PrintAs 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.
| 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:
| 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)
- 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.
| 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.
| 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)
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.
| 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.
| 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)
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.
| 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.
| 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.