Hedge Using Futures and Derivatives Disaster - Assignment Example

Futures Contracts Student’s Name Class Name Professor’s Name University State Date Question B 1 Futures Futures contract, mostly referred to as futures is a set forward contract which is legally binding to a buyer or a seller to buy or sell something at an agreed price after a given period of time in future. According to Hull (2017), some of the common transaction traded involves physical commodities such as maize, oil and precious metals, and financial instruments such as currencies, bonds and mortgage securities. To be precise, this contract gives an avenue to the traders to fulfill a contract to either deliver a commodity or accept delivery or delivery of some sort of financial asset in a future given date in line to the condition offered in the contracts effective for a price agreed on the contract. Once a party agrees to accept the delivery of an instrument or a commodity, he or she takes the long position, while the part agreeing to take the delivery of the asset whether financial instrument or commodities assumes the short position. Hedging The purpose of features is for the reason of hedging commodity price against uncertain future price. Producers who are involved in selling of commodities such as wheat will not afford to take risk of unknown future prices of their wheat by speculating future prices; instead famers will enter into future contract with a willing buyer in a future time. Wisner (2002) explained hedging as taking equal but opposite positions in the cash and futures market. Given the example of wheat farmers, hedging will be a temporal option to them since the wheat will be finally sold in the in the cash market. Example 1 Assuming a famer who plant wheat takes a short position. If the famer has 10000 bags of wheat and who has sold the 10000 bags wheat future is in a hedged position. Assuming the price of wheat per bag is speculated to be 30$ after 6 month and the famer agrees to enters into a future contract with a buyer, and after the sixth month the price of a bag of wheat falls to 25$, this will means there will be a drop of 5$ per bag. The famer who entered into a future contract will be hedged against losing the 5% dollar drop per bag which will be the profit earned by the famer. Speculation Hull (2017) explained speculation as; assuming the long position in the underlying asset at an agreed price in the contract with the expectation that after a given period of time, the prices of the commodity will have rose significantly such that they will make handsome profit in the future. Example 2 Supposing a business man assumes a long position. This will mean the business man agrees to buy a bag of wheat in after a given period of time effective with price agreed on. Assuming the business man agree to buy a bag of wheat at a price of 30$ after the sixth month and reaching the sixth month the price of wheat per bag is sold at 35$ per bag, it will the buyer will buy a bag of wheat at the agreed price of 30$ and sell a bag of wheat at 35$ making a profit of 5$ per bag. Question B2.1 From the background information of what it explains the losses MGRM incurred, I tend to believe from my point of view that, MGRM had entered into a forward contract. The purpose of MGRM to installed the hedge with a mindset that the market would be in a backwardation. Backwardation is case scenario where, the party expecting to make delivery or the party assuming the short position expects results where the spot price would be higher than the future prices. But the unexpected may have happened, the market shifted into a contango; the future prices become higher than the spot price. This shift created a scenario where the cost of hedging became higher. The whole scenario created a problem where the firm was not able to raise funds that was necessary for the firm to maintain their positions. Secondly, the purpose of hedging was to entirely to reduce the risk that the firm my encountered due to unpredictable prices of their commodities, but from my point of view, the firm must have speculated instead of hedging due to financial problems that the firm encountered in the event of contango. Another case scenario with the possible cause of financial loses of the firm was that, the firm used a stack and roll strategy which increased loses because in a case where a market undergoes a contango, the spot prices usually decrease more than the future price. Although they had entered into a forward contract, am of the opinion that the position they had taken would have offset the losses resulting from the hedge, the negative cash flow will result in the short run because the only fund that would have been used to offset the losses was all dependent on oil sales, this was motivated by the size of position that really created a funding risk. Question B2.2 Maturity mismatch and underlying asset mismatch In his book Hull (2017), both maturity mismatch and the underlying assets mismatch are usually treated as cross hedge. Cross hedging is a case where, when placement of contracts are made directly, the possibilities of risk elimination is present when hedge is lifted at the end of the maturity period of the futures contracts. And when there are no existing futures contracts that have no setlements dates that match with the hedging horizon, then mismatch maturity can applied to the futures but again the risk will be present in the event. How maturity mismatch impact hedge result Maturity mismatch, is when the underlying asset has a sequence of maturity dates, the maturity date of the underlying asset can come earlier before the exposure date or extends out over multiple years. Up to this point, the problem has been hedging risk of an underlying asset at its maturity date with the future contract having a matching maturity. According to Hull (2017), there are cases where the underlying assets holding period exceeds the maturity date of the futures contracts, and in such event it will be wise for hedgers to apply a roll over strategy which means the a futures contract will be closed at an early stage prior to the maturity or delivery month. In the event that rolling strategy is applied, there will be a maturity mismatch and as a result, the hedger will assume the same position in the futures contract but on longer delivery date. In other instances, some of the traders use maturity mismatch a way of reducing risk in a hedge position, but in general terms, when the hedge ratio of a commodity is equal to one , this risk reduction strategy may not be effective as the hedge ration applied may not reduce the risk. In his book Hull (2017), he said that, in some other instances, lack of maturity mismatch can improve the hedging effectiveness. In hedge positions, spot position fully determined the number futures contracts. According to Hull (2017), this hedge is effective if a dollar change in the spot price is exactly offset by a dollar change in the futures price. How mismatch of the underlying assets impact hedging Hull (2017) explained that, in most cases, all the hedge contract entered are cross hedges. When a trader trading gold want to hedge gold using futures related to gold, the futures has a cross hedge if at the time of exposure the underlying gold that is held is not deliverable to the party who is the buyer of the gold. Asset mismatch therefor affects the hedging process in the sense that, effective cross hedging in most cases does not exist. Therefore, cross hedging will affect the normal hedging process in a manner that there should be a buildup of a multiple futures contract to be used. Peter Ritchken (1999), gave an example of cross hedging a portfolio of a corporate bond where he indicated that, a corporate bond can be hedged using both the futures of treasury securities and futures of security/stock indices. Question B2.3 How maturity mismatch is critical in the case of Metallgescellschaft AG. MGRM main objectives in this case scenario was to win the business from their competitors, the firm resorted to long negotiable fixed price contract in a long period of as long as 10 years in the future time. This strategy traded MG at a very high risk. If the oil prices where to rose, then the firm will have to get the oil at higher prices and deliver to their prospective customers at a lower price which resulted to losses. MG had believed that the roll-over would not result in a problem. On the contrary, with the growing number of the agreement of fixed prices entered into by the firm, future position taken by the firms grew so larger than it actually went beyond the number of contracts that was required to purchase in the NYMEX. Maturity mismatch is very critical as there was need for the company to hedge risk. One of the strategies that the company was to employ was to enter into or purchase future contracts on NYMEX. Given that there was a maturity mismatch, the MGRM should have taken into account the idea of to roll over the future contracts into new in the event that the old contracts expire. Hull (2016) in his book indicated that, successive rolls caused the firm to incure a huge lose that amounted to 30 million dollars from a report that substantiated that the basis risk of a role over dates in a forward contracts. As the company was making successive roll over the industry started experienced a slip in the prices of oil, causing a negative records of profits on future positions of the firm. Hull (2016) conclude in his book that, as a result of the timing mismatch between the hedging price and income received from the company’s clients who are the customers, the monetary constraints almost brought down the company. The trouble escalated to the ceiling when a margin call of 200 million dollars was issued later in the year 1993 by NYMEX. According to Hull (2016) he indicated that, “basis risk can be eliminated if the hedge is lifted at the expiration of the futures contract through cross hedging”. The critical aspect of the firm’s state was motivated by the fact that the company considered roll over instead of cross hedging which could have leveraged the situation. Much of the time firms might need to fence against value developments in an item for which there is no forward contract. References Block,S. and T. Gallagher, “The Use of Interest Rate Futures and Options by Corporate Financial Managers”, Financial Management, Vol 15, 1989, 73 − 78. Gramatikos, T and A. Saunders, “ Stability and the Hedging Performance of Foreign Currency Futures”, Journal of Futures Markets,Vol. 3, 1983, 295 − 305. John C. Hull, 2017, Global edition, 8th edition, Fundamentals of Futures and Options Markets, pearson. Read More