• Internal Code :
  • Subject Code : MAF308
  • University : Deakin University
  • Subject Name : Derivatives Securities

Part C

Question C1

Future contracts are most common technique applied to hedge risk. The main objective of any company or investor is to use the future contract for minimize their risk exposure and restrict themselves from any changes in the price of underlying security. In other words, it can be said that investors by using the future contract offset their risk associated with security.Hedging and speculation are two different aspects. Future contract can be used for hedging as well as speculation. In hedging, the investors minimize their risk exposure connected with the price fluctuation and in speculation investor try to earn return due to the change in price. Future contract means a contract between two parties to purchase or sell of an asset at an agreed time for a specified price (Martínez, and Torró, 2018). The price is determined at the time of entering into the contract. If an investor wants to purchase a particular asset in the future period, then he/she can enter into the future contract at present at a particular price. If in case, the price of asset in the future is more than the price at which contract entered for purchasing the assets, then he/she minimizes their risk against the price fluctuation.  The main benefit of entering into the future contract is that it mitigates any uncertainty about the future price of assets (Wang, Wu, and Yang, 2015). On the other hand, if the investor is expected that price of the particular assets is high, then in such case they can sell their assets and wait for reduction in the price of assets, at which they can purchase the assets and earn the profit. Overall, it can be said that investors try to attempt minimize the risk as much possible by entering into the future contract. 

Question C2

The fundamental aspect of hedging is related with reduction of risk exposure by taking an offsetting place in the market. In such situation company try to mitigate the fluctuation in the prices of an asset by entering into the opposite position to what it have presently (Cifarelli, and Paladino, 2015). On the other hand, speculation means attempting to generate the profit due to the change in the prices of security. Moreover, in the hedging hedger make the effort to reduce risk connected with uncertainty, while in the speculation, speculator bet against the movement in order to earn profit because of the changes in the price of security (Ekeland, Lautier, and Villeneuve, 2019). Therefore, it can be said that hedger are the risk averse, while speculators are the risk fans. In the present case, it is questionable whether MG was engaged in hedging or speculation. It has been observed that MG established the long energy futures and Swap position as it is expected that price will rose in the future and by this it can generate the profit. However, because of the dropping in the prices, MG incur huge amount of loss. If they used hedging, then due to the change in price, there position would be indifferent. The reason behind the same in that in hedging, company take the opposite position in the derivate market in order to reduce the risk exposure from the fluctuation in prices (Furqan, and Mirza, 2015). By taking the contrary position, the impact on price would be set off, which leads to indifferent to a change in prices (Jiao, Klopfenstein, and Tankov, 2017).  In the present case, since MGRM were used indirect hedging of their forward position, therefore it was not indifferent to the price movement of oil. By using this, they unprotected themselves to funding risk and therefore it can be said that they were speculating. Further, by entering into fixed rate forward contract of 160 Million barrels of oil, they speculate their position. 

Question C3

In the hedging, there is possibility that mismatch can occur in assets or in delivery period, and due to this risk arises. This type of risk is referred as basis risk.  Basis risk that arises from mismatch is not written. This will further impact on imperfection of hedge contract therefore losses in an investment are not precisely counter off hedging strategy (Hull, 2016). For example, if an investor hedge the three year bond with the purchase of Treasury bill, then there is risk that price of the Treasury bill and Bond will not fluctuate in the same manner, then it is known as basis risk rose due to mismatch in assets. On the other side, if an investor wants to hedge 3 year bond with same maturity period, but in case if it is not available, then he/she may enter with different time period. Both situations, leads towards the imperfection of hedge contract, by which risk associated with change in price cannot be mitigated precisely by hedging strategy. Moreover, in case of large investment, this risk makes the significant impact on probable profit or losses (Martínez, and Torró, 2018). In case of hedge, if the base will remain constant until the trader closes out both of his position, then he can attempt successful market position. On the other hand, if basis has varies significantly, then it may assist in large profit or losses. By considering the above analysis, it has been seen that risk due to mismatched in assets or delivery period in a hedging strategy will not offset its entire position because of the change in price (Mayer, Packham, and Schmidt, 2015). 

References

Cifarelli, G. and Paladino, G., 2015. A dynamic model of hedging and speculation in the commodity futures markets. Journal of Financial Markets, 25, pp.1-15.

Ekeland, I., Lautier, D. and Villeneuve, B., 2019. Hedging pressure and speculation in commodity markets. Economic Theory, 68(1), pp.83-123.

Furqan, M. and Mirza, N., 2015. MOTIVES BEHIND THE USE OF DERIVATIVES: HEDGING OR SPECULATION?. Pakistan Business Review, 17(2), pp.450-461.

Hull, John C. 2016, Fundamentals of Futures and Options Markets, Global Edition (8e), Pearson Higher Ed USA, P73

Jiao, Y., Klopfenstein, O. and Tankov, P., 2017. Hedging under multiple risk constraints. Finance and Stochastics, 21(2), pp.361-396.

Martínez, B. and Torró, H., 2018. Hedging spark spread risk with futures. Energy policy, 113, pp.731-746.

Martínez, B. and Torró, H., 2018. Hedging spark spread risk with futures. Energy policy, 113, pp.731-746.

Mayer, P.A., Packham, N. and Schmidt, W.M., 2015. Static hedging under maturity mismatch. Finance and Stochastics, 19(3), pp.509-539.

Wang, Y., Wu, C. and Yang, L., 2015. Hedging with futures: Does anything beat the naïve hedging strategy?. Management Science, 61(12), pp.2870-2889.

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