do one of the following:
 If a trader expects a price fall he simply has to
sell a futures contract today and buy it later;
 If a trader anticipates a rise in prices he simply
has to buy the futures today and sell later;

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 Spread strategies in futures are concerned
with the mispricing of futures contracts
a) in two different assets called
Inter-commodity spread
b) in two different markets called
Inter-market spread
c) of two different maturities called
Calendar spread

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 Spread strategies can be used for protecting
gross profit margin where futures are
available on inputs and outputs. For example
sugarcane and sugar.
 Variations in gross profit margin can be
minimized
 By going long on futures of raw material we can
have assured raw material price and hence the
cost.
 By going short on futures on finished goods items
we can have assured prices for finished goods.
 With revenue and cost hedged the gross profit
margin can be protected or made more stable.
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