Master Class Basics of Hedging

8/8/2019 Master Class Basics of Hedging

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Important Information

The information and opinions contained in this document are not intended to bea comprehensive study, should not be regarded by any recipient as providingthe basis for any investment decision and should not be treated as a substitutefor specific advice concerning individual situations.

Cambridge Risk Limited neither gives any warranty nor makes anyrepresentation as to the accuracy or completeness of this document and doesnot accept any liability for the consequences of any reliance upon anystatement of any kind (including statements of fact and of opinion) containedherein.

Cambridge Risk Limited is authorised and regulated by the Financial ServicesAuthority


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1. Introducing ABC Mining

The underlying asset, produced by ABC Mining, gold, can be sold when it is

produced at the spot price, which is the price for immediate delivery.

Miners are exposed to market price risk, the risk of adverse movements inthe spot price over time.

ABC Mining could seek to mitigate price risk by hedging with financialderivatives. This could either fix the future sale price, or provide insurance in

the case of adverse price movements.

ABC Mining plc is developing a small mine that plans toproduce gold over the next 10 years. The plan assumes acurrent gold price of $940 per oz, with variable productioncosts of $500 per oz.


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2. What is a Financial Derivative?

Contractual Details of the contract can be crucial

May involve counterparty risk if losing party fails to meet commitments under the

contract

Frequently Involve Gearing

Final losses can easily exceed any initial cash requirements and be material to

even the largest listed entities

Derivative position may constitute a substantial unrealised asset or liability

Financial Derivative: A contractual agreement between parties to makepayments between the parties based on the price of the underlying asset at aparticular point in time.

Key Properties:


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3. History of Hedging and Derivatives

Early Commercial Contracts 12-13th Century traders made forward sale agreements. E.g Monasteries who

frequently sold their wool up to 20 years in advance to foreign merchants.

17thCentury Tulip Mania in Holland. Fortunes are lost in after a speculative boom intulip futures burst. Futures contracts deemed non-enforceable in law.

Exchanges open Late 17thCentury, Dojima in Japan trading rice futures.

Chicago Board of Trade (1848), Chicago Mercantile Exchange (1898) etc

Options valuation theory develops 1960s - Black and Scholes work on options valuation

Chicago Board of Options Exchange (1973), Liffe London (1982)

Rapid increase in range and value of derivatives traded Expansion to include interest rates, stocks, indexes and a wide variety of metals and

soft commodities.

1990s onwards - series of derivatives related corporate disasters - Metallgesellshaftlosing $1.5 billion on oil futures (1994) and Barings Collapse (1995), to SocitGnrale losing 4.9 billion in Jan 2008


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4. Who might use Financial Derivatives?

Hedgers producers like ABC mining can use derivatives to reduce market riski.e. from falling prices. Their derivatives positions are said to be covered by theirphysical capacity to produce the underlying commodity.

Speculators take a view on which way a market will move, and use derivativesto increase exposure to their expected market movement. Their derivativespositions are usually uncovered ornaked.

Arbitrageurs Look to make series of balancing trades within or acrossmarkets to exploit small pricing differences or errors for the same or similarcommodities.


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5. How to enter a derivatives contract

Over the Counter Market (OTC) Bespoke contract with a financial institution, bank etc

Very flexible contract terms e.g. quantity, delivery time, delivery method etc

Higher cost, less transparent pricing

May not require cash up front, but will price in credit risk of ABC Mining failing to

meet obligations Exchange Traded

Fixed contract terms

Limited liquidity on longer expiry dates, especially for base metals

Contracts are novated to the clearing house, so almost zero counterparty risk

Initial margin and daily variation margin payments required to ensure no

counterparty risks Commercial contracts

Derivatives embedded within normal commercial contracts, e.g. off-takeagreements, sale agreements etc

Can be surprisingly significant for mining companies.

There are several ways ABC mining could enter a derivatives type contract:


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6. Basic Instruments

Forwards orFutures a commitment to sell an underlying commodity at sometime in the future, at a price agreed today.

Options the right, but not the obligation to buy a commodity (a call option) orsell a commodity (a put option) at an agreed price (the strike price).

Swap an agreement to swap cashflows with a counterparty, e.g. swap anobligation to pay a fixed interest rate on a loan for an obligation to pay a floatinginterest rate over the period of the loan.

There are two sides to every contract. The buyer of the commodity or option is

said to be long, the sellershort. For options, the seller of the option is said towrite or grant the option.

Most financial derivatives are one of three basic types of instrument:


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7. Hedging with Forwards

ABC Mining can use a short forward (sell forward) to 100% hedge market pricerisk.

Consider a forward sale of one months expected production, e.g. Jan 09

Assume the forward price for delivery in Jan 09 is approx $963 per oz


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7. Hedging with Forwards

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8. Forwards: Valuation Basics

The forward value can be derived from todays spot price, the cost of carry andthe financing costs.

The cost of carry is the net cost or benefit of holding the commodity from nowuntil the forward delivery time, including factors such as costs of warehousing,income from leasing the commodity and so-called convenience yields fromholding base metals.

If the forward price does not reflect the spot price and cost of carry, there will bearbitrage opportunities that would ultimately correct the price, e.g.

Forward price too high, you could Sell forward, borrow cash, buy at spot,hold until delivery and make a risk free profit.

Forward price too low, you could buy forward, borrow the underlying andsell at spot, invest the proceeds until the forward delivers then return the

borrowed commodity.


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8. Forwards: Valuations for Gold

Gold is an asset that is primarily held for investment.

Implies when calculating the cost of carry that you can obtain a return (the leaserate) from lending gold, warehousing costs are negligible, and there will alwaysbe a supply available to meet short term demand.

This results in a forward price generally higher than the spot price, known as acontango market.


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8. Forwards: Valuations for Gold

Forward Price - Precious Metal

925

930

935

940

945

950

955

960

965

970

Feb-08 May-08 ug-08 Nov-08


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8. Forwards: Valuations for Base metals

Base metals are primarily held for consumption

As a result of this, although warehousing costs may now be significant, there is abenefit to holding stock e.g. to avoid short term shortages, introducing aconvenience yield to the cost of carry.

As a result, forward prices for base metals tend to be lower than the spot price,

know as a market in backwardation.

This can make it very expensive to hedge base metals by selling forwards!


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8. Forwards: Valuations for Base metals

Ni l F r r ri U r , F 08)

23000

24000

2 000

2600027000

28000

29000

C h 3 1 27


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9. Hedging with Options: Long put

ABC mining could buy a put e.g. with a strike price of $800 per oz expiring in Jan09, which is the right, but not the obligation to sell gold at $800 per oz.

This is an insurance policy against falling prices. If the spot price falls below$800 per oz, the option will become in the money, and the payoff from theoption will then compensate for the lower sale price of gold produced.

If the price is above $800 per oz, the option expires unexercised, but ABC Miningwould enjoy the benefit of selling gold at the higher spot price.

The cost of this insurance is the premium paid for purchasing the option


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9. Hedging with Options: Long put

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100

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400

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600

700

800

600

700

800

900

1,000

1,100

1,200

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otal rofit


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9. Hedging with Options: Short call

ABC Mining could sell (write) a call option at $1,200 per oz, covered by themines expected production.

If the option expires out of the money (spot price below $1,200), the optionwouldnt be exercised, and ABC would just keep the premium paid by the buyerof the option.

If the spot price is higher than $1,200 on expiry, the option will be exercised bythe buyer, restricting ABCs revenue on gold produced to $1,200.


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9. Hedging with Options: Short call

-400

-200

0

200

400

600

800

1000

$800

$900

$1,00

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$1,10

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$1,20

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Spot ri i 2009

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9. 9. Hedging with Options: Collars

Why might ABC mining want to sell a call?

As part of a collar, a combination of a long put at a low strike and short call at ahigh strike. This insures against significant falls in the gold price, paid for byforgoing the benefits of a significant rise in gold price.


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9. Hedging with Options: Collars

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10. Options: Valuation

The key theory for valuing an option (i.e. the premium) is the Black Scholesequation, devised by Robert Merton, Fischer Black and Myron Scholes in apaper published in 1973. This was awarded the Nobel Prize forEconomics in1997. Key factors affecting the price of both puts and calls are:

The strike price compared to the current spot price. Further in the money =more valuable/expensive

The time to expiry. Longer till expiry = more valuable/expensive

The volatility of the price of the underlying. More volatile = more valuable. There are several styles of options:

European options: Can only be exercised on expiry

American options: Can be exercised at any point up to expiry, which canonly help the buyer of the options, so tends to make them more expensivethan European options.

Asian options: the strike price is compared to an average market price e.g. in

the monthup to expiry. Common in base metals, as prevents manipulation ofthe spot price near expiry. Tend to be lower cost as volatility of the averageprice is lower than the volatility of the spot price.


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11. StakeholderExpectations

ABC Mining is thinking of hedging its production what might its stakeholdersthink?

Providers of debt finance just want their money back. May expect or insist onhedging to protect repayments in the event of a fall in market price

Shareholders have invested in a gold mine. Likely to expect to have a

significant exposure to the market price of gold

Potential for conflict between the needs of different stakeholders


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12. Hedging the mining plan

ABCs mining will result in production expected over a number of years, so careneeds to be taken to match derivatives expiry and cashflows to the productionplan.

Hedging strategies frequently require a strip of options or forwards to be enteredinto - sets of options with different expiry dates, typically a month apart.

One way of achieving this is a flat forward, an over the counter forward product

that offers a fixed price for monthly deliveries over the course of the mining plan.

Flat forward pricing for a commodity with a contango forward curve will includean element of interest and credit risk charges.


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12. Hedging the mining plan: Flat Forwards

Flat r ar s ta For ar

925

930

935

940

945

950

955

960

965

970

Fe -08 May-08 A g-08 Nov-08


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13. Exotic Options

Exotic Options are more complex instruments, built up from a number of basicinstruments, or with particular conditions relating to when they can be exercised.

Examples inlcude:

Barrier options like a standard option, but can only be exercised if aparticular spot price is reached during the life of the option (knock-in) or if aparticular spot price isnt reached (knock-out).

Digitals effectively an option with only two outcomes a bet with a fixedpayback.

Frequently used to make the price of options (and hedging) cheaper, byexcluding some opportunities for exercise.

Beware! Exotics can be complex to value (i.e. expensive) and hard to

understand (i.e. involve high gearing)


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14. The Greeks

The Greeks refer to how the value of an option moves with a movement inanother factor such as time, volatility or the price of the underlying

Most useful is the Delta of an option - how much the option value movescompared to movements in the underlying.

For example, the delta of a put option at the money is -0.5, i.e. if gold increasesin value by $10, an at the money put option will decrease by $5.

Monitoring the overall delta of a hedging portfolio of derivatives can be useful todetermine how the value of a hedging portfolio will change with movements inthe spot price.


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15. Conclusions

Hedging isnt free in order to protect against adverse price movements, youeither need to pay for insurance, or forgo some of the upsides

Hedging can be a complex topic need to understand in detail the effects ofcontracts entered into

Gearing can result in substantial liabilities being incurred for little initial outlay, sorisks need to be carefully evaluated and monitored


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Contact Cambridge Risk

E-mail: [email protected]

Telephone: +44 1223 245 357 and +44 7889 657590

Address: 15 Long Road, Cambridge CB2 8PP

Chris Howell: +44 7779 326808


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ABCs of Hedging

Chris Howell, Cambridge Risk Ltd

February 2008

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Master Class Basics of Hedging