Hedging Futures

Hedging With Futures

1

July 17, 2004

Agenda z Introduction z Hedging Strategies z Diversification Benefits z Practical Problems in Hedging

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What is Risk? z Exposure to market movement of prices z In general, down side risk is what we mean by risk

z Quantification of risk - the volatility of the price movements z Volatility is nothing but the standard deviation (deviation from the mean prices)

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What is Risk Management? z No risk can be eliminated z Risk Management z Transferring the risk to some one who can handle it better or z Transfer the risk to some one who has the appetite for risk

z Financial derivatives are used to hedge the exposure to market risk z Hedgers transfer their risk to speculators who are willing to assume the risk

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Risks faced by an entity Foreign exchange risk Interest rate risk Commodity price risk Credit risk Operational risk

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•Commodity price risks include • Increase in purchase cost vis-à-vis commitment on sales price • Change in value of inventory • Counterparty risk translating into commodity price risk

•Commodity futures •Inventory hedging •Borrowings linked to commodity prices

What is a hedge? z A hedge is a futures position that is roughly equal and opposite to the position the hedger has in the cash market z A hedge is designed to reduce price risk.

The profit (loss) in the cash position is offset by equivalent loss (profit) on the futures position 6

What are the risks in commodities? Commodity enterprises face two classes of risk: z Price risk – risk relating to movements in the world price, the exchange rate and the basis between local and world prices) z Quantity risk (eg from weather)

Hedging may allow reduction in price and cost risk Insurance may be available for quantity risk 7

Volatility comparison - Summary Average annual volatility z Sensex or Nifty - 25-30% z Govt Sec Index - 5-10% z Gold - 12-18% z Silver - 15-25% z Cotton - 10-12% z Oil seeds - 15-20% z Commodities are less volatile compared to stock market z The determinants of volatility are different for capital market and commodity markets

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Agenda z Introduction z Hedging Strategies z Diversification Benefits z Practical Problems in Hedging

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Commodity price risk - significance Industry (data of 1500 companies)

Estimated Aggr. Turnover (Rs Cr.)

% of Raw Material cost to Aggr. Turnover

Agro/ FMCG/ Edible Oils

65,000

70%

Auto/Auto Ancil.

35,000

90%

Chemicals

5,000

65%

Construction

10,000

40%

Consumer Goods

3,000

50%

Engineering/Industrial G.

30,000

50%

Fertilizer/Pesticides

15,000

45%

Livestock/Leather

2,000

65%

Metals/Mining/Steel

60,000

70%

Packaging

10,000

60%

3,00,000

85%

Sugar

5,000

65%

Textiles

20,000

90%

Transport

2,000

40%

Oil/Petro/Refineries

Source of data – ICICI Bank Corporate Infobank

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Industry in India today runs the raw material price risk, Going Forward they can hedge this risk

Commodity price risk & corporates z Exposure to commodity price risk can do damage to the bottom line z Impact of commodity risk on profits is examined for three companies z These companies are exposed to unique commodity price risk (Cotton, Aluminium and Copper) z Market leaders in their respective industry z Impact on PBT if the companies had not hedged their commodity price risk

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Commodity price risk – Impact Amount in Rs crores Company Name

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Sales

A Tex

1326.28

Raw Materia l 567.00

RM as % of sales

PBT

Price risk

Impact on PBT

% Impact

B Al

2639.55

1117.43

42.33

899.39

1.90%

(50.15)

(5.57)

C Cu

3406.48

2565.35

75.31

194.28

2.65%

(90.27)

(46.46)

42.75

129.00

1.30%

(7.37)

(5.71)

Commodity Price risk – Impact on commodities z Hedging can improve the profits z Impact depends on the raw materials intensity of the company z % of raw material expenditure on Sales z Value addition by the company

z Is companies profits a function of the commodity prices? z Textiles Industry – Cotton price increase cannot be passed down to the customers z Metal Processing Industry – Profits are direct function of the market prices of the commodities

z How does the share price of the company behave with the commodity price movements? 13

Commodity Price Risk – Cotton 6000

5000

4000

3000

2000

1000

0 1 /0 1 /0 1

1 0 /0 8 /0 1

C O T T O N P R IC E S

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7 /1 5 /0 2 C O M P A N Y A -S H A R E P R IC E

Increase in raw material cost means reduction in share prices

Commodity Price risk – Aluminimum 1800 1600 1400 1200 1000 800 600 400 1 /0 1 /0 1

5 /2 1 /0 1

1 0 /0 8 /0 1

C O M P A N Y - B S H A R E P R IC E

2 /2 5 /0 2

A L U M IN IU M P R IC E

Share prices mimic the commodity price movements 15

Commodity Price Risk – Copper 2000

1600

1200

800

400 1 /0 1 /0 1

5 /2 1 /0 1

1 0 /0 8 /0 1

C O M P A N Y - C S H A R E P R IC E S H A R E P R IC E (X 5 )

2 /2 5 /0 2 C O P P E R P R IC E S

Share prices mimic the commodity price movements 16

Types of Hedges z Long Hedge z This requires taking a long position in the futures contract z Appropriate when a certain asset or commodity would be purchased in the future and one is interested in locking in the price now z Textile Company would use a long hedge z Short Hedge z This involves a short position in the futures contract z Applicable when a hedger already owns an asset and expects to sell it in the future z The Aluminum producer would use a short hedge

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Cross Hedge z Cross Hedge is used to hedge price risk of different but economically related commodities z Correlation analysis is used

z Hedging and cross hedging should only be attempted if the price movements are similar and basis risk is acceptable to the hedger

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A cotton hedge – an example z Two varieties of cotton are available for trading on NCDEX – J-34 (short staple) and S-6 (long staple) z Suppose, a farmer in Andhra Pradesh producing Buny / Brahma variety (extra long staple) wishes to hedge on NCDEX

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Cotton hedge - continued S-6 futures market

S-6 spot market

May 25, 2004

Sell one Aug futures (Rs. 6650/- per quintal

Rs. 6763/- per quintal

Buny / Brahma spot market Rs. 2500/- per quintal

August 20, 2004

Buy one Aug futures (Rs. 6550/- per quintal

Rs. 6550/- per quintal

Rs. 2470/- per quintal

Not relevant

Rs. (1620/-)

Net gain (loss) Rs. 1870/-

Net gain- Rs 1870- Rs 1620= Rs 250 20

Cotton hedge - continued z Thus, we see that the farmer gains Rs. 250/- (per contract) by hedging at NCDEX. z The loss in the spot market is notional

z For hedging to be effective, two things are necessary. z The futures and spot price for S-6 should move together z Also, the spot price for S-6 and Brahma / Buny should also move together.

z Optimal hedge ratio

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Unbalanced hedge z The future contract standardized size units do not match the cash position quantity z Use a combination of regular size futures and mini contracts to reach a futures position as close as possible to the cash position z An over hedged occurs when futures quantity exceeds the cash quantity z An under hedged occurs when the cash position exceeds the future quantity z The problem can be handled by trying to match quantities as closely as possible

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Unbalanced hedge Cash

Futures

Buy

Now

Sold two contracts

629000

3 Months Later

Bought two contracts

611200

625000

Sold Head at

607200

Loss

-17800

17800

Cash from sale of Gold Cash from Futures

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910,800 35,600

Total Cash

946,400

Per pound

630,933

Rolling Hedge z When cash position is not known, then a process of hedging with the near contract and rolling the hedge is a common and accepted hedging practice

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Dynamic Hedge z Dynamic hedging is done on the basis of a price forecast z During periods when favorable price movement is expected, the hedge is held in abeyance z Hedge is entered into when adverse price movement is expected z Exposed to risk if price views turn out incorrect

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Inter-commodity spread z Price movements between related underlying instruments tend to correlate fairly well and such gains in one derivatives position may offset losses in a related instrument z Companies can hedge their input and output price risk z Soya oil manufacturers--Soybean and Soya oil z Refiners—Crude and gasoline z Crack Spread

z Exchanges offer an inter-commodity spread discount on initial margin

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Agenda z Introduction z Hedging Strategies z Diversification Benefits z Practical Problems in Hedging

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Trends in Nifty, NSE G-Sec Index, Bullion 25.0

20.0

15.0

10.0

5.0

0.0

1/1/1997

1/1/1998 Gold/1000

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1/1/1999

1/1/2000 NSE Nifty/100

1/1/2001

1/1/2002

G-Sec/10

1/1/2003 Silver/1000

1/1/2004

Correlation Correlation coefficients in Indian m arkets Gold Silver Stocks Bonds Gold 1 0.089 0.206 0.741 Silver 1 -0.099 0.146 Stocks 1 0.112 Bonds 1 Data: LBMA bullion prices, NSE Nifty, NSE G-Sec Index

Benefit of diversification can be seen from the 29

Risk Adjusted Returns

Risk-Adjusted Returns Portfolio structure 100% Stock Portfolio Stocks (50% ) & Gold Portfolio Stocks (50% ) & Silver Portfolio 100% Gold Portfolio 100% Silver Portfolio 100% Bonds Portfolio Bonds (50% ) & Gold Portfolio Bonds (50% ) & Silver Portfolio

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(50% )

Cumulative Returns 73.70% 47.80%

Risk of portfolio 24.43%

Risk Adjusted Return 3.017 3.326

14.37%

(50% )

48.30%

3.634 13.29%

(50% )

21.80% 22.90% 25.20% 23.50%

7.92% 8.79%

2.001 1.742 3.182 2.673

(50% )

24.00%

6.58%

3.647

Agenda z Introduction z Hedging Strategies z Diversification Benefits z Practical Problems in Hedging

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Costs of hedging z There is a risk-return trade-off z Lower return due to lower risk z Lack of liquidity in the market resulting in impact cost z Low liquidity results in higher volatility

z Margin finance z Margins are based on volatility z The real cost of hedging is the finance cost of margins z Margins could range from 5% to 50%

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Basis Risk z Basis is defined as the difference between the cash price and futures price of a commodity. It can be either positive or negative z Basis = Spot price – Futures price

z The basis can improve or worsen the position of the hedger z When a hedger is short futures, increases in the basis creates gains z When a hedger is long futures, decreases in the basis creates gains

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Cost of Physical Delivery z Cost of dematerialization z DP charges related to demat holdings

z Cost of assaying z Physical verification vs. scientific verification

z Cost of accreditation of warehousing z Own warehouse vs. accredited warehouse

z Cost of handling, storage and transportation z Own warehouse vs. transportation, storage and handling charges of accredited warehouse

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Cost of Physical Delivery on NCDEX NCDEX - Indicative warehouse charges Commodity

Location

Warehouse

Delivery

Charges to be paid on deposit

Units

(in Rupees) Fixed charges@

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Fixed

Warehouse

Testing charges to be paid

Charges - rate per unit per

Directly to assayers (Rs)

Gold

Mumbai

Brinks

Kg

310*

55 per kg

0

260

Silver

Delhi

Brinks

Kg

610**

1 per kg

0

560

Soy Bean

Indore

MPWLC

MT

110

13 per MT

650

60

Soya Oil

Indore

Jhawar ICS

MT

110

30 per MT

1815

60

Mustard seed

Jaipur

ACE India

MT

110

18 per MT

900

60

Mustard oil

Jaipur

ACE India

MT

110

42 per MT

2285

60

RBD Palmolein

Kakinada

IMC

MT

110

26 per MT

1000

60

CPO

Kandla

CRPL

MT

110

25 per MT

1625

60

Cotton - long

Ahmedabad

Gujcot

Bales

110

6 per Bale

2280

60

Cotton - medium

Bathinda

PAFCO

Bales

110

6 per Bale

2280

60

Rubber

Kottayam

KSWC

MT

110

36 per MT

50 per MT (i)

60

Rubber

Kochi

KSWC

MT

110

36 per MT

50 per MT (i)

60

Pepper

Kochi

KSWC

MT

110

22 per MT

20 per MT (ii)

60

Chana (Gram)

Delhi

Total Log

MT

110

37.5 per MT

1000

60

Chana (Gram)

Indore

MPWLC

MT

110

9 per MT

1000

60

Chana (Gram)

Indore

Jhawar ICS

MT

110

10 per MT

1000

60

Jute Sacking Bags

Kolkata

Tewari WH

Bales

110

6.25 per Bale

12 per Bale (iii)

60

Guar seeds

Jodhpur

VCO WH

MT

110

9 per MT

1000

60

Thank You

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Short Hedge Example Short Hedge in Wheat Futures Cash Market

Futures Market

Wheat Price at

193

September

Sell Wheat at

195

Sell Wheat at

172

April

Buy Wheat at

174

Opportunity loss

21

Gain

Net gain or loss =0

37

21

Long Hedge Example Long Hedge in Wheat Futures Cash Market

Futures Market

Wheat Price at

143

Now

Buy Wheat at

148

Buy Wheat at

155

3 Months Later

Sell Wheat at

161

Loss

13

Gain

Net gain or loss =0

38

13

Basis Example—Long Futures Cash Market

Futures Market

Wheat Price at

143

Now

Buy Wheat at

148

-5

Buy Wheat at

155

3 Months Later

Sell Wheat at

163

-8

15

-3

Loss

12

Gain

Net gain or loss =3

Decrease in basis creates gains in case of a long hedge 39