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PROCUREMENT STRATEGY COUNCIL
Research Brief September 2008
2008CORPORATE EXECUTIVE BOARD
Introduction to Financial Derivatives and
Hedging StrategiesOVERVIEW
The recent rise in commodity price volatility has increased companies interest in implementing
a broader array of market-based derivatives to protect against future market increases whileenabling the company to take advantage of market declines. In a recent Council survey, almost
half of the respondents reported that they are investigating opportunities to use more financialderivatives to stem commodity price risk. This makes sense as respondents indicate that curren
commodity hedging only mitigates roughly 11% of the volatility experienced within the market
While there are many reasons why companies have not taken the next step to implementpotential financial hedges, a majority of companies cite a lack of the necessary infrastructure
and unfamiliarity with potential hedges as the primary reasons for not implementing these toolsTo help members better acquaint themselves with the most common financial instruments, theCouncil has developed this summary document outlining how each operates and the strengths
and weaknesses of each hedge.
43%
14%
6%3%
34%
Have no intention of exploring or expanding
Exploring potential hedging strategies
Relying MORE on hedging strategies
Relying LESS on hedging strategies
Continue using the same strategies
HEDGING STRATEGIES ON PROCUREMENTS RADAR
Percentage of Survey Respondents
n=35
Source: Procurement Strategy Council Research (2008)
27%
23%22%
17%
11%
Offset by Cost Reduction
Pass to Customer
Absorb in Lower Margin
Avoided by Long Term Contract
Avoided by Hedge
RESPONSE TO RAPID RISE IN COMMODITY PRICESPercentage of Survey Respondents
n=53
CONTENTS
OVERVIEW(Page 1)
DERIVATIVES:DEFINITION ANDTYPE(Page 2)
FORWARD CONTRACT(Page 2-3)
FUTURES CONTRACT(Page 3-4)
OPTION CONTRACT(Page 5-6)
SWAP CONTRACT(Page 6-7)
SUMMARY OF DERIVATIVES(Page 8)
HEDGING STRATEGIES(Page 9)
COLLAR HEDGE(Page 9)
BULL CALL SPREAD(Page 10)
SWAPTIONS(Page 10)
SUMMARY OF HEDGING
STRATEGIES(Page 12)
COMMON MISUNDERSTANDINGS(Page 13)
RESEARCH PROCESS IN BRIEF(Page 14)
Source: Procurement Strategy Council Research (2008)
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Derivatives: Definition and Types
Derivatives are securities whose value is derived from an asset (referred to as an underlier
within the market) such as a commodity, currency, or a market basket of different assets1.
Following sections discuss details of four categories of derivatives
Forward Contracts - A private agreement between two parties to make payments for afuture delivery of the underlying commodity
Futures Contracts - An agreement made in an open commodities market to makepayments for a future delivery of the underlying commodity
Option Contracts - An agreement made through an open commodities exchangeproviding right to buy a commodity in the future at a predetermined price
Swaps - A contract enabling exchange of unpredictable cash flow, such as price paidfor heating oil based on index prices, for a predictable cash flow, such as fixed price ofheating oil.
FORWARD CONTRACT
A forward contract is
a customized
agreement between
two parties much likea standard sourcing
contract, the maindifference being that
complete advance
payment is made fora delivery in the
future2.
The trading parties
are either brought
together by an
intermediary (such asa brokerage firm or
financial institution)or have conducted
business in the past (as in supply contracts developed by Procurement). In this arrangement, the
price of the underlying asset, in whatever form, is paid before ownership of the asset changes.
The ability to hedge any commodity or product using forward contracts, and the availability of
long and short parties through diverse Over-the-Counter markets makes Forward Contracts
highly flexible agreements. The flexibility is further enhanced by ability to incorporate terms
and conditions agreeable to both trading parties. The process to negotiate a Forward Contract isvery similar to negotiating a normal sourcing contract (see the process map on next page). The
difference between sourcing and forward contract lies in invoicing, while payment is made after
delivery in sourcing contracts, forward contracts mandate payment before delivery. However
this flexibility also makes forward contracts the most vulnerable to default. In instances of
default, the long partys only recourse is suing the short party in open court.Forward Contract Applicability: Given the highly flexible nature of the contracts, forwards are
instruments of choice for buyers trying to hedge processed products with weak correlation to
exchange traded commodities. However, it is advisable to limit exposure to low quantities ordemand collateral as absence of a monitoring body increases risk of default.
Forward Contract Characteristics
Market Type Over-The-Counter (OTC)
ContractExecution
Physical Delivery
Pros
Terms are easily customized to meet theneeds of both the short and long parties
The future price is fixed for the long party Can provide coverage for commodities and
products without liquid marketplaces
Cons
The risk of the short party defaulting on theagreement increases during times of rapidinflation or supply disruptions
Long parties can find it difficult to forfeittheir right to participation if prices go down
(as the money has already been paid)
Complete payment required in advancewhich ties up working capital
Definition of Long And Short Parties
In each hedging arrangement, thereare two primary parties involved.
These parties are known as the LongParty and Short Party.
The Long Party is the organization orindividual that purchases the
contract or commodity
The Short Party is the organization or
individual that sells the contract orcommodity.
The Types of Commodity Markets
In most cases, commodity hedging is
conducted in one of two venues called markets.
Public Exchanges - A regulated
marketplace where short and longparties can trade a standardized setof market derivatives. In these
markets, most of the commoditycontracts are cash settled rather thansettled by final delivery of the physical
product to the long party. This meansthat at the end of these contracts,any differences between the currentvalue of the underlier and the originalcontract price is settled in cash.
This enables organizations to holdcommodities without needing to
manage warehouse and physicalinventory costs.
Private Over-The-Counter - A non-
regulated market place where twoparties come together or are brought
together by a mediator (usually abrokerage house or financialinstitution) to enter a derivatives
contract. Over-The-Countermarketplaces can be as easy as aforward contract between you and
your supplier, or, for moresophisticated trades, involved a bankas the mediator.
However, because these markets are
not regulated, the risk that either sidewill default on the trade is muchhigher as it wont result in exchange-
enforced penalties outside of a courtsetting.
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FUTURES CONTRACT
A futures contract is an
exchange traded,
standardized contract thatrepresents an agreement to
buy or sell a quantity of
asset at a predetermineddelivery date and fixed
price2.
To execute future contracts,
Procurement (long party)needs to establish a
relationship with a broker
registered with an
exchange that trades in the
desired commodity. Thisbroker then operates a
margin account on behalf
of Procurement through which future contracts offered by short parties can be bought. On anygiven day, the exchange may list a variety of contracts that vary in length, volume (quantity),
and settlement (a full list of contract terms is located on the following page). Procurement
organizations interested in using these derivatives must then patch together a series of contractsmeeting their needs.
The contracts are then settled each day based on the difference between the contract price and
the spot market price. The exchange marks all the contracts to market prices at the end of the
day. If the contract is out of money, meaning that a buyer struck a deal where the contract priceends up above the current spot price, the exchange may issue a margin call, a request to
deposit money in the margin account, to mitigate risk of default (see the process map below).
Futures Contract Characteristics
Market Type Public Exchanges
Contract
ExecutionCash settled
Pros
Mediation by exchange lowers risk of defaultby either party
Procurement only pays the complete contractat the end of the contract term (rather than
before as in a forward contract)
Cons
Structure prevents procurement from takingadvantage of market declines.
Can only be executed in exchanges that tradein the commodity Procurement wishes to
purchase
Long parties must set aside funds to pay formargin account
Procurement and SuppliersMeet to Negotiate Price of
Contract
Savings Relative to Spot Price
PROCESS MAP AND SAVINGS CHART FOR FORWARD CONTRACT
A simplified version of procedure to participate in Forward Contract market
Source: Procurement Strategy Council Research (2008)
Both Parties Enter a BindingLegal Contract to Trade aCommodity for Fixed Price
Both Parties Deposit aSecurity to Mediating Party
to Cover Risk of Default
Optional Step
Contract is Executed Either
by Cash Settlement orDelivery of
Commodity/Product
K
Long Party
(Procurement)
Short Party
(Supplier)Mediating Party
SupplierDelivers
ProcurementPays-20
-15
-10
-5
0
5
10
15
20
10 20 30 40
Spot Price
Savings
Legal Contract
K = Fixed Price
Margin
A margin is the collateral that shortand long parties must set aside tocover the credit risk for contracts thatrequire cash settlement sometime in
the future. The size of the margindepends on the size of the contract,
the partys bond rating, and itsrelationship with its counterparty (e.g.broker).
An account set up to handle these
cash settlements is considered amargin account. Once companiesset up these accounts with aparticular exchange, multiple futures
and options can be traded from asingle margin account with sufficientfunds to cover credit risk.
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Applicability: Futures contracts are suitable for companies that require commodities or near-commodities traded on an exchange at a predetermined fixed price. The exchange plays the role
of mediating party, lowering the risk of default significantly. Futures contracts lock the buyers
into a fixed price with potential loss of opportunity to save if the market prices fall.
A standard futures contract contains the following details
The underlying asset or instrument The type of settlement (cash settlement or physical settlement) The amount and units of the underlying asset per contract The currency in which the futures contract is quoted The grade of the deliverable. The delivery month The last trading date Other details such as the commodity tick, the minimum permissible price fluctuation
PROCESS MAP AND SAVINGS CHART FOR FUTURES CONTRACTA simplified version of procedure to participate in Futures Contract exchange
1
5.b
Each Day, if Market Moves
Up, Exchange DepositsMoney into Margin Account
If Commodity Prices
Moved Up, CompanyReceives Money
Procurement Provides
Hedging Requirements and
Margin Money toTreasury/Bank
Bank/Brokerage Firm Take
Long Position by Buying
Futures from Exchange
Each Day, if Market Moves
Down, Bank Deposits Margin
Money
Savings Relative to Spot Price
2 3.a
3.b
Expiry Date: Contracts are
Matched for Settlement
4If Commodity Prices
Moved Down, Company PaysMoney
5.a
K
BankProcurement Bank Exchange
Exchange
ExchangeBank
Bank
ExchangeShort Party Long Party
Procurement Short Party ProcurementExchangeExchange
-20
-15
-10
-5
05
10
15
20
10 20 30 40
Spot Price
Saving
s
Short Party
Note that the future behaves the same asa forward. The differences are in the risk of
default (lower with a future), and modes ofsettlement and delivery.
K = Fixed Price
Source: Procurement Strategy Council Research (2008)
Safer Than Forward
xchange mitigates risk of default viasue of margin call, making futuresontract a safer hedge compared to
orward contract
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OPTIONS CONTRACT
An options contract provides
a Long Party a right- but not
an obligation- to buy or sell
an underlying asset offered
by a Short Party at apredetermined price within a
specified time period3.
In order to gain the luxury of
this flexibility, a Long Party
must pay a premium to theShort Party upfront in order
to hold the option for a
future purchase.
There are four basic trades in
Option Contracts 1.Long Call Long party
gains right to buy the
underlying commodity ata set price
2.Long Put Long Partygains right to sell the
underlying commodity ata set price
3.Short Call Short Party charges a premium for promising to sell the underlying commodity4.Short Put Short Party charges a premium for promising to buy the underlying commodity
The long party (buyer of an option) pays a premium. The short party (seller of an option) earns
a premium.
Most of the option contracts are cash settled like future contracts and include issuing margincalls to the appropriate party after each day of trading (also like future contracts). There are two
main styles of options 1.European an option that may only be exercised on expiration date of the option2.American an option that may be exercised on any trading day on or before expiration
date.
Calculating the Premium: The premium for options is based on two values the intrinsic value
of the contract and the time value of the contract. The intrinsic value of the contract is thedifference between spot price and the contract price included in the premium to cover the risk
short party takes in promising to trade at a price different from the market price. The time value
of the contract, calculated using annualized volatility, risk free interest rate, term of contract,and price of the contract, is included in the premium to cover the risk the short party takes in
promising to trade at a future date.
Applicability: Implementation of this hedge requires the buyer to pay a premium for the right to
execution. Premiums tend to discourage casual use of options contracts by Procurement; optionare a good choice when Procurement has access to sufficient upfront capital full support of
corporate Treasury or Finance.
Option Contract Characteristics
Market
TypeExchange Traded
Contract
Execution Cash settled
Pros
Mediation by exchange lowers risk ofdefault by either party
Provides Procurement an opportunity to takeadvantage of lower prices should thecommodity market decline
Cons
Can only be executed in exchanges that tradin the commodity Procurement wishes to
purchase
Commodities with low volatility may not beworth premium (whereas highly volatile
commodities may require hefty upfront riskpremiums)
Long parties must set aside funds to pay formargin account
Requires the upfront payment of a riskpremium
Definition of an Option Call and Put
Call An option that gives contractolder a right to buy the underlyingommodity at a specific price during a
pecific timeframe.
ut An option that gives contract
older a right to sell the underlyingommodity at a specific price during apecific timeframe.
Premiums
he premium is the upfront cost ofuying an option paid to the seller
whether it is exercised or not. The
remium represents the estimated riskaken on by the seller.
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SWAP CONTRACT
A swap contract is an agreementto exchange a fixed cash flow for
a floating cash flow, or visa
versa at a future time in fixedintervals4.
There are two types ofcommodity swaps
1. Fixed-Floating Swaps Afixed commodity based cash
flow is exchanged for a
floating cash flow (based onindex or price of traded
commodity)
2. Commodity-for-InterestSwaps - a total return on thecommodity is exchanged for
some money market rate
(plus a spread)
Swap contracts are traded over-the-counter and are usually offered by financial institutions thatwill seek out and connect interested parties. As with forward contracts, these arrangements are
highly customizable and can offer companies flexibility in arranging deals that help spread out
unique exposures to commodity markets.
Applicability: A swap contract enables a company to flatten the ups and downs in a commodity
market over the short term as it enables hedgers to get a fixed price from a financial institutionin exchange for an index-based price. Swap contracts are not suitable as a long term strategy in
volatile market places as prices will move away from fixed price significantly5.
Swap Contract Characteristics
Market Over-the-counter
Suitable
PeriodLong-term hedge
Pros
Terms are easily customized to meet theneeds of both the short and long parties
Can provide coverage for commoditiesand products without liquid marketplace
Help flatten volatile market prices socosts are more predictable
Cons
Financial institutions will extract heavypenalties if swaps are settled before
maturity
Commodity-index correlation mightbreak down in high volatility
Difficult to set-up and may requirestrong correlation proof for banks
PROCESS MAP AND SAVINGS CHART FOR OPTIONS CONTRACTA simplified version of the procedure to participate in an Options Contract exchange
Source: Procurement Strategy Council Research (2008)
If Commodity Prices Decline,Let the Contract Expire, and Buy
on the Spot Market
Savings Relative to Spot PriceWhen the Premium is 5.00
Procurement Provides
Hedging Requirements andPremium to Treasury/Bank
1Bank/Brokerage Firm Buys
Long Call by Paying aPremium
2Expiry Date: If Commodity
Prices Moved Up, ExerciseContract to Buy the
Commodity at a Savings
3.a
3.b
K
BankProcurement Bank Exchange
Exchange
ExchangeProcurement
Procurement-10
-5
05
10
15
20
25
30
10 20 30 40 50
Spot Price
Savings
Defining Swap Cash Flows
A cash flow, in context to commoditywaps, is a recurring payment to a
upplier for purchase of a commodity.
xed Cash Flow A fixed price due at a
uture date for the purchase of aommodity (e.g. the purchase of oil on
long term fixed contract).
oating Cash Flow A fluctuating price
ue at a future date for the purchase of commodity (e.g. the purchase of oilt index price).
K = Strike Price
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PROCESS MAP AND SAVINGS CHART FOR SWAP CONTRACT
A simplified version of procedure to participate in Swap Contract
Source: Procurement Strategy Council Research (2008)
Contract Period: If the IndexBased Prices are Above Fixed
Prices, Bank Pays
Company Trades Fixed CashFlow for Floating Cash Flow
Procurement ProvidesCommodity Requirements to
Treasury/Bank
If the Index Based Prices are
Below Fixed Prices, CompanyPays
BankProcurement
Fixed
FloatingBankProcurement
BankProcurement
BankProcurement
Savings Relative to Index Price
K
-20
-15
-10
-5
0
5
10
15
20
10 20 30 40
Index Price
Savings
K = Fixed Price
3.a
3.b
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SUMMARY OF DERIVATIVES
The table below compares financial derivatives pros and cons discussed individually in earlier sections.
FEATURES OF DIFFERENT DERIVATIVES
A table providing snapshot of features of financial derivatives
Forward Contract Future Contract Option Contract Swap
ContractMarket
Type
Over-The-Counter Exchange Exchange Over-The-Counter
Contract
Type
Long party must take
delivery at expiration
Long party must settle
full contract in cash
Long party can settle the
contract in cash or cancel
Long party trades cash
flows as per agreement
Pros - Terms are easily
customized to meet theneeds of both the short
and long parties
- The future price is
fixed for the long party
- Can provide coveragefor commodities and
products without liquid
marketplaces
-Mediation by exchange
lowers risk of default byeither party
-Procurement only paysthe complete contract at
the end of the contract
term (rather than before
as in forward or optioncontracts)
-Mediation by exchange
lowers risk of default byeither party
-Provides Procurement anopportunity to take
advantage of lower prices
should the commodity
market decline
-Terms are easily
customized to meet theneeds of both the short
and long parties
-Can provide coverage for
commodities and products
without liquid
marketplaces
-Help flatten volatile
market prices so costs are
more predictable
Cons -The risk of the short
party defaulting on the
agreement increasesduring times of rapid
inflation or supply
disruptions
-Long parties can find it
difficult to forfeit theirright to participation if
prices go down (as the
money has already been
paid)
-Complete payment
required in advance
which ties up working
capital
-Structure prevents
procurement from takingadvantage of market
declines
-Can only be executed in
exchanges that trade inthe commodity
Procurement wishes topurchase
-Long parties must set
aside funds to pay for
margin account
-Can only be executed in
exchanges that trade inthe commodity
Procurement wishes to
purchase
-Commodities with lowvolatility may not be
worth premium (whereashighly volatilecommodities may require
hefty upfront risk
premiums)
-Long parties must set
aside funds to pay for
margin account; requires
the upfront payment of a
risk premium
- Financial institutions
will extract heavypenalties if swaps are
settled before maturity
-Commodity-index
correlation might breakdown in high volatility
-Can be difficult to set upas deals are heavily
customized and may
require strong market
correlations
Applicability Companies willing topay in advance and have
trustworthy sellers ofspecialized commodities.
Companies purchasingexchange-traded
commodities and do nothave a trustworthy
source to execute
forward contract.
Companies purchasingexchange-traded
commodities and willingto pay a premium for the
option to buy on the
spot market should pricesdecline
Companies purchasingcommodities from
suppliers demandingindex-based prices for
commodities not traded
on the open exchange
Source: Procurement Strategy Council Research (2008)
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HEDGING STRATEGIES
By using the above financial instruments in different combinations, companies can construct
mechanisms that both help limit downside risk without entirely losing the ability to takeadvantage of declining market prices. Common combinations are often referred to by name and
are treated as natural extensions of simple market derivatives.
COLLARHEDGE
A collar is formed when a partytakes both call and put position
in the market at prices equally
spread from the spot price.
A party sells a put at a price
lower than spot price and buys a
call at a price higher than spotprice. Both the contract prices
are placed equidistant from the
spot price and have sameexpiration date. The collar hedge
enables Procurement to pay the
spot price while capping the
upper and lower price (see the process map below)6.
Applicability: The difference between the premium received for selling a put and premium paidfor buying a call is negligible, making this strategy suitable for multiple hedging cycles in small
time period keeping the prices between a floor and ceiling.
Collar Characteristics
Underlying
DerivativeOption
Pros
Upper limit on price of commodity Low cost hedging strategy as cost of
margins are offset between the call and
the put
Cons
Limits savings to a lower limit if marketdecline, unlike a straight option where
the downward benefit is not limited Only available for those commodities
traded in a liquid market
Buy a Call by
paying a premium
Sell a Put and earn
a premium
Offset the
premium
At the endof term
Spot Price: $50Call Strike Price: $60
Spot Price: $50
Put Strike Price: $40
Spot Price < $40 Spot Price > $60
$40 < Spot Price < $60
Call expiresPut is executed
Buy commodity at $40
Both contracts expireBuy at spot price between
$40 and $60
Call is executedPut expires
Buy commodity at $60
PROCESS MAP FOR EXECUTING COLLAR HEDGEA simplified version of procedure to participate in CollarHedge
Source: Procurement Strategy Council Research (2008)
Limit Risk Spread
Collar hedge limits the risk of price rise
without complete loss of opportunity touy from market if price falls. However,also puts a lower price cap.
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Bull Call Spreads
A bull call spread is similar to
the collar in that it employs a
pair of options to create a low
risk, low reward strategy -- butit is different in that it is biased
to improve your reward upon
the assumption that the marketis more likely to rise than fall,
while it also allows you to fullybenefit from a drop in prices if
the market should happen tofall7.
In a market with an upward
outlook, the hedger can buy one call near the spot price and sell a second call further above.The difference between the premiums for the calls bought and sold is the maximum loss for the
hedge if the market falls, the calls are not exercised and only the premium costs remain. If the
market rises, the user now has the right to buy at the lower call price, generating savings, and ifthe market continues to rise the user has the obligation to sell at the higher call price, still
returning a profit but limiting the upside gain. In the case of commodities hedging rather than
speculation, this profit is then applied to buying the good in question, offsetting the rising price.
Applicability: This strategy is cheaper than buying just a call option, although it limits the
upside potential. The strategy is best when you expect a mild, but not a dramatic market rise.
Bull Call Spread Characteristics
Underlying
DerivativeOption
Pros
Limits upside price risk for thecommodity
Part of the premium cost is offset byselling as well as buying an option
Cons
The buyer still has to pay the remainingdifference on the premium if the market
drops and the calls arent exercised.
Only available for those commoditiestraded in a liquid market
Buy a Call bypaying a premium
Sell a Call and
earn a premium
Offset thepremium
At the endof term
Spot Price: $50Long Call Strike Price: $52
Spot Price: $50
Short Call Strike Price: $60
Spot Price < $52 Spot Price > $60
$52 < Spot Price < $60
Calls expire
Buy commodity at spotprice.
Exercise the low call
purchasing thecommodity at $52.
Both calls are executed:you buy at $52 and sell at$60, using the $8 gain tooffset the spot price for
your own purchasing.
PROCESS MAP FOR EXECUTING BULL CALL SPREADA simplified version of procedure to participate in Bull Call Spread
Source: Procurement Strategy Council Research (2008)
Medium Cost, Higher Benefit Hedge
A bull call spread enables a buyer touy and sell a pair of call options so
hat the premiums partially but notully offset each other. Unlike a collaredge, the buyer can still take fulldvantage of a drop in the market,
while also benefiting from a wider rangef gains assuming the market rises.
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SWAPTIONS
A swaption is a combination of
swap and option which gives
buyer a right to enter a swap at
a future point in time.
A call swaption gives buyer a
right to swap a fixed cash flowfor a floating cash flow (such as
an index). A put swaption gives
buyer a right to swap a floating
cash flow for a fixed cash flow.
A hedger is interested in a put swaption as it provides right to exchange floating cash flow for afixed cash flow at predetermined rates at a future point in time8.
Applicability: Hedgers trying to gauge extent of volatility before entering a swap should use
Swaptions as the contract gives buyer the right to exchange a fixed cash flow for a floating cashflow at a future point in time.
Swaptions Characteristics
Underlying
DerivativeOption and Swap
Pros Fixed price for volatile commodities Large OTC market enables hedging of
products not traded on Exchanges
Cons Option to not enter swap in case of
market slide
Premium to buy right to swap
Buy an Option toenter Swap
Expiry dateof Option
Spot Price: $50Fixed Price Offered: $55
Market price fellSpot Price: $34
Market price roseSpot Price: $62
Swaption expires
Continue to buy at spot price
Execute swaptions contract
Receive $7 to compensate risein prices
PROCESS MAP FOR EXECUTING SWAPTIONA simplified version of procedure to participate in Swaption
End of 1stterm
Pay $3 to Swap writer frombudget
Buy commodity at $52 withremaining budget
Receive $13 to compensate risein prices
Market price roseSpot Price: $68
Market price fellSpot Price: $52
Source: Procurement Strategy Council Research (2008)
Premium to Swap
nlike most other Swaps, an option onwaps is bought by paying a premium.
Long Term View
may be worth purchasing a swaptionespite a short-term price fall not
upported by fundamental changes inupply; otherwise the buyer remainsxposed to higher prices in the long run.
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SUMMARY OF HEDGING STRATEGIES
The table below compares hedging strategies pros and cons discussed individually in earlier
sections.
FEATURES OF HEDGING STRATEGIES
A table providing snapshot of features of hedging strategies
Collar Hedge Bull Call Spread Swaptions
Underlying
Derivative
Option Contracts Option Contracts Option on Swaps
Pros - Upper limit on
price of commodity
- Low cost hedging
strategy
- Limits upside price
risk for the
commodity
- Part of the
premium cost isoffset by selling as
well as buying anoption
- Optional fixed
price for volatile
commodities
- Large OTC market
enables hedging ofproducts not traded
on exchanges
Cons - Limits potential of
saving if prices
decline- Only applicable to
exchange-traded
commodities
- Buyer still has to
pay the remaining
difference on thepremiums.
- Only applicable to
exchange-tradedcommodities
- Premium required
to buy the contract
Applicability Companies looking
to evenly spreadupward and
downward risk of
buying exchange-
traded commodities
Companies looking
for a low-riskstrategy built on a
bias that the market
will move up during
the term of thehedge.
Companies trying to
convert index-basedprices into fixed
prices with the
option to observe the
market beforeentering the contract
Source: Procurement Strategy Council Research (2008)
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INTRODUCTION TO FINANCIAL DERIVATIVES AND HEDGING STRATEGIES PAGE 13
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2008CORPORATE EXECUTIVE BOARD
COMMON MISUNDERSTANDINGS
The table below addresses common misunderstandings around hedging via financial derivatives
Myth Explanation
The premium charged for anoption contract is a true measure
of the expected volatility in themarket
The formula used to calculate the premium for an optioncontract takes into account volatility, spot and contract
prices, risk-free interest rates, and term of contract. Asthe calculation depends on various other factors, it doesnot directly correlate to expected volatility.
Financial derivatives are just
speculators tools and hedging onan open market is a risky gamble.
Financial derivatives markets were invented to protect
traders from unforeseen circumstances. While profit-seeking speculators participate and skew the market,
responsible use of financial derivatives can enableProcurement to secure predictable price ranges for
commodities.
If markets do not move, an optionbought with contract price below
the market price will enablesavings.
The intrinsic value embedded in the premium charged forthe option is equal to the difference between the spot and
contract price. Any savings made by execution of theoption will only offset the intrinsic part of the premium,making the landing cost of the commodity equal to the
market price plus time value embedded in the premium.
Source: Procurement Strategy Council Research (2008)
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1 Durbin, Michael,All About Derivatives, New York: McGraw-Hill Companies, 2006, p. 1-42 Bansal, Manish, Navneet Bansal,Derivatives and Financial Innovations, New Delhi: Tata McGraw-Hill Companies,2007, p. 4933 Bansal, Manish, Navneet Bansal,Derivatives and Financial Innovations, New Delhi: Tata McGraw-Hill Companies,
2007, p. 4984 Durbin, Michael,All About Derivatives, New York: McGraw-Hill Companies, 2006, p. 31-365 Author Unknown, Some Basic Ideas About Commodity Swaps, The Financial Express,
http://www.financialexpress.com/news/Some-basic-ideas-about-commodity-swaps/201454/ (11 June 2007)6 Arunajith, Upul, The Zero Cost Collar Hedging Strategy, The Sunday Times Online,
http://sundaytimes.lk/070513/FinancialTimes/ft315.html (13 May 2007)7 optionsXpress, Bear Call Spread, http://www.optionsxpress.com/educate/strategies/bearcallspread.aspx8 Gilbert, Christopher L., Alexandra Tabova, Commodity Swaptions,
http://www.performancetrading.it/Documents/CgCommodity/CgC_Swaptions.htm
THE RESEARCH PROCESS IN BRIEF
Project Aims and Research Methodology
This document seeks to provide procurement executives with an overview of
financial instruments and hedging strategies. Because it employs an abbreviated
research process to maximize its timeliness, this project (by design) does not
provide an exhaustive evaluation of the problem or the practice. Looking forward,
the Procurement Strategy Council plans to periodically update this collection as new
practices and insights emerge.
While this report describes the opinions of experts and others regarding an issue of
key strategic concern, we cannot emphasize enough that (consistent with our
charter) we are not recommending any particular course of action.
This document is compiled from extensive primary and secondary research completed
by the Procurement Strategy Council.
Professional Services Note:
The Procurement Strategy Council has worked to ensure the accuracy of the information it provides
to its members. This project relies upon data obtained from many sources, however, and theProcurement Strategy Council cannot guarantee the accuracy of the information or its analysis in
all cases. Furthermore, the Procurement Strategy Council is not engaged in rendering legal,
accounting, or other professional services. Its projects should not be construed as professional
advice on any particular set of facts or circumstances. Members requiring such services are advised
to consult an appropriate professional. Neither Corporate Executive Board nor its programs are
responsible for any claims or losses that may arise from any errors or omissions in their reports,
whether caused by Corporate Executive Board or its sources.
Project Aims
ResearchMethodology