PrintHedge includes taking two equal but opposite positions in the cash and futures market. In that case, gain and loss in one market is offset by loss and gain in the other market and the hedger’s risk exposure will be reduced or eliminated.
Perfect Hedge
1. Seller's hedge or short hedge
Assume the current spot market price for crude oil is $60/bbl. A crude oil producer is planning to sell 500,000 barrels of crude oil in the cash market in December (they are said to be “long” the commodity). As we learned in Lesson 4, commodity prices in the spot market (cash or physical market) are affected by the local supply and demand. Consequently, spot market prices are more volatile than the futures prices and the producer is subject to price risk until December.
Assume the current NYMEX December futures market price is $61.00. In order to hedge the December price against the price fluctuations, the crude oil producer has to take the short position (the opposite of the physical position) in the financial market and sell 500 December crude oil contracts. When the hedger has the long position in the spot market and the short position in the financial market, it is called seller's hedge or short hedge. In this case, the price is now set at $61.00 for December delivery of West Texas Intermediate Crude Oil at the Cushing, OK, Hub.
However, the crude oil producer is intending to sell the product in the spot market and not interested in delivering the crude oil at the Cushing, OK, Hub. And remember that all December futures contracts must be financially settled at the end of November according to the rules of the exchange. So, by the end of November, the producer must buy back the contracts in order to balance their financial position (close the position). Remember, if producer doesn't close the financial position, they have to deliver the crude oil to Cushing, OK, Hub.
So, what happens to the price that the producer will receive when they actually sell their crude oil in the December cash market? Since the futures pricing represents the “market,” the December futures prices rose and fell as the contracts traded. Both the value of the futures contracts that the producer sold, as well as the cash price (market), fluctuated throughout the life of the December futures contract trading. When the producer had to buy back the futures contracts on final settlement day, if the contract price had risen, they took a loss on their financial transaction. But what happened in the cash market? Since futures rose, so did cash, thus providing a gain in the physical market for the producer. Conversely, if futures prices had fallen by final settlement, the producer would’ve paid less for buying the futures contracts back and made a profit on the financial transaction. However, since the futures market declined, so did the cash market, thus lowering the actual price the producer received when the December crude oil production was sold in the physical market.
In both of these scenarios, the gain or loss in the financial market is offset by a corresponding and opposite gain or loss in the physical cash market. If the spot and financial markets move exactly in tandem, this results in a perfect hedge. We refer to a “perfect” hedge when there is a 1:1 correlation between the financial and physical markets.
Example 1: Assume the price has gone down. On November 1st the spot market prices are $59.3/bbl and in that case (assuming perfect hedge) the December futures contract would be $60.30/bbl.
| Date | Cash Market | Financial Market | Net |
|---|---|---|---|
| Now | Long Price = $60/bbl |
Short Producer sells 500 December contracts Price = $61/bbl |
|
| November 1st | Price = $59.30/bbl Loss = (59.30-60)*500,000 = - $350,000 |
Close the position: Producer buys 500 December contracts Price = $60.30/bbl Profit = (61-60.30)*500,000 = $350,000 |
-$350,000 + $350,000 = 0 |
In this case, the loss in the spot market is offset by the profit in the financial market.
Example 2: Assume the price increased and on November 1st the cash prices are $60.50/bbl. In that case (assuming perfect hedge) the December futures contract would be $61.50/bbl.
| Date | Cash Market | Financial Market | Net |
|---|---|---|---|
| Now | Long Price = $60/bbl |
Short Producer sells 500 December contracts Price = $61/bbl |
|
| November 1st | Price = $60.50/bbl Profit = (60.50-60)*500,000 = $250,000 |
Close the position: Producer buys 500 December contracts Price = $61.50/bbl Loss = (61-61.50)*500,000 = - $250,000 |
$250,000 + (-$250,000) = 0 |
As we can see in the above table, the profit in the spot market is offset by the loss in the financial market.
Mini-lecture: Short hedge (seller’s hedge) (10:51 minutes)
So we learned that a perfect hedge is when the hedge completely eliminates the gain and loss in the market due to the price fluctuations. We started this with this example and said, "Okay, assume you work for an oil-producing company and you know that you're going to have your production plan and you know you're going to have $500,000 of crude oil for the market in December. Right now, let's say it's March. You know that you're going to produce around $500,000 of crude oil in the market in December. So your position in the cash market is going to be long. Always, it is going to be long. You're going to be long commodity in the cash market. So the hedging strategy is you have to go to the financial market and sell how many? 500 contracts right now in March, right? Let's go through some numbers here. Let's assume the current price in the spot market is $60 per barrel. December futures contract delivering in December is $61, right? So you will go and sell 500 futures contracts expiring in December right now, right?
And let's say time passes and we are getting close to December. It's November, early November. Price changes, and in this scenario, prices go down. Prices go down in the financial market and also go down in the spot market. Why? Because we said the relationship between the spot market and futures can be explained in two terms. One term is when the financial market and the spot market are highly correlated. They track each other. They are being affected by the same factors. One goes up, the other goes up. One goes down, the other goes down too. And the other term is convergence. Convergence is for the expiration date. When we get close to the expiration date, these two prices, financial market and futures, get close to each other. They converge under this scenario. So we'll see that it's early November. It is still some time to the expiration date, but prices have gone down.
Okay, I'm trying to put the pen. So the spot market has gone down 70 cents. You remember in March it was $60. Right now it's $59.30, 70 cents. And also in the financial market, prices have gone down too. It was $61 early on in March when we sold December futures at $61, and right now prices have gone down and it is $60.30, right? So this is how we set up the table. As you can see, early on in March, the price in the cash market was $60. So we went to the financial market and we shorted 500 futures contracts expiring in December at $61, right? Time passes. It's early November. Prices go down 70 cents in the cash market, 70 cents in the futures market, and because we are not interested in delivering the commodity to Cushing, Oklahoma, we have to close our position in the financial market. Now we are going to calculate the money that we lose in each market.
So we learned that because prices have gone down in the cash market, we're going to lose some money in the cash market, right? We are producers. We aimed for $60. Now prices have gone down to $59.30. How much money do we lose in the cash market? $500,000 of crude oil times this difference, $59.30 minus $60, times $500,000, which is going to be minus $350,000. How much do we gain or lose in the financial market? You remember the position is short. We sold the contracts at $61. Price went down from the fundamental factors. We know that if we take a short position, we will make money if the market is bearish, right? So we sell high, we buy low. How much money do we make? The difference, right? It is going to be 70 cents, the difference between these two, times 500,000 barrels, 500 contracts, 1,000 barrels each contract. So it is going to be 500,000 barrels. So we're going to make a profit of $350,000. And as we can see, these two are exactly equal, so the net is going to be zero. This is called a perfect hedge, right? When what we lose or gain in one market equals what we gain or lose in the other market.
Okay, let's work on another example here. We assume from now to November prices went down. Prices go down. Let's assume the other way. Let's assume from now to November prices go up. Let's see what happens. In this example, we saw how hedging was successful in helping us make up the money that we lost in the cash market, right? Okay, another example. Let's say prices go up. Prices go up to $60.50 in the cash market and $61.50 in the futures, right? Again, we set up the table. In March, right now, the price in the cash market was $60. We had 500,000 barrels of crude oil, and the position was short $61. Sorry, this should be $61. I should correct this. I think I missed that. Slide number 41. Okay, so the price was $61. The position was short. Now time passes. It's November. Prices go up 50 cents here, 50 cents here. Let's see how much money we make or lose in the cash market. So prices go up, right? And we are producers. We are crude oil producers. When prices go up, we make money, 50 cents. How many barrels? 500,000 barrels. So we are going to make $250,000 in the cash market. How about in the financial market? Prices go up, right? 50 cents go up. The position was short. From the fundamental factor, we know that if we have a short position, if the market is bullish, if prices go up, we lose money, right? How much? The difference times the barrels that we are going to have in the market. How much do we lose? $250,000. Again, in this case, these two gain and loss, they match, and we end up losing nothing, gaining nothing. Very important point here. If there was no hedging strategy, we could have made $250,000 because prices went up. Now, because we are obligated under this hedging strategy, because we shorted 500 contracts, we are obligated to close the position, and we lose money. So because we hedged, we lose money. If there was no hedging, there was no loss here. But remember, hedging is not only about getting rid of potential loss. Hedging is when you are going to say, "Okay, I don't want any deviation in my revenue. I'm going to stay with what I plan, and I am willing to get rid of potential profit as well as potential loss." So this is what we see here. If there was no hedge, you could have made $250,000. But when you are in March, you don't know what is going to happen in November. So you say, "Okay, I don't want to risk that. I could make money, or I could lose money. I'm going to get rid of both." In this case, we can see under this scenario, we could have made money, but because we are under this hedge, then we lost some money under the hedge, but they cancel out the job.
Perfect Hedge - Seller's Hedge or Short Hedge
- Let's assume a crude oil producer is planning to sell its product of 500,000 barrels of crude oil in the cash market in December.
- They are said to be "long" the commodity.
- Producer sells 500 December futures contracts.
- In this case, the price is now set at $61.00 for December delivery of West Texas Intermediate Crude Oil at the Cushing, OK, Hub.
- Producer sells 500 December futures contracts.
- The price is now set at $61.00 for December delivery of West Texas Intermediate Crude Oil at the Cushing, OK, Hub.
| Date | Cash Market | Financial Market |
|---|---|---|
| Now | Long Price = $60/bbl Producer sells 500 December contracts |
Short Price = $60/bbl Producer sells 500 December contracts |
| Nov. 1st | Price = $60.50/bbl Profit = (60.50 - 60) * 500,000 = $250,000 |
Close the position: Producer buys 500 December contracts Price = $61.50/bbl Loss = (61 - 61.50) * 500,000 = -$250,000 |
| Net: $250,000 + (-$250,000) = 0 | ||
The profit in the spot market is offset by the loss in the financial market.
2. Buyer's hedge or long hedge
Assume a refinery is planning to buy the same amount of crude oil in the same spot market and the refinery wants to hedge the December price and its profit against the price fluctuations. The refinery is said to be “short” the commodity and having the short position in the spot market. In order to hedge, the refinery has to buy 500 December futures contracts (1000 bbl each) in the financial market and sell them by the end of November (closing position). This is called buyer's hedge or long hedge, which is opposite to the seller's hedge.
Example 3: Assume on November 1st, the spot market prices are $59.3/bbl and in that case (assuming perfect hedge) the December futures contract would be $60.30/bbl.
| Date | Cash market | Financial Market | Net |
|---|---|---|---|
| Now | Short Price = $60/bbl |
Long Refinery buys 500 December contracts Price = $61/bbl |
|
| November 1st | Price = $59.30/bbl Profit = (60-59.30)*500,000 = $350,000 |
Close the position: Refinery sells 500 December contracts Price = $60.30/bbl Loss = (60.30-61)*500,000 = - $350,000 |
$350,000 + (-$350,000) = 0 |
The profit in the spot market is offset by the loss in the financial market.
Example 4: Assume prices increased and on November 1st the cash prices are $60.50/bbl and in that case (assuming perfect hedge) the December futures contract would be $61.50/bbl.
| Date | Cash Market | Financial Market | Net |
|---|---|---|---|
| Now | Short Price = $60/bbl |
Long Refinery buys 500 December contracts Price = $61/bbl |
|
| November 1st | Price = $60.50/bbl Profit = (60-60.50)*500,000 = -$250,000 |
Close the position: Refinery sells 500 December contracts Price = $61.50/bbl Loss = (61.50-61)*500,000 = $250,000 |
-$250,000 + $250,000 = 0 |
As we can see in the above table, the refinery's loss in the spot market is offset by the profit in the financial market.
Note that based on the concept of "convergence", getting close to the expiration date, the final settlement price for the December crude oil contract on the NYMEX would represent the cash market price for that month.
This process can be performed many times over by the producers and consumers as desired. Thus, suppliers and end-users can establish a fixed-price and hedge against the price fluctuations. And theoretically, they can do so for as many future months as the particular contact allows (this is dependent on the number of market participants willing to trade that far out).