EBF 301
Global Finance for the Earth, Energy, and Materials Industries

Imperfect Hedge

PrintPrint

As we learned previously, the perfect hedge can remove the price risks for sellers and buyers in the spot market. In the perfect hedge, we assume spot and financial market move exactly in tandem and prices in both markets are perfectly correlated, which means the case basis (the difference between spot and futures prices) stays unchanged. However, this assumption is not very realistic. Spot and futures market prices are highly correlated (parallelism) but the correlation is not usually perfect and basis changes over time. In that case, hedging is still effective but it doesn’t eliminate the price risk. The hedger’s gain and loss in the spot and futures market are not fully offset and the hedger will end up with some gain or loss. This is called imperfect hedge. Note that the gain or loss of hedging will be much less than not utilizing hedge.

1. Seller's hedge or short hedge

Following the example from the previous page, assume the price has gone down between the time of selling the futures contract and November 1st and the basis has changed a bit (imperfect hedge). Let's explore two cases:

  • On November 1st, the spot market prices are $59.5/bbl and the December futures contract would be $60.60/bbl.
  • On November 1st, the spot market prices are $59.60/bbl and the December futures contract would be $60.40/bbl.

Example 5: On November 1st, the spot market prices are $59.50/bbl and the December futures contract would be $60.60/bbl.

Example 5
Date Cash Market Financial Market Net
Now Long
Price = $60/bbl
Short
Producer sells 500 December contracts
Price = $61/bbl
November 1st Price = $59.50/bbl
Loss = (59.50-60)*500,000
= - $250,000
Close the position:
Producer buys 500 December contracts
Price = $60.60/bbl
Profit = (61-60.60)*500,000
= $200,000
-$250,000 + $200,000 = -50,000

Example 6: November 1st the spot market prices are $59.60/bbl and the December futures contract would be $60.40/bbl:

Example 6
Date Cash Market Financial Market Net
Now Long
Price = $60/bbl
Short
Producer sells 500 December contracts
Price = $61/bbl
November 1st Price = $59.60/bbl
Loss = (59.60-60)*500,000
= - $200,000
Close the position:
Producer buys 500 December contracts
Price = $60.40/bbl
Profit = (61-60.40)*500,000
= $300,000
-$200,000 + $300,000 = 100,000

As the results show, gain or loss in the spot market are not fully offset by the loss or gain in the financial market. But hedging is still effective in reducing the risk.

Now let's assume the price goes up from the time of selling the futures contracts in NYMEX to November. We consider two cases:

Mini-lecture: Short hedge (seller’s hedge) imperfect hedge example (8:08 minutes)

Short hedge (seller’s hedge), imperfect hedge example part 1 mini-lecture
Click for a transcript

Credit: Farid Tayari
  • On November 1st, the cash prices are $60.35/bbl and the December futures contract would be $61.50/bbl.
  • On November 1st, the cash prices are $60.50/bbl and the December futures contract would be $61.40/bbl.

Example 7: November 1st, the cash prices are $60.35/bbl and the December futures contract would be $61.50/bbl.

Example 7
Date Cash Market Financial Market Net
Now
Long
Price = $60/bbl
Short
Producer sells 500 December contracts
Price = $61/bbl
November 1st Price = $60.30/bbl
Profit = (60.35-60)*500,000
= $175,000
Close the position:
Producer buys 500 December contracts
Price = $61.50/bbl
Loss = (61-61.50)*500,000
= - $250,000
$175,000 + (-$250,000) = -75,000

Example 8: November 1st the cash prices are $60.50/bbl and the December futures contract would be $61.40/bbl.

Example 8
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 = $61.40/bbl
Loss = (61-61.40)*500,000
= - $200,000
$250,000 + (-$200,000) = 50,000

Mini-lecture: Short hedge (seller’s hedge), imperfect hedge example (5:00 minutes)

Short hedge (seller’s hedge), imperfect hedge example part 2 mini-lecture
Click for a transcript

Credit: Farid Tayari

2. Buyer's hedge or long hedge

Following the example from the previous page, assume prices have gone down from the time the refinery buys the future contracts until November 1st. Let's consider the above cases:

  • On November 1st, the spot market prices are $59.50/bbl and the December futures contract would be $60.60/bbl.
  • On November 1st, the spot market prices are $59.60/bbl and the December futures contract would be $60.40/bbl.

Example 9: On November 1st, the spot market prices are $59.50/bbl and the December futures contract would be $60.60/bbl.

Example 9
Date Cash Market Financial Market Net
Now Short
Price = $60/bbl
Long
Refinery buys 500 December contracts
Price = $61/bbl
November 1st Price = $59.50/bbl
Profit = (60-59.50)*500,000
= $250,000
Close the position:
Refinery sells 500 December contracts
Price = $60.60/bbl
Loss = (60.60-61)*500,000
= - $200,000
$250,000 + (-$200,000) = 50,000

Example 10: On November 1st, the spot market prices are $59.60/bbl and the December future contract would be $60.40/bbl.

Example 10
Date Cash Market Financial Market Net
Now Short
Price = $60/bbl
Long
Refinery buys 500 December contracts
Price = $61/bbl
November 1st Price = $59.60/bbl
Profit = (60-59.60)*500,000
= $200,000
Close the position:
Refinery sells 500 December contracts
Price = $60.40/bbl
Loss = (60.40-61)*500,000
= - $300,000
$200,000 + (-$300,000) = -100,000

Mini-lecture: Long hedge (buyer’s hedge), imperfect hedge example (6:32 minutes)

Long hedge (buyer’s hedge), imperfect hedge example, part 1 mini-lecture
Click for a transcript

Credit: Farid Tayari

Now let's assume price increases considering two cases:

  • On November 1st, the cash prices are $60.35/bbl and the December futures contract would be $61.50/bbl.
  • On November 1,st the cash prices are $60.50/bbl and the December futures contract would be $61.40/bbl.

Example 11: On November 1st, the cash prices are $60.35/bbl and the December futures contract would be $61.50/bbl.

Example 11
Date Cash Market Financial Market Net
Now
Short
Price = $60/bbl
Long
Refinery buys 500 December contracts
Price = $61/bbl
November 1st Price = $60.35/bbl
Profit = (60-60.35)*500,000
= -$175,000
Close the position:
Refinery sells 500 December contracts
Price = $61.50/bbl
Loss = (61.50-61)*500,000
= $250,000
-$175,000 + $250,000 = 75,000

Example 12: On November 1st, the cash prices are $60.50/bbl and the December futures contract would be $61.40/bbl.

Example 12
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 = $61.40/bbl
Loss = (61.40-61)*500,000
= $200,000
-$250,000 + $200,000 = -50,000

As we can see from the above examples, imperfect hedge doesn’t fully eliminate the price risks. In this case, hedging is still effective and gain or loss is much less than the case of not using the hedge.

Mini-lecture: Long hedge (buyer’s hedge), imperfect hedge example (4:53 minutes)

Long hedge (buyer’s hedge), imperfect hedge example, part 2 mini-lecture
Click for a transcript

Credit: Farid Tayari