Hedging & Spreading

Hedging

Historically, futures market participants have been divided into two broad categories: hedgers, who seek to reduce risks associated with dealing in the underlying commodity or security, and speculators (including professional floor traders), who seek to profit from price changes. More recently, a new category of participant has emerged--the portfolio manager who uses futures and options as essential elements of portfolio management. For speculators, the attraction of futures markets includes their leverage, the diversification they add to a portfolio, the ease of assuming short as well as long positions, and the low cost of market entry and exit. Speculators and market-makers assume the risk transferred by hedgers and provide the liquidity that assures low transaction costs and reliable price discovery in futures markets.

Hedging is central to futures and options markets, and a familiarity with hedging practices is necessary to understand how these markets work. In simplest terms, hedgers:

• Identify their price risk,
• Decide how much to hedge, and
• Decide where and how to hedge.

In futures markets hedging involves taking a futures position opposite to that of a cash market position. That is, a corn farmer would sell corn futures against his crop; an importer of Japanese cars would buy yen futures against her yen liability; a precious metals merchant would purchase gold futures against a fixed-price gold sales contract; and a pension fund manager would sell stock index futures against the fund's portfolio of equities in anticipation of a market decline.

Examples of the types of risk - management activities that rely on the use of futures include: 

• Stabilizing cash flows;
• Setting purchase or sale prices of commodities and securities;
• Diversifying holdings;
• More closely matching balance sheet assets and liabilities;
• Reducing transaction costs;
• Decreasing costs of storage; and
• Minimizing the capital needed to carry inventories.

 

The cash-futures basis

Cash-futures Basis

·         The difference between a commodity's or security's cash and futures prices is known as the "cash-futures basis," as illustrated in right diagram. While futures trading can eliminate price level risk, it cannot eliminate the risk that the basis will change unfavorably and unpredictably during the lifetime of the hedge. The cash-futures basis is subject to many influences, including seasonal factors, weather conditions, temporary gluts or scarcities of commodities, and the availability of transport facilities. Other factors affecting the relationship between cash and futures prices are costs related to carrying commodities and securities, such as interest rates and warehouse fees. In certain financial markets, basis reflects the difference between long-term and short-term interest rates.

·         Basis risk is particularly prevalent in "cross hedging" one commodity with another one. For example, if the commodity to be hedged does not have an exact match in the futures market, the closest commodity may have to be substituted--e.g., heating oil futures to hedge jet fuel needs or Deutschemarks to hedge Dutch guilder payments. Prices of the two types of fuel or two currencies may have moved closely for significant periods of time, but there is no guarantee that past price relationships will continue into the future.

Spreading

A spread position is the simultaneous purchase and sale of two related futures or options positions. Spread positions are undertaken when the prices of two futures or options contracts are considered out-of-line with each other. In many ways futures and options spreads are analogous to arbitrage or quasi-arbitrage positions. Futures spreads can be divided into two broad categories: intramarket spreads and intermarket spreads.

Intramarket Spreads

An intramarket spread, also called a time spread, comprises a long position in one contract

 month against a short position in another contract month in the same futures contract on

 the same exchange. An example would be long March

 world sugar futures vs. short July sugar futures on the

 Coffee, Sugar & Cocoa Exchange or short October cotton futures vs. long

 December cotton futures on the New York Cotton Exchange.

The spread, or difference, between the prices of various futures delivery months reflects supply, demand and carrying costs. Because carrying costs generally increase over time, in many futures markets the price of each succeeding delivery month is higher than that of the preceding delivery month. This is called a carrying-charge, or contango, market, as illustrated in left diagram above.

In contrast, in some futures markets the highest price is for the nearby or spot month, and each successive delivery month is priced lower than the preceding month, as depicted in right diagram above. This is called an inverted market, or one in backwardation. Inverted markets sometimes occur when demand for the cash commodity is strong relative to its current supply. Inverted markets also occur when the income from holding the cash position exceeds the costs of carrying the position--for example, a U.S. Treasury bond futures position when long-term interest rates (the underlying bonds' yield) exceed short-term rates (the cost of financing the cash bond portfolio).

Intermarket Spreads

An intermarket spread consists of a long position in one market and a short position in another market trading the same or a closely related commodity. An example is the "TED" spread--the difference between the prices of a U.S. Treasury-bill futures contract and a Eurodollar time-deposit futures contract--on the Chicago Mercantile Exchange. The TED spread changes with changes in the relationship between short-term interest rates for private and government debt. Another intermarket spread is the "NOB" spread, or U.S. Treasury notes over U.S. Treasury bonds, on the Chicago Board of Trade. This spread reflects the difference in interest rates on U.S. Treasury securities of different maturities. Other intermarket spreads include gold and silver as well as platinum and palladium.

Examples of intermarket spreads on different exchanges are light sweet crude oil futures at the New York Mercantile Exchange and Brent crude oil futures on the International Petroleum Exchange or wheat contracts traded on the Chicago Board of Trade and the Kansas City Board of Trade. Intermarket spreads often involve different grades or specifications of a commodity, thereby introducing additional basis risk.

Also included among intermarket spreads are commodity-products spreads, which comprise a long position in a commodity against short positions of an equivalent amount of the products derived from the commodity, or vice versa. Examples are the soybean crush and the petroleum crack spreads. A crush spread involves a long soybean futures position, representing the raw, unprocessed beans, against short positions in soybean meal and soybean oil futures. The petroleum crack spread involves purchasing crude oil futures and selling the products--heating oil and/or unleaded gasoline futures.