Corporate Strategies to Hedge Commodity Price Risks Applying

disconcert of contents propensity of abbreviationsIII List of figuresIII List of tablesIII 1Introduction1 1. 1Problem and prey1 1. 2Structure of this paper1 2Background Information2 2. 1Definitions of fundamental enclosures2 2. 2Commodity charge gamble in different firms2 3Explanation of derivatives3 3. 1Options3 3. 2Futures4 3. 3Forwards6 3. 4Swaps6 4 evaderow strategies with derivatives7 4. 1Hedging with natural selections7 4. 2Hedging with early days7 4. 3Hedging with fore8 4. 4Hedging with alternates8 5Pros and cons of hedge strategies with derivatives8 5. 1Pros and cons of elections9 5. Pros and cons of futures9 5. 3Pros and cons of forwards10 5. 4Pros and cons of swaps10 6Practical example of embodied trade good impairment chance hedging10 6. 1Introduction on firms practical hedging system10 6. 2Analysis on this strategy11 7 synopsis12 vermiform appendix13 Appendix 1 Amounts outstanding of over-the-counter ( unlisted) derivatives by risk category and legal instrumentin billions of US dollar13 Appendix 2 Derivatives monetary instruments traded on unionized exchanges by instrument and locationin billions of US dollar14 Bibliography15 Internet Source16 List of abbreviations CHClearing HouseIMInitial valuation reserve MBMargin Balance MM NMaintenance Margin No OTCOver The Count VM YVariation Margin Yes List of figures suppose 1 Structure of this paper2 Figure 2 P of each filling side of meat4 Figure 3 F outset chart of marking-to-market influence5 Figure 4 P of each future status6 Figure 5 Hedging model on fuel oil of Air China11 List of tables Table 1 Summary for 4 option positions4 Table 2 Summary for future positions6 Table 3 Summary for 4 derivatives9 1Introduction 1. 1Problem and objective The risk of commodity worth is a ferocious topic in collective operation.Corporate profit is equal to total revenue minus total make up. For firms, because of the juicy volatility on commodity wrong, their in raises and outputs relating to commodity argon unpredictable. As a consequence corporate profit allow for be immensely volatile, which volition possibly lead the firm to go confideruptcy if no whatever preventive actions be fruitn. For example, producers of commodities probably need to assume unexpected departurees, when the footing of outputs goes down or the expense of necessary raw materials goes up. The situations atomic number 18 exchangeable to wholesale vendees, retailers, exporters and even governments.Volatility of commodities determine has great impacts on corporate workaday operation. The objective of this term paper is to introduce derivative hedging strategies for corporate managers to reduce or even eliminate future unpredictability, mainly from the perspectives of the intention commodity price risks play, what the typical derivative instruments atomic number 18, where and how to apply these different derivatives in terms of hedging principles thereof, and both advantages and di sadvantages when applying each derivative in certain business doings. 1. Structure of this paper Firstly, this term paper highlights problems existing in real world. Secondly, it introduces advanced derivatives theory that dissolve be applied to run these problems. Thirdly, specific details on the theory will be presented, including explanation, application, as well as pros and cons of each derivative instrument. Then, an example is analyzed to register how companies apply derivatives to hedge commodity risks practi bring downy. Last is a stocky of this term paper. Following figure shows the body of this paper. 2Background Information 2. Definitions of fundamental terms In financial markets derivative is a slue or security whose measure out is derived from the value of early(a) to a greater extent basic primal variables . One of its nigh important functions is hedging. In corporate operation, hedging is to secure the companies against potential loss caused by variable ris ks that arise in international market, such(prenominal) as the commodity price risks. In this paper, commodity means each concrete goods or raw materials that may be sold or traded in the markets, such as energy, bullion, or agricultural products. 2. Commodity price risk in different firms Volatility of commodities price influences firms daily operation signifi tintly. Producers of commodities, such as farms, oil producers, mining companies, face price risk on output. Wholesalers and retailers, face price risk during the time period from bargaining from suppliers and change to customers. Exporters, face the same price risk as well as money exchange risk. And governments face price and yield risks generating from tax revenues that forecast on firms operational conditions. 3Explanation of derivativesDerivatives are traded in exchange-traded markets and over-the-counter markets. (See recent derivatives transaction status in appendix 1 and appendix 2. ) Notably, exchange-traded derivatives are fail risk tolerant and liquid. However over-the-counter traded derivatives are the opposite. 3. 1Options An option is the contract that gives the tainter the right barely not obligation to demoralise ( bellyache option) or sell (put option) an underlying asset at a influence price (exercise price) for certain quantity during a inflexible period of time (maturity).The buyer of the option pays a particular amount of money (option bounteousness) to the seller to buy a right whereby he can decide whether or not to exercise this option, simultaneously the seller has the obligation to perform if the buyer exercises the option. European options only can be exercised on expiration day, and American options can be exercised at any time before maturity. The buyer of the call option is named long call, while the seller of the call option is named diddle call. Similarly, the buyer of the put option is named long put, while the seller of the put option is named diddle p ut.In commodity market, underlying of commodity option is a commodity, such as oil, wheat, or gold. Commodity options are both exchanges-traded and OTC traded. Following figure shows P of each option. Following table is the summary for these 4 option positions. Table 1 Summary for 4 option positions Market price expectationMaximum profitMaximum lossBreakeven point desire callup unfathomableoption premiumexercise price + option premium Short calldown or stableoption premiumunlimitedexercise price + option premium Long putdownexercise price option premiumoption premiumexercise price option premium Short putup or stableoption remiumexercise price option premiumexercise price option premium Source designers own. 3. 2Futures A future is a contract amidst two parties to buy or sell a stipulate amount of asset at a specify time period in the future for a certain price. Normally there are two types of futures, commodity futures whose underlying are commodities and financial futures whose underlying are financial assets. They are passing standardized, regulated, and traded in exchange markets with highly liquid and default risk free property. Because of the marking-to-market process, at maturity the settling price is the spot price at expiration date with profit gaining or loss paying from a border account, which indirectly fakes the effective bargain price equal to the predetermined price in the future contract. Notably, to ensure high liquidity of futures, marking-to-market process plays a significant role. The following figure shows the marking-to-market process. Generally there are two alternative ways at maturity to settle futures, all by cash or by actual delivery of underlying, which is clear defined by futures exchange.Following figure and table show the details of a future. Table 2 Summary for future positions ?Maximum profitMaximum lossBreakeven point Long positionunlimitedexercise pricespot price + cost of anticipate Short positionexercise pric eunlimitedspot price + cost of carry Source authors own. 3. 3Forwards A forward contract is a customized and over-the-counter agreement to buy or sell an asset at a specified time in the future for a specified price, where a long position has the obligation to buy and a short position has the obligation to sell. Compared with futures, no marking-to-market process are required.Counterparties can transact with each about the parameters of the contract. As a case, a firm who regards to make forward contract needs to find the counterparty by itself. 3. 4Swaps A swap is a customized and over-the-counter agreement to exchange a series of specified assets periodically in the future. Normally the counterparties of a swap contract are a large institution such as a bank and a company. raw materialally, we can view a swap as a complicated forward. Except currency swaps, counterparties just need to pay the differences between the cash flow they should exchange. Because swaps are bespoken as a result they are less liquid.There are commodity swaps, worry rate swaps and currency swaps. Interest rate swaps is an agreement of two counterparties to change fixed interest and floating interest on predefined nominal principal in the future periodically. Commodity swaps normally vary tremendously among different markets. In a currency swap, counterparties change same value of different currencies in innovation and termination, where the exchange rate of the tow currencies depends on the negotiation of counterparties. 4Hedging strategies with derivatives This chapter will snap on the principles of hedging strategies on commodities. . 1Hedging with options If a trader wants to procure a commodity with high volatile price, he can buy a commodity call option to hedge the price risk of release up. Similarly, if a company wants to sell a commodity product, it can buy a long put to hedge the price risk of release down. In practice, because investors want to bet more precisely on the future price of the underlying, and hedgers with long positions want to save option premiums, a a couple of(prenominal) combinations of options come out, such as a long call and a short put with identical parameters except the different strike price. 4. 2Hedging with futuresWhen the objective of a commodity trader wants to neutralize the price risk as far as possible, usually he will choose to take a position on a future on commodity. A hedger who already owns a commodity asset or doesnt own right now but will at more or less future time expecting to sell it in the future without assuming any price risk, he can apple future hedging strategy to cipher into a short position to become a short. Likewise, a hedger who has to buy a certain commodity asset in the future and wants to lock in spot price immediately, he can apply a future to enter into a long position to become a long. . 3Hedging with forwards The principles of hedging strategy with forwards are similar with futures. W hether to use futures or forwards depends on different requirements. Generally, financial assets investors who need high liquidity prefer to choose futures, while commodity investors such as producers who need high customization prefer to choose forwards. 4. 4Hedging with swaps When investors want to hedge risks of interest rates, currencies, or commodities, they can use swaps. In gold swaps, counterparties change fixed lease rate with variable lease rate.In swaps on base metals, counterparties change fixed metal price with average price of near dated metal future. In oil swaps, counterparties change fixed West Taxes Intermediate (WTI is a benchmark in oil price) price with average price of near dated WTI future. 5Pros and cons of hedging strategies with derivatives The following incorporate summary of these derivatives depending on pervious analysis makes systematic comparisons. (The options here are exchanged-traded European options) Table 3 Summary for 4 derivatives SUMMERY OF D ERIVATIVES FOR normal TYPES OptionsFuturesForwardsSwapsTypes of contractstandardizedstandardizedcustomizedcustomized Settlementscash and delivery or so cash and few deliverydeliverydepends on individuals Trading marketExchange tradedExchange tradedOTCOTC Liquidityhighhighlowlow Marketing-to-marginnorequirednono Time of settlementmaturitydailymaturityperiodically Initial investmentoption premiuminitial margin nodepends Default risk assumed byClearing houseclearinghouseBoth partiesBoth parties ProsDefault risk free &038 liquiditycustomization &038 no initial investment Consinitial investment &038 inflexibledefault risk for both party &038 illiquidity Source authors own. . 1Pros and cons of options The pros of options are obvious. Firstly, they have no risk to assume more loss than premium but have possibility to get unlimited potential profit. Secondly exchanged-traded options are highly liquid and OTC traded options are flexible. However, the cons of options are also explicit, such as the difficulty to decide when to enter into a long position.Because buying an option needs to pay option premium, if the spot price cannot go above (for a long call) or go below (for a long put) the breakeven point the hedger will suffer a loss, and depends on statistics the possibility of a long position to lose is about 66%. 5. 2Pros and cons of futures It definitely makes sense for most companies whose study are in businesses but not professional in omen the price of commodities price volatility, which can make them pay more care on their core competences kinda of fearing about volatile price.Nonetheless, taking neutralized strategies make hedgers give up the possibility of both profit and loss. Moreover, instead of hedging risks by companies, shareholders can hedge themselves according to their preferences. Additionally, if other competitors of the same industry dont apply hedging strategies, in fact, it is the hedging company itself that assumes risks, because competitive pressures are the same for other all competitors but different for the hedging company its own. 5. 3Pros and cons of forwards Basic pros and cons have been listed in the table in front of this chapter.Generally, compared to futures, the most explicit pro is that forwards are highly customized and therefore the con is that they are hardly liquid. 5. 4Pros and cons of swaps Basic pros and cons have been listed in the table in front of this chapter. Gernally, compared to futures and forwards the most precise pros is that both counterparties could reap benefits from a swap, such as in a currency swap where a firm with a low rate may get a cheaper loan as other firms with high rates, and the counterparty may get a payment as compensation.However the correspondent cons is that counterparty may need to pay commision to intermediary, because it is difficult to find an appropriate counterparty by itself. 6Practical example of corporate commodity price risk hedging 6. 1Introduction on firms practical hedging strategy Air China is an airline company, whose cost of fuel oil occupies 44. 75% of total revenue in 2008. To hedge the fuel oil price risk, Air China bought a call option with strike K1, meanwhile sold a put option with strike K2, where K1