Problem 1: Hedging with forwards and futures

Today is 13th December 2019. You work in the risk management department of a large publicly listed manufacturing company. Your company will need to purchase 1000 units of asset S on the 15th of February 2020. Asset S is a consumption asset that is crucial for production in your company. You have some historical data on the price movements of asset S and the price movements for a futures contract (F) written on an asset that is correlated with your asset S. You are responsible for the technical process of any hedging activity, as well as communicating the pros and cons of hedging activity to upper management who have minimal finance experience. Please refer to the data in the sheet titled ‘Problem 1’ in the ef5050_exam.xls file to answer parts of this question that require calculation.

Question 1.1

a) Describe how you would hedge the purchase price risk of asset S using a forward contract.

b) What challenges could you face with this hedging strategy?

Question 1.2

Imagine a situation in which no forward contract is available and you must use a futures contract to hedge the price risk. You have available a futures contract (in the series F) that expires on the 15th of February 2020. The commodity underlying the futures contract F has price movements that are correlated with asset S. Answer using the data in the sheet for Problem 1 under ‘Historical Data on Prices of Futures and Asset’. Each futures contract is for 1 unit of asset F.

a) Calculate the number of futures contracts needed to hedge.

b) Please explain the logic of this hedge ratio to management.

c) Would you recommend using this hedge ratio? Give reasons why/why not.

d) Can you think of alternative types of hedge ratio and their potential advantages.

Question 1.3:

Consider the data in the sheet for Problem 1 under ‘Realised Outcomes on Prices of Futures and Asset’ to be the true outcome of the data. Assume, for now, that there are no margins for trading futures.

a) What is the outcome of your hedging strategy using the hedge ratio from 1.2 (a)?

b) What hedge ratio would you use in the future given access to this longer dataset?

c) Does the difference, if any, impact your approach to hedging?

Question 1.4:

The initial margin is 8% of the contract value and the maintenance margin is 5% of the contract value.

a) Describe the evolution of your cash position, for the realised outcomes from ‘Realised Outcomes on Prices of Futures and Asset’ given the hedge ratio calculated in 1.2 (a).

b) How could you estimate the potential risks associated with margins? Try to come up with a simple measure of risk.

c) Provide some analysis to management that helps them understand the risk measure you came up with in part (b). 

Question 1.5:

You learn that there are some political developments that could affect the price of the commodity S.

There is a 1% chance that the price will increase by 280% during the life of the hedge. You are the only person that knows this.

a) Does this change your hedging approach?

b) Does your answer change if you discover that other people were privy to the information?

c) How would your approach to hedging change if there was a 1% chance that the price would drop by 80% rather than increase in the next two weeks?

d) What market data could potentially reveal if other market participants had learned the same information as you?

Question 1.6

a) Suggest some alternative approaches to forwards and futures for hedging in the context of this question.

b) What are the advantages and disadvantages of each of the other approaches?

c) Before you make a final recommendation on the hedging strategy, what other information could you request from upper management?