Question

2. Hedge Using Futures A chemical company expects to buy 500,000 barrels of oil at a spot price one year later. In futures market oil futures are available for delivery one year later and the futures price is $63 per barrel now. One futures contract is for 5,000 barrels of oil. (a) The company wants to hedge the risk of oil price in its payment. Which position and how many contracts does the company need to take? (b) The company takes the futures position found in (a). Suppose that the spot price of oil is $55 per barrel a year later. What is the payoff from futures? What is the total payment for the company? (c) Suppose that the spot price of oil is $70 per barrel a year later. What is the payoff from futures? What is the total payment for the company? (d) In (b) and (c), do we always see a positive payoff from futures? If not, what is the benefit from entering futures contract?

Answer 1

(a)

In a futures contract, the party that wants to buy the underlying asset takes the long position. Therefore, this company is going to take a long position in 100 contracts (500,000/5,000).

(b)

The party that has gone long in a futures contract is at a loss when the spot price of the underlying asset is less than the futures price. This is because the party has to now buy the asset at the agreed upon futures price when actually it could have bought it for a lesser price in the spot market.

The payoff per barrel = $55 - $63 = -$8

Total payment for the company = -$8 * 500,000 = -$4,000,000

(c)

In this case the spot price is higher and so the company is at a profit.

The payoff per barrel = $70 - $63 = $7

Total payment for the company = $7 * 500,000 = $3,500,000

(d)

No, in part (b) when the spot price was lower that the futures price, the company suffers a loss whereas when it was higher it makes a profit. The reason for entering into futures contracts is to reduce uncertainty. Futures contracts let companies lock in a price for an asset that they will require at a future date. For example, in this case the chemical company knows that it will require 500,000 barrels of oil 6 months in the future. Now, because prices tend be volatile (especially oil prices), companies prefer locking in a price right now. This helps them hedge against aggressive price increases and also helps them budget their expenses.