Imperfect Hedge

The imperfect hedge, which is a more realistic case. So, same examples but different prices, different scenarios. The structure of an imperfect hedge is very similar to the perfect hedge. The only difference is the change in the prices in the financial and futures markets are not going to be exactly the same. So, we are going to have eight examples: four for short hedger, four for long hedger.

Now, let's walk through the first four examples. Again, let's assume you are working for an oil-producing company. It's early March. You know that you're going to have 500,000 barrels of crude oil ready for the market in December. Right now, the cash market price is $60. The futures delivering in December is $61. And you are a producer, so you're going to be long in the cash market. So, you have to take the opposite position in the futures. Your position is going to be short in the futures. You go and sell 500 contracts expiring in December in the futures market.

Let's start with the first example. Let's assume time passes, and prices go down. Right, first two scenarios, prices go down. Here we can see the spot market goes down 50 cents. The spot market goes down 40 cents. So, it was $61 minus 40 cents, it is $60.60. The second example, which we will get to after a couple of slides, prices still go down, but the change in the futures market is larger than the spot market. You can see the spot market price drops 40 cents, futures price drops 60 cents.

Right now, let's work on the first example. So, price drops in both markets, but in the spot market, it drops a bit more than in the financial market. Okay, so here's the table. Today, it's March. Spot price is $60. December futures are going to be $61. So, we take a short position, 500 contracts delivering in December, right? This is the hedging strategy. Time passes. The market is bearish. Price drops. Price drops 50 cents in the cash market and 40 cents in the financial market.

How much do we lose in the cash and the financial market? How much are the gain and loss in the cash and financial market? So, here we can see we aimed for $60. Now, the price drops. We are sellers, so we make less money. Price is down. How much money do we lose? The difference between these two, right? 50 cents times 500,000 barrels of crude oil, right? So, this is going to be 50 cents times 500,000 barrels of crude oil, and it is going to be $250,000.

What happens in the financial market? That was the loss, right, negative. Do we make or lose money in the financial market? Short position, bearish market, making money. How much? The difference. We sell at $61, we buy at $60.60. How much do we make? We make 40 cents, the difference between these two, times 500 contracts. So, this is a gain, 40 cents times 500 contracts. And what is the net? 500,000 barrels of crude oil, right? So, I have the calculations here. We lost $250,000 in the cash market. We gained $200,000 in the financial market. So, the net is minus $50,000, right? So, in this hedging strategy, we ended up losing $50,000, right? So, hedging is still efficient. It didn't eliminate the entire loss, but as you can see, this minus $50,000 is a lot less than minus $250,000. Under this hedge, we still lost some money, but this is far less compared to minus $250,000, right? So, hedging is still effective. The net is not zero. We lost some money, but this is far less than if we were not hedged.

Second example. Prices drop. Still, the market is going to be bearish, but it drops less in the cash market. Cash market is $60. Right now, it drops 40 cents going to November. Futures, right now, is $61. Then it drops to $60.40. So, in futures, it drops 60 cents. Setting up the table, right now, $60 going down to $59.60 in the cash market. Do we make money or lose money? We lose money. We are sellers. Price goes down, we get less money. How much? The difference between these two, which is going to be 40 cents times these 500,000 barrels of crude oil, which is going to be $200,000.

Financial market. Do we lose or gain money? Short position, bearish market, so we gain money. How much? The difference between when we open the position compared to when we close the position. This difference is 60 cents. How much money do we make? 60 cents is the difference times 500,000 barrels. I have the calculations here. We lost $200,000 in the cash market. We gained $300,000 in the futures. Under this hedge, what is the net? $100,000. So, in this case, we ended up making money. Under this hedging, we are protected against this loss and also made some extra cash.

Now let's move on to the case. Still, we are talking about the seller's hedge, but in this case, the market is going to be bullish, right? Example three and example four. In both cases, prices go up. In one, cash prices go up smaller than the futures, and in the other one, cash prices go up larger than the futures, right?

Example three. It is going to be a seller's hedge or short hedge. It is early March. The spot price is $60. Futures delivering in December is $61. The market is bullish. Prices go up. It goes up 35 cents in the cash market, but it goes up 50 cents in the futures market. We set up the table. This is the hedging strategy. Again, we are going to be long in the cash market, so we take a short position in futures. The market is bullish. Prices go up. Sorry, this is a typo. This should be 35 cents. So, this is what we made in the cash market. This is what we lost in the futures market, and this is the net. As you can see, under this scenario, under this hedging strategy, we ended up losing a little bit of money, $75,000. And again, remember, because we are obligated to close these positions, we lost this $250,000 in the financial market. If we had known that the market was going to be bullish, there was no need for hedging because we didn't know what was going to happen in November. We got into the hedge, and right now, we got stuck, and we have to pay $250,000. If there was no hedging, we could have made $175,000 more, and right now, because under this hedge, we ended up losing $75,000.

Okay, the fourth example. The market is still going to be bullish, but what happens here is the increase in the cash price is going to be higher compared to the futures. So, prices go up 50 cents in the cash market but only 40 cents in the futures. We set up the table. Right now, the cash market is $60, and futures delivering in December is $61. Time passes. It's early November. The market is bullish. Prices have gone up 50 cents in the cash market and 40 cents in the financial market.

So, do we make money or lose money in the cash market? Prices go up. We are sellers, so we are going to make more money, right? So, how much? The difference between these two, which is 50 cents, times the amount of oil that we have, which is 500,000 barrels. We make more money in the cash market. Financial market. Do we lose money or make money? Short position, bullish market, we lose money. How much? The difference between these two, which is 40 cents, right? 40 cents times the 500 contracts times 1,000 barrels each. So, here we make $250,000 in the cash market and lose $200,000 in the financial market. What is the net? The net is positive, slightly positive, right? Again, here, because we are under this hedging, we are obligated to close the position. We lose the money in the financial market. If there was no hedging, if the company was fully exposed to any risk, then we could have made $250,000, but we lost $200,000 of that in the financial market.

Buyer's hedge or long hedge. A buyer is short in the physical market, in a spot market, so the buyer should take the opposite position, which is long in the financial market. Working with the same example, let's assume that you work for a refinery that will need, that will know in December, the refinery will need 500,000 barrels of crude oil. They have to buy 500,000 barrels of crude oil from the cash market in December. So the hedging strategy is they have to take a long position right now in March, or whenever it is right now, and wait until before December.

So, for example, this is, let's say, example five. Under this scenario, we'll have four scenarios. The first scenario, example five, is when prices go down. The first scenario, it goes more down in the spot market compared to the futures. The second scenario is the opposite.

Okay, so we set up the table. Right now, in March, the cash market price is $60. We know that the buyer is always short in the spot market, so buyers should take a long position in the financial market. So the buyer will buy 500 December futures contracts from the financial market. The price is $61 right now. Time passes. It's early November, and so what happens when prices go down? Do buyers make or lose money in the cash market? Because the price goes down, they pay less money in the cash market, so they end up making some money in the cash market. How much? 50 cents per barrel. So it is going to be 50 cents per barrel. They make money in the cash market, make more money because they have to pay less, and they will need 500,000 barrels.

Financial market. Do they lose money or make money? We know that a long position loses money in a bearish market. The market is bearish from now to November, so they lose money in the financial market. How much? The difference between these two, which is 40 cents, times the amount of 500 contracts, a thousand barrels each. So they end up losing $200,000. So they make $250,000 more in the cash market. They lose $200,000, and as you can see, they still end up making a little bit more. The net is not zero, it is a bit more, but under this hedging strategy, they lost money in the financial market, right? Again, the important thing here to remember is because they were under this hedge, they lost money in the financial market. In this scenario, if there was no hedging, they could have made $250,000. But when you are hedging for some time in the future, you don't know what is going to happen in November, right? That's why you hedge.

Okay, the next example. Again, the market is going to be bearish, but changes in the spot market are going to be less than changes in the futures market. Let's see what happens. We set up the table again. Right now, the cash market crude oil price is $60. The financial market delivering in December is $61. The market is bearish moving on to November. Prices drop 40 cents in the cash market, but it drops 60 cents in the futures market. Early November, the contract expires in December, so we have to close our position.

Do we make money or lose money in the cash market? Prices go down. We are buyers. We have to pay less, so we end up making some money because we paid less. How much? 40 cents. 40 cents, and there will be 500,000 barrels of crude oil that we'll need, so we'll make $200,000 in the cash market. We pay less, $200,000.

Financial market. Do we lose or make money? Long position, bearish market, loses money. How much? The difference between when we open this contract, when we open this position, to when we are going to close. 60 cents is the difference. We have 500 contracts. Each contract is a thousand barrels. So we end up losing $300,000 here, and as we can see, the net is going to be negative $100,000. And again, as we can see, under this hedging strategy, we ended up losing some money. If there was no hedging, we could have made $200,000.

The next set of scenarios, which again involves this buyer, is a long hedge but the market is going to be bullish. Prices go up, right? Prices go up.

So, first example, we assume that it's early March. We will need crude oil for December. We work for a refinery. The cash market price right now is $60. The December futures are going to be $61. The market is going to be bullish, so prices go up in the cash market and in the futures, both 35 cents in the spot market but 50 cents in the futures. Let's calculate our loss and gain in each market and the net.

So, the hedging strategy is we have to take a long position in the financial market. This is the table. Prices go up. Do we make money or lose money in the cash market? So, our goal was $60. We are buyers. Prices go up, so we have to pay more. We have to pay 35 cents more, so we end up losing money in the cash market. How much? 35 cents times 500,000. We end up losing $175,000 in the cash market.

Futures. We took a long position. The market is bullish, right? Long position in a bullish market makes money. How much? The difference between prices when we open the position to when we are going to close it. 50 cents is the difference times 500 contracts times 1,000 barrels each. We end up making $250,000. The net is going to be $75,000.

So, under this hedging strategy, under this scenario, we not only didn't lose $175,000 in the cash market, we made some money. We made $75,000 as net under this hedging strategy.

Okay, the last example. The market is going to be bullish, but changes in the spot market are higher than the changes in the futures. So, the spot market increases by 50 cents, but futures increase by only 40 cents.

What happens? How much do we gain or lose in the cash and futures market? In the cash market, prices go up 50 cents. Do we make money or lose money? We are buyers. Prices go up, so we have to pay more. How much? 50 cents per barrel, and there are 500,000 barrels. We end up losing $250,000 in the cash market.

Do we make money or lose money in the financial market? Again, long position, bullish market, making money. How much? The difference between when we open the position to when we close it. 40 cents is the difference. 40 cents, 500 contracts, and 1,000 each, right? So, we are going to make $200,000 here. What is the net? Minus $250,000 plus $200,000. We are negative $50,000.

So, as you can see here, we still lost some money, but this money is far less compared to the $250,000 that we could have lost if we were not hedged, right? So, this is hedging using the financial futures contract hedging strategy.