Download - price risk mgmt
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Price Risk Management
Price Risk Management
using Hedging
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Agenda
Advance Concepts
Hedging
Optimal Hedging
Q & A
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Basis Risk
Basis is difference between the spot price of anassetand the futurespriceof thesameunderlyingasset
BasisRiskarisesduetouncertaintyinthedifferencebetweenspotandfuturesprice
Basis = Spot Price Futures Price
What is Positive and Negative Basis?
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To minimize basis risk, price correlation between spot
priceandfuturespriceshouldbehigh
Convergence ofFutureswithSpotpriceuponexpiryoffuturescontract
ResearchandAnalysisbeforehedging
Technical Analysis (Moving Average, RelativeStrengthIndex,Fibonacci,etc.)
FundamentalAnalysis(DemandSupply)
How to minimize Basis Risk?
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2004 Sep Oct Nov Dec 2005 Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec 2006 Feb Mar Apr May Jun Ju l Aug
100
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230
240
250
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290
300
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0.0%
23.6%
38.2%
50.0%
61.8%
100.0%
HG COPPER CONTINUOUS 25000 LBS [COMEX] (371.750, 374.350, 359.500, 362.450, -8.54999)
Correlation between MCX
Copper and COMEX
Copper is 99.70%
Hedging to Be Backed by Extensive Analysis: Technical &
Fundamental
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Stochastic Risk Variables:
Market prices of commodities
Interest rates
Exchange rates
other market variables
VolatilityLiquidity
Depth
Transparency
BenchmarkingMarket Patterns
Fundamental & Technical Analysis
Screen Reading
Trading Key
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ATTITUDE Game .!!!!!
How you be in market depends on your attitude
Love HateTake
Tackle Insure Minimize
Trade
Hedging Financial
Institutions
Diversification
costly
w/o derivatives
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Risk Profile of Market Participant
Risk Averse
Risk Seeker
Risk Neutral
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Fundamental Factors
Exchange
Rate
RBI
Intervention
Performance of
Equity Market
Policy
Decisions
Performance of
Other Asian
Currencies
PoliticalFactors
Capital
Flows
Fundamental
Factors
Uncertain
Events
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Basis in Contango and Backwardation
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When do we say that the basis is strengthening?
Whenthecashpriceofacommodityincreasesmorethanitsfuturesprices,thebasisisstrengthening.
When do we say that the basis is weakening?
When the futures price of a commodity increasesmorethanthecashprice,thebasisisweakening
Strengthening and Weakening of Basis
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When is the basis said to be narrowing?
Thebasisissaidtobenarrowingwhentheabsolutedifferencebetweenthespotandfuturespricereduces
When is the basis said to be widening?
Wideningofbasisoccurswhentheabsolutedifferencebetweenthespotandfuturespriceincreases
Narrowing and Widening of Basis
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In a contango market, who benefits when the basis narrows?
Inacontangomarket,wherethe futuresprice ishigherthanthespotprice,narrowingofbasisbenefitstheshorthedger (short hedger is onewho sells the futures andbuystheunderlyingcommodity)
In a contango market, who benefits when the basis widens?
Inacontangomarket,wideningofbasisbenefitsthelonghedger (longhedger is onewhobuys futuresandsells
underlyingphysicalcommodity)
Basis in a Contango Market
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In a backwardation market, who benefits when the basisnarrows?
In a backwardationmarket, where thespotprice ishigher than the futures price, narrowing of basisbenefitsthelonghedger
In a backwardation market, who benefits when the basiswidens?
In a backwardation market, widening of the basisbenefitstheshorthedger
Basis in a Backwardation Market
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Basis Risk to conduct extensive analysis and research
beforeenteringintohedgepositions
Physical assetdifferentfromunderlyingassetofthefuturesavailable for trading correlation of different asset pricesshouldbehightominimizebasisrisk
Unequal durationbetweenhedgeperiodandfuturescontracttradingcycle
Financing CostforMarktoMarketsettlementofthefuturesposition
Intricacies involved in Hedging and Solutions
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Pricing Commodity Futures
Relationship between the future and its underlying spot can be best
explained with the help ofCost of Carry Model
COST OF CARRY MODEL
Futures Price=Spot Price + Cost of Carry
Constituents of Cost of Carry:
- Cost of financing
- Cost of storage
- Cost of insurance
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Interest Rate Compounded Annually
F = S + C
Where
F= Future Price, S=Spot Price, C=Cost of Carry
Example:
Cost of 100 gms of gold in the spot market is 80,000
Cost of Carry = 12% p.a., compounded annually
The fair value of a 4 months future contract will be
F = 80,000 + 3200*
F = Rs. 83,200
* 80,000*12/100*4/12 = 3,200
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Interest Rate Compounded Continuously
F = Sern
Where
e = 2.71828 (exponential function)
Example:
Cost of 100 gms of gold in the spot market is 80,000
Cost of Carry = 12% p.a. compounded continuously,
The fair value of a 4 months future contract will be
F = 80,000*2.71828(0.12*0.333)
F = Rs. 83,265*
* 80,000*2.71828(0.04)
= 83,264.85
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HEDGING
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Derivatives Basics
Hedging
Hedging means taking a position in the future market that is opposite to
position in the physical market with a view to reduce or limit risk
associated with unpredictable changes in price
A long futures hedge is appropriate when you know you will purchase an
asset in the future and want to lock in the price
A short futures hedge is appropriate when you know you will sell anasset in the future & want to lock in the price
Types of Hedges
The profit(loss) in the cash position is offset by equivalent loss(profit) on
the futures position
Thi ki i t k t
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Thinking in two market
Hedgers must think in two markets:
FINANCIALrisk management tools workin parallelwith PHYSICAL
transaction.
PHYSICAL MARKET
1. Producers buy and sell theirphysical product.
2.The physical good is delivered to awarehouse or location.
3.Payment is made based on thevalue of the physical good at thevolume delivered.
FINANCIAL MARKET
1. Producers buy and sell contractsthat represent a physical good.
2. The physical good is not typicallydelivered, rather the papercontract are closed or offset.
3. Payment is made based on thedifference between the purchasevalue of the contract and thesold/offset value of the contract
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+ =Gains/Losses
in Cash Market
Gains/Losses
in Currency Futures Mitigate Risk
Cash Market Future Market
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Managing Commodity Risk
T f H d L h d
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Types of Hedge - Long hedge
Buying hedge mean buying a futures contract to hedge the cash position.
Its used by dealers, consumers, fabricators etc. who have or will be
having an exposure in the physical market.
Buying hedge is used in the following cases:
To protect against the possible rise in the prices of raw materials
Sh t h d
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Short hedge
Selling hedge/Short Hedge means selling a future contract to hedge a
cash position. Its used by dealers, consumers, fabricators etc. who have
or will be having an exposure in the physical market.
Selling hedge is used in the following cases:
To protect the price of the products for which sales are commitment
has been made.
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The ratio of number of futures contracts to be
purchased or sold, to the quantity of cash assetthat is required to be hedged
Hedge Ratio
Standard Deviation is a measure of the volatility or risk
Correlation provides the relationship between spot andfutures prices
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Hedge Ratio: Example
Copper Futures vs. Copper Spot
Correlation = 0.997547 (or 99.7547%)
Standard Deviation (Change in Spot Price) = 0.022178
Standard Deviation (Change in Futures Price) = 0.018966
Hedge Ratio = (0.997547)x(0.022178) = 1.1665(0.018966)
If exposure in physical copper market is 10 MT,
then the hedge quantity = 1.1665 x 10 = 11.665
12 futurescontracts
Based on actual Closing Prices
Determining Optimum Hedge Example
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Determining Optimum Hedge Example
3rd September - a gold jeweler buys 8 kgs of gold in the cash market as raw material, to
create jewelry and sell the same after 15 days. To manage his price risk he decides to hedge
by selling MCX Gold October Future contract. The CPof gold and FPof gold over the
15 days period is 1.17 and 0.62 respectively and the between the cash and future price of
gold for 15 days is 0.60.
Help the gold jeweler to determine the optimum hedge required to protect his exposure?
The optimal hedge ratio is 0.60*1.17/0.62 = 1.13
The gold jeweler should sell 1.13*8/1=9.04 kgs or 10 (always advisable to be over hedge
than under hedge) gold futures contracts to hedge the physical exposure of 8 kgs of gold.
Solution to the given problem
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Thank you