Perfect Hedge

Hedge 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.

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.

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)

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.

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.

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).

Mini-lecture: Long hedge (buyer’s hedge) (5:23 minutes)