Corporate Strategies to Hedge Commodity Price Risks Applying

put back of contents contention of abbreviationsIII List of figuresIII List of bowsIII 1Introduction1 1. 1Problem and purpose1 1. 2Structure of this paper1 2Background Information2 2. 1Definitions of fundamental footing2 2. 2 good charge essay in diverse firms2 3Explanation of derivatives3 3. 1Options3 3. 2Futures4 3. 3Forwards6 3. 4Swaps6 4Hedging st ordaingies with derivatives7 4. 1Hedging with pickaxs7 4. 2Hedging with earlys7 4. 3Hedging with previouss8 4. 4Hedging with swaps8 5Pros and cons of hedging strategies with derivatives8 5. 1Pros and cons of plectrons9 5. Pros and cons of forthcomings9 5. 3Pros and cons of forwards10 5. 4Pros and cons of swaps10 6Practical physical exercise of corporate trade good determine take chances hedging10 6. 1Introduction on firms pragmatic hedging strategy10 6. 2Analysis on this strategy11 7Summary12 Appendix13 Appendix 1 Amounts outstanding of nonprescription(a) (OTC) derivatives by risk category and instrumentin billions of US dollar13 Appendix 2 Derivatives pecuniary instruments traded on organized stand ins by instrument and locationin billions of US dollar14 Bibliography15 Internet root16 List of abbreviations CHClearing HouseIMInitial allowance MBMargin Balance MM NMaintenance Margin No OTCOver The Count VM YVariation Margin Yes List of figures Figure 1 Structure of this paper2 Figure 2 P of severally extract dapple4 Figure 3 Flow chart of marking-to-market process5 Figure 4 P of apiece emerging position6 Figure 5 Hedging precedent on fuel oil of Air China11 List of tables tabularize 1 Summary for 4 extract positions4 Table 2 Summary for future positions6 Table 3 Summary for 4 derivatives9 1Introduction 1. 1Problem and objective The risk of goodness charge is a ferocious topic in corporate operation.Corporate lolly is equal to total revenue minus total cost. For firms, because of the postgraduate unpredictability on goodness cost, their inputs and outputs relating to commodity be unpredictable. As a wake corporate profit will be immensely volatile, which will peradventure lead the firm to go bankruptcy if no any burden actions ar taken. For example, producers of commodities probably pauperisation to assume unexpected issuees, when the terms of outputs goes vote out or the monetary value of necessary raw materials goes up. The situations atomic number 18 standardised to convey purchasers, retailers, exporters and even governments.Volatility of commodities price has great impacts on corporate daily operation. The objective of this term paper is to introduce derivative hedging strategies for corporate managers to void or even eliminate future unpredictability, mainly from the perspectives of the role commodity price risks play, what the typical derivative instruments are, where and how to open these different derivatives in terms of hedging principles thereof, and both advantages and disadvantages when hireing each derivative in objectiv e railway line transactions. 1. Structure of this paper Firstly, this term paper highlights problems existing in real world. Secondly, it introduces advanced derivatives theory that can be applied to solve these problems. Thirdly, unique(predicate) details on the theory will be presented, including explanation, application, as good as pros and cons of each derivative instrument. Then, an example is analyzed to show how companies apply derivatives to falsify commodity risks practically. Last is a digest of this term paper. future(a) figure shows the body of this paper. 2Background Information 2. Definitions of fundamental terms In financial markets derivative is a contract or security whose comfort is derived from the value of other more basic underlying variables . One of its most main(prenominal) functions is hedging. In corporate operation, hedging is to secure the companies against authorization loss caused by variable risks that arise in international market, such(pren ominal)(prenominal) as the commodity price risks. In this paper, commodity means any tangible goods or raw materials that may be sold or traded in the markets, such as energy, gold, or agricultural products. 2. Commodity price risk in different firms Volatility of commodities price influences firms daily operation significantly. Producers of commodities, such as furtherms, oil producers, mining companies, flavour price risk on output. Wholesalers and retailers, confront price risk during the time period from buying from suppliers and selling to customers. Exporters, face the same price risk as well as capital ex kind risk. And governments face price and yield risks generating from tax revenues that depend on firms operational conditions. 3Explanation of derivativesDerivatives are traded in exchange-traded markets and over-the-counter markets. (See recent derivatives transaction view in appendix 1 and appendix 2. ) Notably, exchange-traded derivatives are default risk free and liquid. However over-the-counter traded derivatives are the opposite. 3. 1Options An survival of the fittest is the contract that gives the vendee the right but not obligation to buy (call election) or sell (put option) an underlying asset at a predetermined price ( process price) for authoritative quantity during a fixed period of time (maturity).The buyer of the option pays a particular amount of money (option premium) 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 solely can be exercised on outlet 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 before long call. Similarly, the buyer of the put option is named long put, while the seller of the put option is named short put.In commodity market, underlying of co mmodity option is a commodity, such as oil, wheat, or gold. Commodity options are both exchanges-traded and OTC traded. quest figure shows P of each option. Following table is the summary for these 4 option positions. Table 1 Summary for 4 option positions merchandise price expectationMaximum profitMaximum lossBreakeven point Long callupunlimitedoption premiumexercise price + option premium compendious calld own 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 authors own. 3. 2Futures A future is a contract between 2 parties to buy or sell a specified amount of asset at a specified time period in the future for a certain(a) price. Normally there are two types of futures, commodity futures whose underlying are commodities and financial futures whose underlying are financial asse ts. They are highly 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 crack price at expiration date with profit gaining or loss paying from a bound account, which indirectly perplexs 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, either by gold or by actual delivery of underlying, which is clearly be 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 carry Short positionexercise priceunlimitedspot price + cost of carry S ource 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 negotiate with each about the parameters of the contract. As a result, a firm who wants 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 come with. Basically, we can view a swap as a complicate forward. Except currency swaps, counterparties just need to pay the differences between the hard cash flow they should exchange. Because swaps are bespoken as a result they are less liquid.There ar e commodity swaps, interest rate swaps and currency swaps. occupy rate swaps is an agreement of two counterparties to change fixed interest and aimless 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 inception and termination, where the exchange rate of the tow currencies depends on the negotiation of counterparties. 4Hedging strategies with derivatives This chapter will focus 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 going up. Similarly, if a company wants to sell a commodity product, it can buy a long put to hedge the price risk of going down. In practice, because investors want to bet more nicely on the future price of the underlying, and tergiver sators with long positions want to save option premiums, a few combinations of options vex out, such as a long call and a short put with identical parameters except the different arrive at 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 tergiversator who already owns a commodity asset or doesnt own right now but will at some future time expecting to sell it in the future without assuming any price risk, he can apple future hedging strategy to put on into a short position to kick the bucket 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. Whether to use futures or forwards depends on diffe rent 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 storey metals, counterparties change fixed metal price with average out price of adjoining dated metal future. In oil swaps, counterparties change fixed air jacket 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 integrated 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 DERIVATIVES FOR GENERAL TYPES Op tionsFuturesForwardsSwapsTypes of contractstandardizedstandardizedcustomizedcustomized Settlementscash and deliverymost cash and few deliverydeliverydepends on individuals Trading marketExchange tradedExchange tradedOTCOTC Liquidityhighhighlowlow Marketing-to-marginnorequirednono Time of settlementmaturitydailymaturityperiodically Initial investment fundsoption premiuminitial margin nodepends inadvertence risk assumed byClearing houseclearinghouseBoth partiesBoth parties ProsDefault risk free & liquiditycustomization & no initial investment Consinitial investment & inflexibledefault risk for both party & illiquidity Source authors own. . 1Pros and cons of options The pros of options are obvious. Firstly, they baffle 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 wh en 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 take over a loss, and depends on statistics the possibility of a long position to lack is about 66%. 5. 2Pros and cons of futures It definitely makes sense for most companies whose majors are in businesses but not professional in forecasting the price of commodities price volatility, which can make them pay more attention on their core competences instead 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 perseverance dont apply hedging strategies, in fact, it is the hedging company itself that assumes risks, because competitive pressur es 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 corresponding 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 practica l 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