Speculations

VII: Futures
22: Hedging, Speculation, and Arbitrage

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

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
Existing Risk: Long soybeans
$180,000
$190,000
$200,000
$210,000
$220,000
$230,000
$240,000
360 380 400 420 440 460 480
Price (Soybeans Spot)
Income
© Oltheten & Waspi 2012

Hedge
 An investment that offsets this risk
 Short soybeans
 Short Soybean futures

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

Hedge Strategy
 Use November Futures
November
contracts
deliver
plant
October ?
harvest
Set
Hedge
Spot risk
Lift
Hedge
Offsetting futures risk

Set the Hedge
 George sets the hedge in April
 Spot price: $4.20/bu
 Futures price: 431
 Basis (spot-futures) = -11¢

Set the Hedge
 Set the hedge in April
November
contracts
deliver
$4.20
October ?
harvest
431
Lift
Hedge
-11¢

George Q. Farmer
Hedge is set
Set the Hedge
Long Position (spot)
Short Position
(futures)

431
-$50,000
$0
$50,000
$100,000
$150,000
$200,000
$250,000
360 380 400 420 440 460 480
Price (Soybeans Spot)
Income
Short Position
Long
Position

Scenario 1: Textbook Hedge
 George harvests October 1

Lift Hedge
November
contracts
deliver
$4.00$4.20
411
-11¢
431
-11¢

George Q. Farmer
Hedge is set Sell 10 November futures @ 431
[10*5,000*431 = $215,500]
Margin:
Hedge is
lifted
Buy 10 November futures @ 411
[10*5,000*411 = $205,500]
Margin:
Profit:
Sell 50,000 soybeans spot @$4.00
Net Income:
Lift the Hedge

Lift the Hedge
 Textbook Hedge
Spot price:
$4.20 $4.00
price: 431 price: 411

Scenario 2: Not quite a Textbook Hedge

Lift the Hedge
November
contracts
deliver
$5.00$4.20
508
-11¢
431
-8¢

George Q. Farmer
[10*5,000*431 = $215,500]
Margin:
Hedge is
lifted
[10*5,000*508 = $254,000]
Margin:
Profit:
Net Income:
Lift the Hedge

Lift the Hedge
 Not quite a Textbook Hedge
Spot price:
$4.20 $5.00

Hedge
 Once the hedge is set George trades his
Price Risk for Basis Risk

Scenario 3: Not quite a Textbook Hedge

Lift Hedge
November
contracts
deliver
$1.00$4.20
105
-11¢
431
-5¢

George Q. Farmer
[10*5,000*431 = $215,500]
Margin:
Hedge is
lifted
[10*5,000*105 = $52,500]
Margin:
Profit:
Net Income:
Lift the Hedge

Lift the Hedge
 Trade Price Risk for Basis Risk
Spot price:
$4.20 $1.00

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.

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

Set the Hedge
December
contracts
deliver
$2.00
+5¢
195

George Q. Farmer
Hedge is set
Set the Hedge

Lift the Hedge
 In October
 Spot corn is /bushel
 December corn futures trade at

George Q. Farmer
Hedge is set Sell 2 December futures @ 195
[2*5,000*195 = $19,500]
Margin:
Hedge is
lifted
Net Income:
Lift the Hedge

Set the Hedge
November
contracts
deliver
$2.00
+5¢
195

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