Question

It is now October 2016. A company anticipates that it will purchase 1 million pounds of copper in each of February 2017, August 2017, February 2018, and August 2018. The company has decided to use the futures contracts traded by the CME Group to hedge its risk. One contract is for the delivery of 25,000 pounds of copper. The initial margin is $2,000 per contract and the maintenance margin is $1,500 per contract. The company's policy is to hedge 80% of its exposure. Contracts with maturities up to 13 months into the future are considered to have sufficient liquidity to meet the company's needs. Devise a hedging strategy for the company. (Do not make the adjustment for daily settlement described in Section 3.4.) Assume the market prices (in cents per pound) today and at future dates are as in the following table. What is the impact of the strategy you propose on the price the company pays for copper? What is the initial margin requirement in October 2016? Is the company subject to any margin calls? Date Oct. 2016 Feb. 2017 Aug. 2017 Feb. 2018 365.00 377.00 Spot price Mar. 2017 futures price Sept. 2017 futures price Mar. 2018 futures price Sept. 2018 futures price 372.00 372.30 372.80 369.00 369.10 370.20 370.70 364.80 364.30 364.20 376.70 376.50

Answer 1

To hedge the February 2017, purchase the company should take a long position in March 2017 contracts for the delivery of 800,000 pounds of copper.

The total number of contracts required is:

8,00,000/25,000 = 32

Similarly, a long position in 32 September 2017 contracts is required to hedge the August 2017 purchase.

For the February 2018 purchase the company could take a long position in 32 September 2017 contracts and roll them into March 2018 contracts during August 2017.

As an alternative, the company could hedge the February 2018 purchase by taking a long position in 32 March 2017 contracts and rolling them into March 2018 contracts.

For the August 2018 purchase the company could take a long position in 32 September 2017 and roll them into September 2018 contracts during August 2017.

Hence, the strategy can be:

Oct 2016:       Enter into long position in 96 Sept. 2017 contracts

Enter into a long position in 32 Mar. 2017 contracts

Feb 2017:      Close out 32 Mar. 2017 contracts

Aug 2017:     Close out 96 Sept. 2017 contracts

Enter into long position in 32 Mar. 2018 contracts

Enter into long position in 32 Sept. 2018 contracts

Feb 2018:      Close out 32 Mar. 2018 contracts

Aug 2018:    Close out 32 Sept. 2018 contracts

With the market prices shown the company pays (for copper in February, 2017):

369.00 + 0.8 x (372.30 - 369.10) = 371.56

And, it pays 365.00 + 0.8 x (372.80 - 364.80) = 371.4 for copper in August 2017.

For February 2018 purchase, it loses 372.80 - 364.80 = 8.00 on the September 2017 futures

and gains 376.70 - 364.30 = 12.40 on the February 2018 futures

Hence, the net price paid is:

77.00 + 0.8 x 8.00 - 0.8 x 12.40 = 373.48

For the August 2018 purchase is concerned, it loses 372.80 - 364.80 = 8.00 on the September 2017 futures and gains 388.20 - 364.20 = 24.00 on the September 2018 futures.

Hence, the net price paid is:

388.00 + 0.8 x 8.00 - 0.8 x 24.00 = 375.20

The hedging strategy succeeds in keeping the price paid in the range 371.40 to 375.20.

In October 2016 the initial margin requirement on the 128 contracts is:

128 x $2,000 o = $256,000

There is a margin call when the futures price drops by more than 2 cents.

This happens to the March 2017 contract between October 2016 and February 2017, to the September 2017 contract between October 2016 and February 2017, and to the September 2017 contract between February 2017 and August 2017.

Please note: Under the plan above the March 2018 contract is not held between February 2017 and August 2017, but if it were there would be a margin call during this period.