Unit 3

Commodity Futures

 Commodity futures have commodities as underlying

assets.
 Futures on commodities help mitigate price risk.
 Trading in forward and futures on commodities is not
new. It has been in there for more than 100 years.
 Due to possibility of speculation with futures, the
commodities futures is often regarded as unwarranted
product and as a disservice to society.
 In India, many times futures on some of the commodities
like sugar, wheat, maize…etc has been banned.
 Commodity Futures - Uses

 Futures contracts on commodities enable Price

discovery,
 Smoothing of seasonal price variations,
 Efficient dissemination of information,
 Reduction in cost of credit, and
 Increased efficiency of physical markets.
 Commodity Futures & Economy

 The usual tools of containing the volatility in the

commodity prices like buffer stocks, controlled and
phased release of commodities, minimum support
price etc have either failed or have proved too
expensive for the economy.
 Commodity futures trading in developing country
can contribute a lot to the stability of fiscal
management, increasing the effectiveness of price
protection at national level and improving the
efficiency of developmental programmes.
 Commodity & Financial Futures

 Futures contracts on commodities differ significantly

from those on financial assets in terms of quality
specifications and delivery mechanism. The consumption
value of commodity makes valuation of futures difficult.
 Different qualities of commodities has pricing and
delivery problems.
 Commodity futures are governed by seasons and
perishable nature of the underlying assets.
 Supply of commodities (the agricultural products) is
confined to the harvesting period while the consumption
is uniform throughout the year.
 Hedging with commodity Futures

 Long and Short Positions:

 When one holds the underlying asset he is said to be long
on the asset. For example a jeweler holding gold or silver is
long on the asset.
 When one sells the underlying asset it is considered as
short position.
 Similarly in the futures market
 If one buys a futures contract he is said to be long, and
 If one sells the futures contract he is said to be short.
 Hedging Principle

 To execute a hedge following steps should be

taken:
 One who is long on the asset, goes short on the futures
market, and the one who is short on underlying asset
goes long in the futures market.
 At an appropriate time one can neutralize the position in
the futures market, i.e. go long on futures if one was
originally short and go short on futures if one was
originally long, and receive/pay the difference of prices.
 Sell or buy the underlying asset in the physical market at
prevailing price.
 Short Hedge

 When one has long position in the asset he needs to

take a short position in futures to hedge. It is
referred as short hedge.
 For example, a sugar mill would go short on the
futures contract on sugar to hedge against the fall in
price.
 If prices fall the short position in futures would yield
profit compensating for the loss due to reduced
realized value of sugar in the spot market.
 Short Hedge - Example

 Consider a sugar mill. It is expected to produce 100 MT

of sugar in the month of April. The current price today
(the month of February) is Rs 22 per Kg. April futures
contract in sugar due on 20th April is trading at Rs 25
per Kg. The sugar mill apprehends that the price lesser
than Rs 25 per Kg will prevail in April due to excessive
supply then.
 Let say the intended price Sugar Mill wants to sell at
Rs.25.
 How can the sugar mill hedge its position against
the anticipated decline in sugar prices in April?
 Short Hedge - Example

 To execute the hedging strategy the sugar mill takes

opposite position in the futures market.
 Sugar Mill has to sell sugar supply in the April & due
to supply & other reasons if price of the sugar is
lower then Sugar Mill will loose.
 if price goes down it will hurt Sugar Mill, then it has
to take such a position in the futures market where if
price goes down it earns profit out of it. This profit
from Futures market will set off against the loss due
to lower price in physical/spot/actual market.
 So, Short in Futures market….short hedge.
 Short Hedge - Example

 How can the sugar mill hedge its position

against the anticipated decline in sugar
prices in April?
 To execute the hedging strategy the sugar mill takes
opposite position in the futures market.
 The sugar mill is long on the asset in April. Therefore
it needs to sell the futures contract today.
 Short Hedge - Example

 If price falls to Rs 22 per Kg. Cash flow (Rs per Kg.)

 Sold futures contract in February + 25.00

 Bought back futures contract in April - 22.00

 Gain in the futures market + 3.00
 Price realized in the spot market +22.00

 So, Sugar Mill will realize only Rs.22 when it sells in

actual market in Month of April.

 Here the loss of Rs 3 (Rs 25 – Rs 22) in the spot

market is made up by an equal gain in the futures
market.
 Short Hedge - Example

 If price rises to Rs 26 per Kg. Cash flow (Rs per Kg.)

 Sold futures contract in February + 25.00

 Bought back futures contract in April - 26.00

 Loss in the futures market -1.00
 Price realized in the spot market +26.00

 So, Sugar Mill will realize Rs.26 when it sells in

actual market in Month of April.

 Here the gain of Rs 1 (Rs 26 – Rs 25) in the spot

market is offset by loss in the futures market by same
amount.
 Long Hedge

 When one has short position in the asset he needs to

take a long position in futures to hedge. It is referred
as long hedge.
 For example, an importer of oil would go long on the
futures contract on oil to hedge against the rise in
price.
 If prices indeed rise the long position in futures
would yield profit compensating for the loss due to
increased price of oil in the spot market.
 Long Hedge example

 Assume 6-months futures.

Long Hedge example
 Short hedge-example

 ONGC is leading oil exploration company. It is planning t0

sell 2035 barrels of oil in the month of December. (Current
month is June)
 Currently crude oil price is around Rs. 3500 per barrel.
Firm is concerned that after 6 months due to too much of
supply oil price may be lower than Rs.3,300 per barrel.
 Current Futures price on MCX : Sep- month- Rs. 3320
 Current Futures price on MCX : Dec- month- Rs. 3230
 1 contract = 100 barrels
 Construct the hedge if after 6 month 1) spot price = Rs.
3600 & futures price= 3610 2) spot price = Rs. 3200 &
futures price= 3190
 Long Hedge & Short Hedge

 If firm is going to buy some commodities (as a raw

material..etc.) in future time then, to protect from
upward movement of price firm will enter into Long
hedge.
 If firm is going to sell some commodities (as a finish
goods..etc.) in future time then, to protect from
downward movement of price firm will enter into
short hedge.
 Perfect Hedge

 A perfect hedge is one where loss on the physical

position is exactly offset by gain in the financial
position and vice-versa.
 Imperfect Hedge

 Except by coincidence futures hedge is imperfect. The

gains/losses in the futures do not exactly offset the
loss/gains in the physical position because: the exposure
in the underlying and futures market may not be on the
identical asset & quality,
 the value of exposure in the underlying and the futures
may not be same because futures contract have fixed
size.
 the time of maturity of the futures contract may not be
same as the time of exposure in the physical position
because maturities of futures contract are specific.
 Basis

 Basis is difference of futures price (F) and spot price (S).

 It declines as time to maturity approaches. Basis at the
beginning is B0 = F0 – S0
 Basis at the end of hedge period is B1 = F1 – S1

 With futures hedge we have opposite positions in

physical and futures markets.
 Going with you bought in spot market & sold in
futures then following is the outcome;
 Gain/loss in the spot market = S1 – S0
 Gain/loss in the futures market = Fo – F1
 Basis Risk

 The risk in the hedged portfolio would be equal to

the difference of basis at start and end of hedge.
 If basis risk is zero then it is perfect hedge. Hedger
will try to minimizes the basis risk.
 Hedging with futures is not perfect.
 Price risk gets replaced by much smaller
basis risk.
 Price risk(Difference of spot prices) = S1 – S0
 Cross Hedge

 In case of mismatch of the assets & quality between

futures contract & underlying asset, the hedging in
futures lead to cross hedge.
 Cross hedge: A hedge executed through a futures
contract on an asset different from, but related to,
the underlying asset, is referred to as a cross hedge.
 Example: If no futures is available to hedge
sugarcane price movement and one uses futures on
sugar to hedge it is cross hedge.
 Speculation with Commodity Futures

 Futures can be used for speculation if the estimate of

future spot price is different than the futures price.
 To speculate on the prices of commodities one has to
do one of the following: If a trader expects a price fall
he simply has to sell a futures contract today and buy
it later
 If a trader anticipates a rise in prices he simply has to
buy the futures today and sell later
 Spread Strategies with Futures

 Spread strategies in futures are concerned with the

mispricing of futures contracts
 a) in two different assets called
 Inter-commodity spread
 b) in two different markets called
 Inter-market spread
 c) of two different maturities called
 Calendar spread
 Hedging for gross profit Margin

 Spread strategies can be used for protecting gross profit

margin where futures are available on inputs and
outputs. For example sugarcane and sugar.
 Variations in gross profit margin can be minimized By
going long on futures of raw material we can have
assured raw material price and hence the cost.
 By going short on futures on finished goods items we can
have assured prices for finished goods.
 With revenue and cost hedged the gross profit margin
can be protected or made more stable.
 Strategic Implications of Futures

 Futures can be viewed as a strategic product rather than

a mere tactical product capable of providing hedging of
routine day to day transactions.
 Provides range of futures price during targeted time
period.
 Better inventory mgt., as firm can protect value of closing
stock by going appropriate target price.
 Protected steady gross margin leads to steady cash flows,
which can bring creditworthiness in terms of borrowing
& reduced cost of capital.
 Investors will see consistent steady performance in good
way which will be protecting value of stock price.