Further Insights on Financial Hedging Instruments
Ugo Montagnini
Corporate Sales–Customer Desk Corporate, MPS CAPITAL SERVICES
Background
A hedge is a financial investment used to reduce the risk of unfavorable price movements in an asset. A hedge typically means taking an offsetting position in a related security, such as a futures contract when you will be buying or selling an asset, such as a commodity, in the future. For example, a farmer who will sell wheat in the future can hedge by buying a futures contract now then selling that contract at a future date. Financial tools that can be used are derivatives, which typically move in parallel with the underlying asset: they include options, swaps, futures and forward contracts. These derivatives are only financial instruments and are not related to the underlying assets. The underlying assets can be commodities, but also—in a broader perspective—stocks, bonds, currencies, indices, or interest rates. The derivatives are typically traded on organized exchanges but in some cases banks act as intermediaries for trading of derivatives.
It is essential to know how to make decisions about financial hedging in order to assure reliability and effectiveness to the financial coverage. In particular, there are three conditions that determine whether to pursue a hedging strategy:
The presence of a financial market where the commodity is listed.
The time horizon in the financial market, in terms of quotations “bid/ask.”
The liquidity in each time frame, in terms of volume of contracts (open interest).
When making decisions about financial hedging for managing commodity price volatility, these conditions are essential, because for commodities, the financial markets often are not liquid and are influenced by several exogenous factors. In case of liquid markets, the bid/ ask spread is narrow and the price of the physical commodity is similar to the quotation available on the financial market. An example of a very liquid market is the London Metal Exchange (LME), where the following underlying assets are listed: high-grade aluminum, aluminum alloy, NASAAC (North American Special Aluminum Alloy Contract), copper, lead, nickel, tin, zinc, and steel rods. The LME is the world’s leading market for industrial metals, with over 80 percent of metals contracts traded in this market. In this case, the quotations of the financial market are taken as the basis to determine the price at which the contracts will be negotiated for the physical exchange between customers and suppliers.
Table 9.1 highlights a list of commodities on which it is possible to apply financial hedging; the list is just an example, because the “world of hedging” on commodities is continuously evolving.
However, not all commodities can be effectively hedged. In presence of “oligopolies,” futures often show non-relevant open interests, high bid/ ask spreads, as well as short time horizons. These factors result in a mismatch between the physical price (that is paid for the supply of the physical assets) and the financial derivative quotation. In oligopoly markets, such as in the steel market, price and quantities are determined by a few players. This generates a substantial lack of supply/demand in the financial market. In 2005, for example, there was an attempt to list—for the first time—futures contracts for plastic materials (polyethylene and polypropylene) on LME. However, due to the lack of liquidity, these products were removed in 2011.
In case of commodities not directly listed on financial markets, such as semifinished materials, it is still possible to cross-hedge by doing a correlation study between the underlying asset (historical prices of commodities) and identifying specific indexes/markets whose movements are correlated with the underlying asset. Cross-hedging is used in a number of situations, for example, feed for livestock manufacturers, confectionery companies, and for companies using oil derivatives.
Table 9.1 Example of financial derivatives
Precious metals |
Exchange |
Location |
Gold |
NYMEX-IPE |
New York–London |
Silver |
COMEX |
New York |
Platinum |
NYMEX |
New York |
Palladium |
NYMEX |
New York |
Industrial metals |
Exchange |
Location |
Aluminum high grade |
LME |
London |
Aluminum alloy |
LME |
London |
Copper |
LME |
London |
Zinc |
LME |
London |
Lead |
LME |
London |
Nickel |
LME |
London |
Pond |
LME |
London |
Steel |
LME |
London |
Energy |
Exchange |
Location |
WTI oil |
NYMEX-IPE |
New York–London |
Brent oil |
IPE |
London |
Naphtha |
Platts |
London |
Diesel fuel |
NYMEX |
New York |
Heating oil |
NYMEX |
New York |
Natural gas |
NYMEX |
New York |
Gas formulas |
Platts |
London |
Formulas electricity |
Platts |
London |
Agriculture |
Exchange |
Location |
Wheat |
CBT/Euronext |
Chicago–Parigi |
Corn |
CBT/Euronext |
Chicago–Parigi |
Soybeans |
CBT |
Chicago |
Rapeseed |
Euronext |
Parigi |
Soft |
Exchange |
Location |
Arabica coffee |
NYBOT |
New York |
Robusta coffee |
LIFFE |
London |
Brown sugar |
NYBOT |
New York |
White sugar |
LIFFE |
London |
Cotton |
NYBOT |
New York |
Another condition that influences the ability to financially hedge is firm size. Large corporations, characterized with average volume of annual sales exceeding $500 million typically have the resources to manage commodity risk, and can use financial hedging in a structured way to optimize their operating results. Medium-sized companies, with average annual sales between $100 million and $500 million, often have structured organizational charts that allow an effective management of commodity risk and the adoption of hedging strategies, with formal cooperation between the purchasing manager/buyer and the chief financial officer (CFO). In smaller firms, with average sales less than $100 million, purchases are generally under the responsibility of the chief executive officer (CEO), and the use of financial derivatives for hedging is limited.
Hedging Structures
If the conditions favor hedging, there are various hedging structures that organizations can employ to implement hedging. The hedging structures are typically divided into two categories, depending on the level of standardization and there are a number of approaches that can be used in each. Here we describe “Plain Vanilla” and “Non-Plain Vanilla” approaches from the buyer’s perspective. Additional explanations and descriptions of the following terms in these structures can be found in Kolb and Overdahl1 and Schofield.2
Plain Vanilla Structures
Here we describe four different “Plain Vanilla” approaches, presenting advantages and risks of each of them. Purchasing organizations can decide to hedge using the so-called “calls and puts” options financial derivatives. Options are used to hedge the risk of commodity price increases. A call option gives the buyer the right to buy a specific amount of an asset any time before the expiration of the option but the buyer is not required to make the purchase. A call option is similar but in this case the right is to sell a specific amount of the underlying commodity rather than to buy it. The buyer of an asset who is exposed to the risk of commodity price increases has financial protection against an adverse price movement by purchasing a call option. This instrument requires the payment of an initial premium.
The main advantages of the “calls and puts” options are the following:
The buyer is able to predetermine the maximum purchasing cost.
The buyer, in the case of a commodity price decrease, does not have to exercise the option, losing only the purchase price of the option and can buy the commodity at the market price.
The main risks of the “calls and puts” options are the following:
The option has an initial cost that will not necessarily be offset by a positive revenue.
In the event of an early resolution, the market value may be lower than the premium paid at the time of the contract; in this case, the customer will lose part of the value paid for the financial tool.
If the commodity price decreases, the customer can’t receive the corresponding gain since the “calls and puts” option aims only to assure a financial protection against adverse price movements.
Another financial derivative is the so-called “Asian calls and puts” option. This is a financial instrument that requires the payment of a premium, allowing the buyer of the commodity to protect itself against upward fluctuations in the commodity price, and providing in advance the maximum value of purchase on average, without additional obligations in case of adverse movements in the commodity market. The difference from other “calls and puts” options lies in the mechanism for the pay-off calculation. The pay-off for “Asian calls and puts” options is based on an average price of the commodity, determined in a predefined period of time, while for the other “calls and puts” tools the pay-off of the option is related to the price of the commodity within an exercise.
The main advantages of the “Asian calls and puts” option are the following:
The buyer is able to predetermine the maximum purchasing cost.
The buyer, in the case of a commodity price decrease, may leave the option and buy the commodity at the market price.
The main risks of the “Asian calls and puts” option are the following:
The option has an initial cost that will not necessarily be offset by positive revenue.
In the event of an early resolution, the market value may be lower than the premium paid at the time of the contract.
If the commodity price decreases, the customer will never see a positive spread.
A third plain vanilla structure is the so-called synthetics forward contracts (SFCs). This is a hedging instrument that allows the buyers of commodities to protect themselves against upward fluctuations in the price of a commodity for a specific time frame. In this case, there is the purchase of a call option and the concurrent selling of a put option at the same strike price and the same notional amount on a specific underlying asset and on a specific date. The investor typically combines long calls and short puts. In order to have a position that is similar to a regular forward contract, the call option and the put option have the same strike price and expiration date. The investor pays a “net option premium” when executing a synthetic forward contract, but part of the long position cost is offset by the short position. This strategy enables the customer to set a predetermined purchasing price of the underlying asset.
The main advantage of the “SFC contract” is the following:
The buyer is able to predetermine a certain purchasing price, and therefore there is a real protection in case of price increase.
The main risks of the “SFC contract” are the following:
In the case of an early resolution, should the movement of the underlying asset price be opposite to the position taken by the customer, the buyer may pay an amount, which is not quantifiable ex ante in the form of market value.
The product does not allow the buyer to benefit from a favorable movement of the underlying asset price.
A fourth tool is the “Commodity swap.” This is a contract in which the underlying asset is a commodity, whose amount is determined by the most commonly used parameter (e.g., markets’ standard cubic meters, bbl, lb, m/ton). The contract requires the payment of a fixed price by the customer, agreed between the parties. At the same time, the customer receives the amount given at a variable price, determined on the basis of defined parameters or calculated by a formula linked to the future cost of commodities and agreed by the parties. At the end of each period (monthly, bimonthly, quarterly, half-yearly), two different scenarios may occur, linked to the cost emerging between two specific dates. In the first scenario, the variable price is higher than the fixed price: the counterparty who paid the variable price (the bank) will provide the positive spread between the variable price and the fixed price, multiplied by the quantity of the commodity in the period of reference. In the second scenario, the variable price is lower than the fixed price: the counterparty who paid the fixed price (the customer) will provide the positive difference between the fixed price and variable price, multiplied by the quantity of the commodity in the period of reference.
The main advantages of the “commodity swap” are the following:
The buyer knows in advance the maximum purchasing cost.
The buyer is protected against the commodity price increase.
The main risks of the “commodity swap” are the following:
The contract does not allow the buyer to benefit from a downward movement of the price.
In the event of an early resolution, should the price move downward, the buyer may pay an amount not quantifiable ex ante in the form of market value.
Non-Plain Vanilla Structures
In this section we describe three different “Non-Plain Vanilla” approaches, SFCs with knock-in (KI), collar, and collar with KI, and present the advantages and risks of each of them.
The SFCs with KI are hedging instruments that allow the buyer of a commodity to be protected against upward fluctuations of the commodity price covered by the agreement on a set date. This tool gives the opportunity to benefit from a depreciation of the commodity up to a predetermined level (barrier level) for improvement of price movements compared to the barrier level the buyer buys its raw materials at the agreed strike price. This involves the purchase of a call option and the sale of a “knock in” (trigger barrier) put option at the same strike price and the same notional amount on a specific underlying asset and on a specific date. The strategy enables the buyer to set a predetermined purchasing price. Being a customized product, the duration is determined by the buyer and usually the option’s expiration is aligned with the expiration of the payment set in the contract.
The main advantages of the “SFC with KI” are the following:
Buyer predetermines a certain purchase price of the commodity and therefore is protected from the price increase.
The buyer can benefit from a favorable movement in the commodity price up to the lower barrier level.
The main risks of the “SFC with KI” are the following:
In the event of an early resolution, should the movement of the price be opposite to the position taken by the customer, the buyer may pay an amount that is not quantifiable ex ante in the form of market value.
The product does not allow the buyer to benefit from a favorable price movement (downward in the case of a customer buying commodity) for improvement levels up to the trigger barrier.
A second approach is the “Collar,” a hedging product that allows the buyer of a commodity to be protected against upward fluctuations of the commodity price covered by the agreement on a set date, taking the opportunity of a more favorable price, up to a minimum level set in advance. The strategy consists of buying a call option at a certain level of strike price (upper limit) and, at the same time, selling a put option with a lower strike price (lower limit) than one of the purchased call option for the same notional amount on a specific underlying asset and a specific expiration date. The strategy enables the buyer to set a maximum purchasing price of the chosen underlying (strike of the purchased call option) with the possibility to benefit from a downward movement of the price up to a minimum price limit (strike put option sold). Being a customized product, the buyer determines the duration and usually the option’s expiration coincides with the expiration of the payment set in the contract (beyond 24 months the market is nonliquid, and it is difficult to find efficient hedging instruments).
The main advantages of the “Collar” are the following:
The buyer predetermines a certain purchasing price, assuring the protection from a price increase. At the same time the organization may benefit from a favorable movement in the price up to the strike level.
The main risks of the “Collar” are the following:
In the event of an early resolution, should the movement of the price be opposite to the position taken by the buyer, the buyer may pay an amount that is not quantifiable ex ante in the form of market value.
The product does not allow the buyer to benefit from a favorable movement of the price.
Different from the collar, is the so-called “Collar with Knock In,” a hedging product involving a combination of different options: a CAP and a FLOOR, with a KNOCK-IN on the CAP. This allows you to be protected against upward fluctuations of the price of the commodity covered by the agreement on a set date, with the opportunity to benefit from a depreciation of the commodity cost up to a predetermined minimum level (barrier level). The strategy consists of buying a call option at a certain level of strike price (upper limit), selling—at the same time—a put option with a lower strike price (lower limit) than the one of the purchased call option for the same notional amount on a specific underlying asset and a specific expiration date. The strategy enables the customer to set a maximum purchasing price (strike of the purchased call option) with the possibility to benefit from a downward movement of the price up to a minimum price limit (strike put option sold). Being a customized product, the buyer determines the duration and usually the option’s expiration is aligned with the expiration of the payment fixed in the contract (beyond 24 months the market is nonliquid, and it is difficult to find efficient hedging instruments).
The main advantage of the “Collar with Knock-In” is the following:
The buyer predetermines a certain purchase price of the commodity; therefore there is a protection from the price increase. At the same time the organization may benefit from a favorable movement in the price up to the trigger barrier level.
The main risks of the “Collar with Knock-In” are the following:
In the case of an early resolution, should the movement of the price be opposite to the position taken by the customer, the customer may pay an amount not quantifiable ex ante in the form of market value.
The product does not allow the buyer to benefit from a favorable movement of the underlying price (downward in the case of the buyer) for better levels as to the barrier limit.
Examples of Hedging and Related Markets
Among the described hedging approaches, the most adopted one is the commodity swap. The contract requires the swap of a fixed price, agreed between the parties and expressed in the currency of reference per unit of goods, against a variable price (depending on the future value of the commodity) to certain fixed dates.
The fixed price of the swap is calculated as the sum of future cash flows discounted to the present.
We here analyze in detail the structure of financial flows related to a standard commodity swap where the swap premium is expressed in the same currency of the underlying commodity.
Be 
a payment time series and 
with i = 1,..., P a sample time series within any payment period. The exchanged cash flow at every payment time 
is determined as follows:
where 
is the value of the commodity underlying the swap at the time 
and K the strike (fixed price) of the swap.
If the premium for the swap is expressed in a different currency from the currency of the underlying commodity we adjust the formula
where 
represents the exchange rate foreign currency/premium currency to the time 
.
Thus, in the multicurrency swaps, the variable exchange rate is included in order to determine the pay-off. Obviously this variable will be analyzed and managed during the life of the swap product.
Example 1
This example describes a cost-risk commodity swap whose underlying is the contract of a future (first nearby futures) on Brent Crude Oil listed on the Intercontinental Exchange (ICE) platform:
Pricing date: 05/31/2016
Start date: 10/01/2016
Expiry date: 10/31/2016
Payment date: 11/15/2016
Fixing dates: Every business day from 10/01/2016 to 10/31/2016 included
Volumes: 10,000 barrels
Strike (fixed price): 51.90 USD/bbl (dollars per barrel)
Customer pays fixed price
Customer receives variable price (=arithmetic monthly average of the fixing in October 2016 of the first nearby futures on Brent).
In order to determine the swap strike (fixed price) it is necessary to identify the futures and the related lot on the “market” that identify the underlying.
Levels of the future detected on the ICE platform to the pricing date:
Future December 16th, expiration date 10/31/16, 51.90 USD/bbl
In this example the customer’s financial position is “long,” and thus will benefit from the structure in the case of an appreciation of the Brent during the life of the swap. The position of the bank that has quoted the swap will conversely be “short.” The cash flow swap traded at the payment time will be determined as: (arithmetic mean of the official closing prices of the first nearby futures reported within the period of observation – strike price) * volume.
In the specific case, as we will see in the following, it is interesting to investigate the use of the arithmetic mean to determine the variable flows of the swap for the correct analysis of the risk profile of the product itself and the relative hedging. The fixing of the commodity, on a daily observation, becomes a deterministic component in calculating the arithmetical mean.
Considering 21 working days in the month of October, on October 3rd, our instrument will present an already determined observation and 20 residual observations of component “variable/risky” up to the maturity. At this point, the bank defines the strike, and then builds up the hedge position.
Recalling that the volumes shown in the example is 10,000 barrels, and that a single contract (lot) of futures on Brent is equivalent to a volume of 1,000 barrels, the alternatives to the intermediary are as follows:
The bank goes on the over-the-counter (OTC) market, where swaps on the Brent are actively traded on. The commodity swap contracts on Brent are very “liquid,” that means they present very narrow bid/ offer spreads and with significant volumes of a wide spectrum of maturities. In this case the bank that sold the swap to the customer buys it again on the OTC market to volumes equal to 10,000 barrels. The structure of financial flows of the swap closed with the market is perfectly aligned and coinciding with the transaction executed with the customer.
The bank operates on the futures market, purchasing 10 lots of futures (equivalent to 10,000 barrels) of Brent expiring on December 16th. In this case the profile of the swap cash flows is replicated with the reference futures. Once the swap has daily observations (fixings), and then the calculation of the average becomes the expression of a deterministic component and of a variable, the hedging strategy will have to be updated by selling those lots of futures that are in “excess” compared with the new swap risk profile.
Example 2
Now we consider the case in which the underlying commodity of the swap is a “distilled oil” (i.e., gasoline, diesel, fuel) meaning it is a product that comes from the refining process of the oil and that presents some OTC markets, which are less liquid than the Brent market.
We assume that the first reference commodity of the swap is the Fuel Oil 1 percent CIF MED. The acronyms CIF and FOB specify whether the naval cargo transportation of the oil includes or not the cost of insurance, shipping, and other related costs (CIF: Cost, Insurance, and Freight – FOB: Free on Board), while the acronym MED specifies that the delivery will be at the Mediterranean ports.
The daily values of the Fuel Oil and many other oil derivatives are determined through a daily survey of the main operators of the sector carried out by specialized agencies (information providers) such as Platts or Argus. The values determined in this way represent the daily observations (fixings) that will determine the swap pay-off. Therefore, in this second example, the underlying on which to perform the swap hedging will not be the first nearby future as for the Brent but a spot value determined by using data provided by an information provider.
Pricing date: 05/31/2016
Start date: 10/01/2016
Expiry date: 10/31/2016
Payment dates: 15/11/2016
Fixing dates: Every business day from 10/01/2016 to 10/31/2016 included
Volume: 1,000 MT (metric tons)
Strike: 257.00 USD/MT
Customer pays fixed price
Customer receives variable price (=arithmetic monthly average of the fixing in October 2016).
Being Fuel Oil 1 percent CIF MED is an oil derivative, the swaps on this commodity has a quotation price that is a direct function of the swap price on Brent plus a spread (called crack spread). The term crack spreads is related to the name of the process by which the fuel oil is created from crude oil: the cracking process.
The levels of crack spreads and swaps on the OTC Brent detected to the pricing time are:
Crack spread, 10/31/2016 expiration date – 11.427 USD/bbl
Swaps on Crude Oil Brent, 10/31/2016 expiration date, 51.90 USD/bbl
Calculation of the strike:
Strike = (51.90 – 11.427) × 6.35 = 257.00 USD/MT
The value 6.35 expresses the standard conversion on financial markets to convert barrels in metric ton. In the aforementioned example, a volume of 1,000 MT is equivalent to 6,350 bbls. In this example the customer’s financial position is “long,” so they will have a benefit from the structure in the case of an appreciation of the Fuel Oil during the life of the swap. Conversely, the position of the bank has quoted the swap will be “short.”
Once agreed the strike and improved the operation, the bank builds up the hedge position. This is done by the purchasing of the crack spread on the market using the following combination of commodity swaps:
Purchasing commodity swaps with underlying Fuel Oil 1 percent CIF MED, 1,000 MT volume. This position perfectly covers the exposure of the intermediary toward the customer.
Selling commodity swaps with underlying Brent Crude Oil, 6,350 bbls volume.
This last open position on Brent can be covered by:
Purchasing on the OTC market an underlying commodity Brent Crude Oil swap.
Managing the swap risk with futures listed on the ICE platform (as seen in the previous example).
The intermediary, in this case, has changed its position from an exposure to an extremely “inefficient/illiquid” underlying, such as the Fuel Oil, to a risk position linked to the very liquid Crude Oil.
Summary
In this chapter, we briefly described the most used hedging structures that companies can adopt in order to mitigate commodity price risk. We also described the “best conditions” that organizations should face in order to invest on efficient and effective financial hedging approaches.
The social, economic, and competitive environment is rapidly changing, and commodity price volatility is generally increasing. For these reasons organizations are paying increasing attention to commodity price risk mitigation and financial hedging approaches. On the other side, financial institutions and banks are proposing innovative solutions in order to better help companies manage risk. From the market perspective, we observe that financial markets will become more liquid and dynamic in the future, and there will be an increasing number of raw materials that could be hedged using financial derivatives. A challenge is to increase information exchange and transparency in these markets. From the industry’s perspective, organizations should develop competences and skills in their purchasing offices in order to better manage the procurement of price volatile raw materials.