Country : Australia
Assignment Task :

1. Introduction 

You are hired by a large corporation as a consultant to advise on the use of derivatives to hedge commodity price risk. The analysis will involve (i) designing hedging strategies using futures contracts on the commodity being hedged, (ii) designing cross-hedging strategies using futures contracts on an alternative commodity to the one being hedged, (iii) analysing the effectiveness of the hedging strategies after those strategies have been implemented over the hedge period 16 Dec 2019 – 14 Feb 2020, and (iv) writing a report which summarises the results of your analysis and discusses any implications, issues and recommendations for the futures risk management activities of the company. 

The details of the commodities and firm operations relevant to your analysis are included in the excel file “Student info” posted on Moodle. Note that each student will have a different set of commodity and firm operation to be analysed and therefore every student will have a unique solution to this assignment. The first sheet of the file includes the following information: the commodity being hedged, the quantities required to be hedged (i.e. the firm’s exposure the commodity), type of firm operation (buyer/seller of the commodity), initial and maintenance margin requirement, spot prices at the beginning and the end of the hedge period, student#, names and commodity set #. The hedge period (16 Dec 2019 – 14 Feb 2020) will be the same for all commodities. For example, student with commodity set 2 (Student_info_Wollongong) is required to analyse a company which is a buyer of Corn. The company expects to buy 150,000 bushels of Corn at the end of the ‘Hedge period’. To calculate optimal hedge ratios, you need to determine a related commodity and collect data on its futures contract over the same ‘Hedge period’. Assume the firm implements the hedge at the start of the ‘Hedge period’ and terminates the hedge and conducts the spot transaction at the end of the ‘Hedge period’. Further information and guidance will be provided in lectures and on Moodle. 

Part 1 – Preliminary Analysis 

Obtain the relevant futures contract specifications such as contract size and margin requirement etc. from the CME Group website . Ensure you have the correct contract by matching the product code 

 

Part 2 – Hedging using a futures contract on the underlying commodity 

Calculate the number of contracts required and the type of hedge (long versus short) required, where each commodity exposure is hedged with a position in the corresponding futures contract. Assume the hedge is in operation over the specified “hedge period”, calculate the firm’s total profit and loss in dollars from commodity price changes, assuming an unhedged position. Calculate the daily adjustment to your margin account and compute the cumulative gain or loss in dollars from the futures transaction. What is the basis risk when the hedge is closed out? Calculate the effective unit price in dollars and cents realised on your allocated commodity. 

 

Part 3 – Cross hedging (30%) 

Now assume that futures contracts are not available on your allocated commodity. Find a second commodity whose futures contract is traded by CME and has data available from au.investing.com. Hedge your allocated commodity using futures on your second commodity. You need to provide evidence that the futures price on the second commodity is highly correlated with the spot price of your allocated commodity. Then download monthly futures data on your second commodity (from au.investing.com) and calculate the minimum variance hedge ratio for your exposure. Calculate the optimal number of contracts for hedging the commodity exposure, using the “tailing the hedge” adjustment. Calculate the total gain or loss in dollars from the futures transactions. Calculate the effective unit price in dollars and cents realised on your allocated commodity. 

 

Part 4 – Discussion

The advantages and disadvantages of hedging with futures. 

Issues which practitioners need to be aware of limiting the effectiveness of futures. 

The performance of the hedges, and whether the objectives of the hedges were met. 

 

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  • Posted on : April 06th, 2019
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