1. CHAPTER 5 Agricultural, Energy and Metallurgical Futures Contracts
This chapter explores futures contracts on physical commodities, those written on agricultural, energy and metallurgical commodities. This chapter is organized into the following sections:
Commodity characteristics that interfere with the Cost of-Carry Model.
Commodity Supply and Storability
Commodity Seasonal Production
Commodity Seasonal Consumption
Commodity Poor Storability
Spread
Intra-commodity Spreads
Inter-commodities Spreads
Hedging
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2. Commodity Characteristics
Recall: the Cost-of-Carry Model implies a range of permissible prices. These prices are defined by the cash- and-carry and reverse cash-and-carry arbitrage strategies.
Applying the cash-and-carry arbitrage strategy assumes that the physical good or commodity can be stored from one day to the next.
Applying the reserve cash-and-carry arbitrage depends upon short selling.
Some goods have a convenience yield, which stems from the usefulness of having them in inventory.
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3. Commodity Characteristics
Recall: the relationships between cash and futures prices depend upon:
Storage characteristics of the commodity
Supplies of the commodity
Production and consumption cycle for the commodity
Ease of short selling the commodity
Transaction costs
In the following section, we begin by discussing how the supply and storability move the market to or away from full carry. Then, we provide examples of commodities that are at full carry and commodities that are not at full carry.
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4. Commodity Characteristics Supply and Storability
Insert Figure 5.1 here
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5. Commodity Characteristics Supply and Storability
Table 5.1 presents the various features of the commodities and the expected price behavior.
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6. Commodity Characteristics
SUMMARY
If a good has excellent storage characteristics and a large supply relative to consumption, we expect markets for the good to approximate full carry (e.g., gold).
Commodities with good storability may at some point, depart from full carry, due to fluctuation in production (grains during harvesting time) or fluctuations in consumption (gasoline during summer time).
Commodities with poor storability can depart substantially from full carry (e.g., livestock).
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7. Full Carry Markets Precious Metals
Figure 5.2 shows gold prices for the JUN and DEC futures contracts.
Highly storable commodities with a large supply relative to annual consumption should behave according to the Cost- of-Carry Model.
For precious metals, both the cash-and-carry and reverse cash-and-carry arbitrage strategies are potentially effective because short selling is fairly accessible for precious metals like gold.
Recall: the carrying costs consist of storage, insurance, transportation, and financing charges.
Insert Figure 5.2 here
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8. Full Carry Markets Precious Metals
If gold is a full carry market, the following relationship should hold:
where d > n
Applying this equation to our present example implies:
DEC gold futures = JUN gold futures (1 + C)
Dividing both sides of the above equation by the right-hand side and subtracting 1, we have:
Any time this equation equals something other than zero, an arbitrage opportunity is possible.
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9. A Full Carry Example: Gold
Assume that the prices in Table 5.2 are present in the market and assume that the financing cost is the T-bill rate for the June-December period. All other transaction costs are ignored. We would like to know if the market is at full carry.
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10. A Full Carry Example: Gold
While this value is close to zero indicating that the market is near full carry, the trader with a total carrying cost equal to the T-bill rate could make a profit from a cash-and-carry strategy.
$ $ ( ) = $.36/ ounce
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11. A Full Carry Example: Gold
If the T-bill rate is What is the repo rate?
The futures contract is for ½ year, so to compare this rate to the T-bill rate, we must annualize it as follows:
The difference between the T-bill rate and the repo rate is: =
Thus, if a trader’s financing cost is below %, She/he could engage in a cash-and-carry strategy.
This analysis demonstrates that gold market was very close to full carry on that day.
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12. Departure from Full Carry: Gold
Figure 5.2 shows how gold and other precious metals behave in similar fashion.
INSERT FIGURE 5.3 HERE
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13. Departure From Full Carry: Silver
If prices decline, the results of the full carry market equation may be above zero. This is said to be above full carry.
If the market is above full carry, cash-and-carry arbitrage strategies become attractive.
Assuming short selling is possible and that no convenience value exists:
Borrow money.
Sell a futures contract.
Buy the commodity.
Deliver the commodity against the futures contract.
Recover the money and payoff loan.
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14. Departure from Full Carry: Silver
If prices rise, the results of the full carry market equation may fall below zero. This is said to be below full carry.
If the market is below full carry, reverse cash-and-carry arbitrage strategies become attractive.
Assuming short selling is possible and that no convenience value exists:
Sell short the commodity.
Lend money received from short sale.
Buy a futures contract.
Accept delivery of futures contract.
Use commodity received to cover short sale.
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15. Product Profile: The NYMEX Silver Futures
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16. Departure from Full Carry: The Hunt’s Silver Manipulation Case
In January 1980, the Hunt Manipulation was at its peak and silver hit its all-time record price of $50/ounce.
Traders with no convenience value, delivered silver to benefit from the quasi-arbitrage opportunities.
On Thursday, March 27,1980, the silver manipulation ended, the market crashed, and the silver market quickly returned to almost full carry again.
Figure 5.4 shows the silver market from October 1, through June 30, 1980.
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17. Departure from Full Carry: Silver
Insert figure 5.4 here
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18. Commodities with Seasonal Production
In this section, we examine commodities that are produced seasonally. To facilitate the discussion assume:
Consumption of the commodity is steady.
Long-term inventory is constant.
Production will equal consumption.
Commodity stores well (e.g., wheat, corn, oats, barley, soy products).
Prices exhibit seasonal trends due to harvesting patterns.
Wheat is used to illustrate the seasonal characteristics of commodities.
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19. Inventories and Price Patterns
Insert Figure 5.5a Here
Insert Figure 5.5b here
Insert Figure 5.5c here
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20. Inventories and Price Patterns: Basis
A fluctuating basis is often interpreted as a sign of high risk and unstable prices.
However in this example, due to our assumptions, there is no risk.
This shows that the basis may fluctuate radically even under conditions of certainty.
It is important to separate fluctuations in the basis into the expected and unexpected components.
Insert Figure 5.6
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21. CBOT’s Wheat Futures Profile
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22. Wheat and Wheat Futures
Although, wheat does not fit our model perfectly. The seasonal factor and the availability of wheat in the US is very strong. Figures 5.7 shows that wheat prices tend to be high during winter and low during summer.
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23. Seasonal Character of Cash Wheat Prices
Insert figure 5.7 here
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24. Wheat and Wheat Futures
Table 5.3 shows the average stock of wheat in the US by month from 1969 to Notice the low inventory for June, and the high level for August and September.
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25. Wheat and Wheat Futures
Based on Table 5.3, high supply should cause a drop in price (other factors held constant).
Table 5.4 shows the seasonal character of cash wheat prices.
Results confirm the view that cash prices should be high when inventories are low and low when inventories are high.
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26. Wheat and Wheat Futures
The large number of highs and lows in these months reflects the large forecasting errors in futures prices when the expiration is distant.
There is no tendency for high prices to occur in one month and low prices to cluster in some other time period. Thus, cash prices can be seasonal, while futures prices for the same commodity are not.
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27. Wheat and Wheat Futures
Table 5.6 presents a portion of Telser’s classic study of wheat and cotton futures. Telser concluded “futures data offer no evidence to contradict the simple hypothesis that the futures price is an unbiased estimate of the expected spot price.”
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28. Wheat and the Cost-of-Carry Model
Given the characteristics of wheat, we expect wheat price relationships to differ substantially from the full carry behavior of gold.
First, wheat production is seasonal. Even if the harvest were known well in advance, wheat would still be abundant after harvest and scarce later.
Second, the harvest is not known in advance, so shortages or surpluses of wheat can develop.
In general, we would not expect wheat to behave as a full carry market in all circumstances.
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29. Wheat Versus Gold: The Cost-of-Carry Model
Insert Figure 5.2 JUL and DEC Gold Futures Prices
Insert Figure 5.8 Here JUL and DEC Wheat Futures Prices
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30. Wheat Versus. Gold: The Cost-of-Carry Model
Insert Figure 5.9 here
Deviations from Full Carry for Wheat
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31. Wheat Versus Gold: The Cost-of-Carry Model
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32. Wheat Versus Gold: The Cost-of-Carry Model
Summary:
Wheat cash prices are seasonal, due to fluctuating supply and surprises about the harvest.
The spread between two futures maturities can vary in a systematic way, due to seasonal factors.
Storage, insurance, and transportation costs, as well as the financing cost should be evaluated to determined if a market is at full carry.
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33. Commodities with Seasonal Consumption
In this section, we examine commodities that show seasonal consumption. Particular attention will be given to crude oil.
Seasonal consumption patterns can produce fluctuating stocks of some commodities. This can create shortages and give a convenience value to these commodities.
Oil and related products provide an example of a good with fairly steady production, but highly seasonal demand (e.g., gasoline during summer, heating oil during winter).
Crude oil futures sometimes are at full carry, while at other times, crude oil can have a substantial convenience yield or the market can even be in backwardation.
Table 5.7 shows crude oil prices with virtually every possible price pattern.
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34. Crude Oil Futures Prices
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35. Commodities with Poor Storability
In this section, we examine commodities that show poor storability. Particular attention will be given to livestock.
Livestock is an example of a commodity with poor storability.
Example:
Live cattle must have an average weight between 1,050 and 1,200 pounds at delivery. If cattle are held too long, they cannot be delivered in fulfillment of the contract.
Difficult storage conditions loosen the no-arbitrage connection between futures contracts with different expirations.
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36. Feeder Cattle and Live Cattle
The CME trades contracts on feeder cattle and live cattle.
The decision to slaughter feeder cattle, or to carry forward for delivery as live cattle, depends on the spread between to feeder cattle and live cattle futures contracts and the cost of feeding.
I PHASE: CALF
Conception to weaning
II PHASE: FEEDER
CATTLE
Feeding ≈1 yr
Weight ≈ Lbs
Grow
More
Yes No
III PHASE: LIVE CATTLE
Weight ≈ Lbs
TRADE
Feeder Cattle
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37. Live Cattle Futures Prices
Figures 5.10 and 5.11 show that there is little chance live cattle adhere to the cash-and carry structure.
Insert figure 5.10 here
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38. Commodities with Poor Storability Live Stock
Insert figure 5.11 here
We conclude that the Cost-of-Carry Model does not apply very well to cattle. Prices fluctuate from above to below full carry.
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39. Spreads In this section, we examine spreads: Intra-commodity spreads.
Every intra-commodity spread must have at least two contracts (one short/one long).
Bull Spread
A bull spread is an intra-commodity spread designed to profit if the price of the underlying commodity rises.
B. Bear Spread
A bear spread is an intra-commodity spread designed to profit if the price of the underlying commodity falls.
Inter-commodity spreads.
Every inter-commodity spread must have at least two contracts in two different, but related commodities
Soybeans complex
Energy complex
Livestock
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40. Intra-Commodity Spreads
Recall: the Cost-of-Carry Model for a full carry market with perfect markets.
d > n
Recall further: changes in spreads and changes in prices for full and non-full carry markets behaves as follows:
In full carry markets, if the commodity price rises, the distant futures price rises more than the nearby futures price.
In non-full carry markets, if the commodity price rises, the nearby futures price rises more than the distant futures price.
Table 5.9 lists commodities that follow each type of relationship.
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41. Bull and Bear Intra-commodity Spreads
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42. Inter-Commodity Spread Relationships
In this section, the spread relationships between the following related commodities will be explored:
Soy complex
The energy market (oil)
The livestock market (feeder cattle and live cattle)
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43. Soybeans Futures Market
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44. Soybeans and The Crush
Soybeans must be crushed to yield edible soymeal and soyoil. A 60-pound bushel of soybeans produces approximately:
48 lbs. of soymeal lbs. of soyoil lbs. of waste
Crush Margin
The crush margin is the difference in value between a bushel of soybeans and the resulting meal and oil.
One soybeans contract ( 5000 bushels) produces approximately: tons of soymeal or 1.2 soymeal contracts 55,000 pounds of oil or 92% of a soyoil contract
10 contracts  5,000 bushels ≈ 2,400,000 lbs. of meal ,000 lbs. of oil
≈ 12 contracts of meal + 9 contracts of oil
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45. Soybeans and Crush Spreads
In normal conditions, the value of the meal plus the oil must exceed the value of the soybeans. If this were not the case, there would be no incentive to process the soybeans. Thus, we expect the crush margin to be positive.
The following crush and reverse crush information along with Table 5.11 will be used to illustrate soybean crush spreads.
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46. Soybeans and Crush Spreads
Assume that today, August 4, a speculator believes that the crush margin is too small. That is, the speculator believes that by buying beans and selling the combined meal and oil positions, he/she will make a profit.
Table 5.12 details the transactions the speculator enters to take advantage of his/her beliefs.
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47. Soybeans and Crush Spreads
Bean prices actually fell resulting in a net loss of $27,733.
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48. Soybeans and Crush Spreads
Now the speculator believes that the prices will continue to fall, so the speculator enter the market again with the transactions as shown in Table 5.13.
Bean prices rise causing the speculator another net loss of $13,013.
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49. Oil and the Crack
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50. Oil and the Crack
Crude oil must be refined into other products (e.g., gasoline, heating oil, or propane).
Cracking
Cracking is the process of refining crude oil. The same crude oil can produce a variety of products depending on the techniques used to crack it.
A barrel of oil can only produce a certain amount of total product. The mix is variable, but the total output is a zero- sum game.
Cracking patterns are largely governed by the season of the year (more gasoline will be produce during summer, and more heating oil during winter).
Crack Spread
The price relationship between crude oil and its refined products.
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51. Oil and the Crack There are several kinds of crack spreads, including:
Crude oil/heating oil crack spread
1 barrel crude oil ≈ 1 barrel gasoline
Crude oil/gasoline crack spread
1 barrel crude oil ≈ 1 barrel heating oil
Other Combination based on multiple units of crude oil
2 barrels crude oil ≈ 1 barrel gasoline 1 barrel heating oil
Buy a Crack Spread
The trader buys the refined product and sells the crude.
Sell a Crack Spread (Reverse Crack Spread)
The trader sells the refined product and buys the corresponding crude.
The most popular crack spreads are the 1:1 spreads between crude and heating oil or crude and gasoline.
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52. Oil and Crack Spreads
Table 5.14 shows the contract specifications for crude oil, heating oil and gasoline.
1 barrel = 42 gallons
Figures 5.12 shows the prices of July crude oil and heating oil futures in dollars per gallon and 5.13 illustrates the spread.
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53. Oil and Crack Spreads
Insert Figure 5.12 here JUL Crude and Heating Oil Futures
Insert Figure 5.13 Here Spread between JUL Heating and Crude Oil Futures
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54. Oil and Crack Spreads
Assume that today, March 16; a trade has gathered the information from Table The trader believes that the $.0616 crude oil/ heating oil crack is not sustainable ($.4569-$.5185= $.0616). The trader thinks that the justifiable refining spread is only $.04 per gallon. Therefore, the trader expects the spread to narrow and thus decides to enter into a reverse crack spread (sell heating oil and buy crude oil).
Table 5.16 shows the transactions the trader enters into in order to take advantage of her/his beliefs.
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55. Oil and Crack Spreads
The trader’s assessment was correct and thus he/she made a profit.
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56. Oil and Crack Spreads
The trader now believes that the spread will widen, and that heating oil will now rise in price relative to crude. Therefore, she decides to place a crack spread (crack spread consists of buying the refined product and selling crude). Table 5.17 shows the trader’s transactions.
Notice that the trader’s overall profit depends only on the crack spread, not on the direction of oil prices in general.
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57. Feeder Cattle and Live Cattle
Insert Figure 5.14 here
A Time Line for Cattle Production
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58. The Cattle Crush
The cattle crush depends upon the price of cattle today, the expected price of cattle in the future, and the price of grain necessary to feed the cattle to a larger future size.
A popular cross-exchange spread occurs between corn contracts on the CBOT and cattle contracts on the CME.
The cattle crush spread can be established by holding a long position in corn futures while simultaneously establishing a short position in live cattle.
A reverse cattle crush involves buying two live cattle contracts for each corn contract the trader is short.
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59. Feeder Cattle and Live Cattle
Example
The owner of the newborn calf sells two futures contracts for the calf:
One contract for delivery as a feeder in 12 months.
One contract for delivery against the live cattle contract in 18 months.
The owner has the following options:
Deliver the calf against the feeder contract, and offset the live cattle contract.
Offset the feeder contract, maintain the live cattle contract, and deliver the 18 month steer against the live cattle contract.
The owner’s potential profitability is largely a function of the cost of corn.
If feed prices rise, the profitability of feeding is reduced. Thus, spread between the cash price of feeder cattle and the futures price for live cattle will narrow as corn prices rise.
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60. Corn and Live Cattle Future Prices
Assume that today, May 22, you, a cattle feeder, have gathered the information from Table You have 65 steers and anticipate that the steers will be on feedlot rations for sixth months in order to produce slaughter weight cattle. You know that one corn contract will feed the steers underlying 2 live cattle contracts to slaughter weight. You calculate your current spread to be $ per steer. You fear that the cattle crush spread may narrow, and wish to lock in the current spread. The ratio of corn contracts to live cattle contracts is 1:2.
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61. Corn and Live Cattle Future Prices
The current spread is calculated as follows:
Value of two cattle contracts:
2(40,000)(.7680) = $61,440 or per steer
Value of one corn contract:
1(5,000)(2.675) = $13,375 or $ per steer
The spread is the difference between the value of the cattle contracts and the cost of corn.
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62. The Cattle Crush Spread Position
Table 5.19 shows the transactions you enter in order to lock in your current spread.
Your cattle crush produce a $1,265 gain.
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63. Reverse Cattle Crush Spread Position
Now assume that you believe that the corn/cattle spread will widen. Therefore, to take advantage of your belief, you establish a reverse cattle crush spread.
Table 5.20 shows the results of a reverse cattle crush using the prices displayed in Table 5.18.
You miscalculated. As the spread narrowed, your reverse cattle crush position in the futures market lost $1,265.
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64. Hedging
Chapter 4 explored hedging and basic hedging strategies. This section explores more complicated strategies particular to:
Energy markets
Agricultural markets
Metallurgical markets
We consider hedging different grades of oil.
Two highly publicized cases of improperly implemented hedges will also be explored.
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65. Hedging Worldwide Crude Oil
There are different kinds of crude oil originating around the world. The following table illustrates six types of oil.
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66. Hedging Worldwide Crude Oil
Recall that the easiest way to compute the risk- minimizing hedge ratio, number of futures contracts to hold for a given positions in a commodity, is by estimating the following regression:
From the previous regression:
β = The risk-minimizing hedge ratio
Α = A measure of hedging effectiveness
Where
The closer to 1, the better the chance that the hedge will work.
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67. Hedging Worldwide Crude Oil
Table 5.21 reports the volatility of the weekly price changes for the different oils and the results from two hedging strategies.
Finding a futures contract that closely matches the spot commodity is important and will generally improve the hedge considerably.
Second, for cross-hedges, the naive 1:1 hedging approach may be markedly inferior to using a risk- minimizing hedge ratio.
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68. Improperly Implemented Hedges
Two highly publicized cases of improperly implemented hedges were:
The Hedge-To Arrive (HAT) Fiasco
Agricultural commodities
The Metallgesellschaft Hedging Fiasco
Energy Products
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