Hedging with Examples

No. of futures required

700 / 25 = 24

 

Hence 24 Grade A Copper future contracts are required to hedge the risk, SRN wishes to hedge against by shortening its copper future contracts at a future exchange.

Contract months used

Short one-near month in London Metal Exchange

Assuming, SRN has hedged its copper production risk exposure by purchasing options. As SRN is anticipating bearish trend on copper, it can cover its loss by going long (Buying) copper put options.

As per ASX website, the near month NYSEX Copper future contract is trading at a price of 1.48 USD per pound. A NYSEX Copper Option having strike price of 1.5 USD per pound with same expiry date is priced at 0.1 per lb.  As we know, that each NYMEX Copper future contract represent 25,000 pounds of copper, hence we have to pay premium of 2,500 USD in order to purchase a near month Copper put option.
We can compute gain from long copper put option strategy by taking the product of contract size and difference between options strike price and fair market price of underlying futures.
= (1.5 USD per lb – 1.24 USD per lb) * 25,000 lb
= 6,150 USD
Initial investment paid = 2,500 USD

Net profit = Gain earned from exercise of Put options – Initial margin (Investment)
                 = 6,150 – 2,500
                 = 3,650 USD
Hence at a strike price of 1.5 USD per pound and premium of 2,500 USD, SRN can earn rate of return of (3,650 – 2,500) / 2,500 = 146%
(“London Metal Exchange: Non-ferrous metals”, 2016) and (“Futures & Options Trading for Risk Management – CME Group”, 2016)
Options Combinations Strategies:-

As options prices are widely dependent on the prices of their underlying securities, therefore options combinations can be used to earn profits with less risk. Options combinations can lessen risk even in directionless markets.

An investor looking at the below mentioned options combination strategies should keep into account the risks associated with it which, as per analysts, are far more complex than margin requirements, tax consequences, simple stock options and commissions which are paid to effect these strategies. The most optimum way of exercising options combinations is by delivering the underlying assets instead of cash settlement. (Finnerty & Grant, 2002)

Two effective options combinations strategies

Option Spreads

An option spread involves multiple call and put options which have different strike prices and have more than one expiration dates on the very same security which is underlying of such options. The most effective option spread combination is Ratio Put Spreads. In Ratio Put Spreads, decrease in the price of underlying assets is considered as limited. It is a combination of long put position with multiple short put position which have same expiration dates but different strikes price.  (Wilkinson, 2016)

One of the major aim of exercising Ratio Put Spreads is reducing initial premium outlay. However risk gets considerably high by holding a net short position because investor is exposed to substantial loss at various points.

Covered Call

It involves writing a call for an already owned stock. In case of unexercised call, premium of such option combination technique is kept by call writer and stock is retained by him on which dividends are received by him. In case, call writer exercise the write option, the call writer get the exercise price against the stock along with the premium however the stock profit exceeding strike price is foregone by the call writer. (Wilkinson, 2016) 

Conclusions

In this report, we shed light on financial risk exposures of a non-financial firm and have used multifactor market model in order to access financial risk exposure level which includes interest rate exposure, exchange rate exposure and commodity price exposure. One possible limitation this study exhibited the consideration of net exposure; which is an exposure that remain even after company involves in hedging activity.
 

References

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