MasterclassBasicsOfH edging

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Information about MasterclassBasicsOfH edging

Published on April 18, 2008

Author: Abbott


ABCs of Hedging Chris Howell, Cambridge Risk Ltd :  ABCs of Hedging Chris Howell, Cambridge Risk Ltd February 2008 Important Information:  Important Information The information and opinions contained in this document are not intended to be a comprehensive study, should not be regarded by any recipient as providing the basis for any investment decision and should not be treated as a substitute for specific advice concerning individual situations. Cambridge Risk Limited neither gives any warranty nor makes any representation as to the accuracy or completeness of this document and does not accept any liability for the consequences of any reliance upon any statement of any kind (including statements of fact and of opinion) contained herein. Cambridge Risk Limited is authorised and regulated by the Financial Services Authority 1. Introducing ABC Mining:  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 in the spot price over time. ABC Mining could seek to mitigate price risk by hedging with financial derivatives. 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 to produce gold over the next 10 years. The plan assumes a current gold price of $940 per oz, with variable production costs of $500 per oz. 2. What is a Financial Derivative?:  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 make payments between the parties based on the price of the underlying asset at a particular point in time. Key Properties: 3. History of Hedging and Derivatives:  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. 17th Century Tulip Mania in Holland. Fortunes are lost in after a speculative boom in tulip futures burst. Futures contracts deemed non-enforceable in law. Exchanges open Late 17th Century, Dojima in Japan trading rice futures. Chicago Board of Trade (1848), Chicago Mercantile Exchange (1898) etc Options valuation theory develops 1960’s - 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. 1990’s onwards - series of derivatives related corporate disasters - Metallgesellshaft losing $1.5 billion on oil futures (1994) and Barings Collapse (1995), to Société Générale losing €4.9 billion in Jan 2008 4. Who might use Financial Derivatives?:  4. Who might use Financial Derivatives? Hedgers – producers like ABC mining can use derivatives to reduce market risk i.e. from falling prices. Their derivatives positions are said to be covered by their physical capacity to produce the underlying commodity. Speculators – take a view on which way a market will move, and use derivatives to increase exposure to their expected market movement. Their derivatives positions are usually uncovered or naked. Arbitrageurs – Look to make series of balancing trades within or across markets to exploit small pricing differences or errors for the same or similar commodities. 5. How to enter a derivatives contract:  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-take agreements, sale agreements etc Can be surprisingly significant for mining companies. There are several ways ABC mining could enter a derivatives type contract: 6. Basic Instruments:  6. Basic Instruments Forwards or Futures – a commitment to sell an underlying commodity at some time in the future, at a price agreed today. Options – the right, but not the obligation to buy a commodity (a ‘call’ option) or sell a commodity (a ‘put’ option) at an agreed price (the strike price). Swap – an agreement to swap cashflows with a counterparty, e.g. swap an obligation to pay a fixed interest rate on a loan for an obligation to pay a floating interest 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 seller short. For options, the seller of the option is said to ‘write’ or ‘grant’ the option. Most financial derivatives are one of three basic types of instrument: 7. Hedging with Forwards:  7. Hedging with Forwards ABC Mining can use a short forward (sell forward) to 100% hedge market price risk. 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 7. Hedging with Forwards:  7. Hedging with Forwards 8. Forwards: Valuation Basics:  8. Forwards: Valuation Basics The forward value can be derived from today’s spot price, the cost of carry and the financing costs. The cost of carry is the net cost or benefit of holding the commodity from now until the forward delivery time, including factors such as costs of warehousing, income from leasing the commodity and so-called convenience yields from holding base metals. If the forward price does not reflect the spot price and cost of carry, there will be arbitrage 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 and sell at spot, invest the proceeds until the forward delivers then return the borrowed commodity. 8. Forwards: Valuations for Gold:  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 lease rate) from lending gold, warehousing costs are negligible, and there will always be a supply available to meet short term demand. This results in a forward price generally higher than the spot price, known as a contango market. 8. Forwards: Valuations for Gold:  8. Forwards: Valuations for Gold 8. Forwards: Valuations for Base metals:  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 a benefit to holding stock e.g. to avoid short term shortages, introducing a ‘convenience 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! 8. Forwards: Valuations for Base metals:  8. Forwards: Valuations for Base metals 9. Hedging with Options: Long put:  9. Hedging with Options: Long put ABC mining could buy a put e.g. with a strike price of $800 per oz expiring in Jan 09, 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 the option 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 Mining would enjoy the benefit of selling gold at the higher spot price. The cost of this insurance is the premium paid for purchasing the option 9. Hedging with Options: Long put:  9. Hedging with Options: Long put 9. Hedging with Options: Short call:  9. Hedging with Options: Short call ABC Mining could sell (write) a call option at $1,200 per oz, covered by the mines expected production. If the option expires out of the money (spot price below $1,200), the option wouldn’t be exercised, and ABC would just keep the premium paid by the buyer of the option. If the spot price is higher than $1,200 on expiry, the option will be exercised by the buyer, restricting ABCs revenue on gold produced to $1,200. 9. Hedging with Options: Short call:  9. Hedging with Options: Short call 9. 9. Hedging with Options: Collars:  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 a high strike. This insures against significant falls in the gold price, paid for by forgoing the benefits of a significant rise in gold price. 9. Hedging with Options: Collars:  9. Hedging with Options: Collars 10. Options: Valuation:  10. Options: Valuation The key theory for valuing an option (i.e. the premium) is the Black Scholes equation, devised by Robert Merton, Fischer Black and Myron Scholes in a paper published in 1973. This was awarded the Nobel Prize for Economics in 1997. 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 can only help the buyer of the options, so tends to make them more expensive than European options. Asian options: the strike price is compared to an average market price e.g. in the month up to expiry. Common in base metals, as prevents manipulation of the spot price near expiry. Tend to be lower cost as volatility of the average price is lower than the volatility of the spot price. 11. Stakeholder Expectations:  11. Stakeholder Expectations ABC Mining is thinking of hedging its production – what might its stakeholders think? Providers of debt finance – just want their money back. May expect or insist on hedging 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 12. Hedging the mining plan:  12. Hedging the mining plan ABC’s mining will result in production expected over a number of years, so care needs to be taken to match derivatives expiry and cashflows to the production plan. Hedging strategies frequently require a strip of options or forwards to be entered into - 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 include an element of interest and credit risk charges. 12. Hedging the mining plan: Flat Forwards:  12. Hedging the mining plan: Flat Forwards 13. Exotic Options:  13. Exotic Options Exotic Options are more complex instruments, built up from a number of basic instruments, 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 a particular spot price is reached during the life of the option (knock-in) or if a particular spot price isn’t reached (knock-out). Digitals – effectively an option with only two outcomes – a bet with a fixed payback. Frequently used to make the price of options (and hedging) cheaper, by excluding some opportunities for exercise. Beware! Exotics can be complex to value (i.e. expensive) and hard to understand (i.e. involve high gearing) 14. The Greeks:  14. The Greeks The ‘Greeks’ refer to how the value of an option moves with a movement in another factor such as time, volatility or the price of the underlying Most useful is the Delta of an option - how much the option value moves compared to movements in the underlying. For example, the delta of a put option at the money is -0.5, i.e. if gold increases in 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 to determine how the value of a hedging portfolio will change with movements in the spot price. 15. Conclusions:  15. Conclusions Hedging isn’t free – in order to protect against adverse price movements, you either need to pay for insurance, or forgo some of the upsides Hedging can be a complex topic – need to understand in detail the effects of contracts entered into Gearing can result in substantial liabilities being incurred for little initial outlay, so risks need to be carefully evaluated and monitored Contact Cambridge Risk:  Contact Cambridge Risk E-mail: Telephone: +44 1223 245 357 and +44 7889 657590 Address: 15 Long Road, Cambridge CB2 8PP Chris Howell: +44 7779 326808 ABCs of Hedging Chris Howell, Cambridge Risk Ltd :  ABCs of Hedging Chris Howell, Cambridge Risk Ltd February 2008

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