1. 22: Hedging, Speculation, and Arbitrage
VII: Futures
22: Hedging, Speculation, and Arbitrage

2. Futures Hedge Speculate Arbitrage
use futures to reduce risk on an existing position
Speculate
use futures to take on risk in the hope of making a profit
Arbitrage
Use the difference between spot and futures prices to generate risk-free profit

3. Hedge Identify the existing risk
50,000 bushels of soybeans growing in the fields
The current price of $4.20/bushel can change before George can harvest & sell

4. Existing Risk: Long soybeans
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5. Hedge An investment that offsets this risk Short soybeans
Short Soybean futures

6. Hedge Strategy K K If soybean prices increase
Long Spot J
Short Futures L
If soybean prices decrease
Long Spot L
Short Futures J K K

7. Offsetting futures risk November contracts deliver
Hedge Strategy
Use November Futures
October ?
harvest
plant
Spot risk
Offsetting futures risk
November contracts deliver
Lift
Hedge
Set
Hedge

8. Set the Hedge George sets the hedge in April Spot price: $4.20/bu
Futures price: 431
Basis (spot-futures) = -11¢

9. November contracts deliver
Set the Hedge
Set the hedge in April
October ?
harvest
$4.20
November contracts deliver
Lift
Hedge
431
-11¢

10. Set the Hedge Long Position (spot) Short Position (futures)
George Q. Farmer
Hedge is set
Long Position (spot)
Short Position (futures)

11. Long Position
Short Position

12. Scenario 1: Textbook Hedge
George harvests October 1
Spot price: $4.00/bu
Futures price: 411
Basis (spot-futures) = -11¢

13. November contracts deliver
Lift Hedge
$4.00
$4.20
November contracts deliver
431
411
-11¢
-11¢
© Oltheten & Waspi 2012

14. Lift the Hedge George Q. Farmer Hedge is set
Sell 10 November 431
[10*5,000*431 = $215,500]
Margin:
Hedge is lifted
Buy 10 November 411
[10*5,000*411 = $205,500]
Profit:
Sell 50,000 soybeans
Net Income:

15. Lift the Hedge Textbook Hedge $4.00 price: 411 Spot price: $4.20

16. Scenario 2: Not quite a Textbook Hedge
George harvests October 1
Spot price: $5.00/bu
Futures price: 508
Basis (spot-futures) = -8¢

17. November contracts deliver
Lift the Hedge
$5.00
$4.20
November contracts deliver
431
508
-11¢
-8¢
© Oltheten & Waspi 2012

18. Lift the Hedge George Q. Farmer Hedge is set
Sell 10 November 431
[10*5,000*431 = $215,500]
Margin:
Hedge is lifted
Buy 10 November 508
[10*5,000*508 = $254,000]
Profit:
Sell 50,000 soybeans
Net Income:

19. Lift the Hedge Not quite a Textbook Hedge price: 508 Spot price: $4.20
$5.00
price: 508
price: 431

20. Hedge
Once the hedge is set George trades his Price Risk for Basis Risk

21. Scenario 3: Not quite a Textbook Hedge
George harvests October 1
Spot price: $1.00/bu
Futures price: 105
Basis (spot-futures) = -5¢

22. November contracts deliver
Lift Hedge
$1.00
$4.20
November contracts deliver
431
105
-11¢
-5¢
© Oltheten & Waspi 2012

23. Lift the Hedge George Q. Farmer Hedge is set
Sell 10 November 431
[10*5,000*431 = $215,500]
Margin:
Hedge is lifted
Buy 10 November 105
[10*5,000*105 = $52,500]
Profit:
Sell 50,000 soybeans
Net Income:

24. Lift the Hedge Trade Price Risk for Basis Risk $1.00 price: 105
Spot price: $4.20
$1.00
price: 105
price: 431

25. Hedge George also grows corn (10,000 bushels)
Futures contracts defined as
5,000 bushels
Cents per bushel
Corn futures deliver March, May, July, September, & December.

26. Set the Hedge In April Spot corn is $2.00/bushel
December corn futures trade at 195
Margin requirements at $400 and $300 per contract

27. December contracts deliver
Set the Hedge
$2.00
December contracts deliver
195
+5¢
© Oltheten & Waspi 2012

28. Set the Hedge
George Q. Farmer
Hedge is set

29. Lift the Hedge In October Spot corn is /bushel
December corn futures trade at

30. December contracts deliver
Set the Hedge
$2.00
December contracts deliver
195
+5¢
© Oltheten & Waspi 2012

31. Lift the Hedge George Q. Farmer Hedge is set
Sell 2 December 195
[2*5,000*195 = $19,500]
Margin:
Hedge is lifted
Net Income:

32. November contracts deliver
Set the Hedge
$2.00
November contracts deliver
195
+5¢
© Oltheten & Waspi 2012

33. Futures II