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    Hedging Example - Sheet1

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    Shaunny Bravo
    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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    Hedging Example - Sheet1

    Uploaded by

    Shaunny Bravo
    26 views1 page
    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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    hedging example - Sheet1

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    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.

    Copyright:

    © All Rights Reserved
    Download as PDF, TXT or read online from Scribd
    Download as pdf or txt
    26 views1 page

    Hedging Example - Sheet1

    Uploaded by

    Shaunny Bravo
    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.

    Copyright:

    © All Rights Reserved
    Download as PDF, TXT or read online from Scribd
    Download as pdf or txt
    of 1

    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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