Types of hedging

Different hedging types
Example 1: Hedging a jet fuel purchase using futures
Example 2: Hedging a jet fuel purchase using swaps

Examples of different hedging types

Hedging involves the offsetting of price risk by taking a position in another related market. There are three main hedging strategies.

1. Self-hedging
   This hedge is the simplest. Large companies will make sure their purchases are matched up with sales and provided the sales and purchases do not move wildly out of synch, they believe they are hedged. As well as being the simplest to implement, however, such a hedge does not take any account for lags between purchases and deliveries, or the respective volatilities in the respective markets.
   
2. Hedging fixed price risk
   Hedging fixed price risk is simple. If you buy a physical commodity at, say, $30/bbl, you are exposed to any wild swing in the price. You can make dollars or lose dollars at the whim of the market. This is where futures come in. If you sell a fixed price future at $28/bbl against your physical purchase, you offset risk. If oil prices drop, you lose money on your physical purchase, but the futures would dive in line, and you would make money on the futures position. The opposite would be the case if prices rose: you would make money on the physical, and lose on the future. Another way to hedge would be to buy a put option at the strike price that you wished to lock in. This would give you the right but not the obligation to sell at a certain level, say $28.00/bbl. If the price dropped below $28.00, you would exercise the put at $28.00. In essence, you would only use your insurance if the price moved enough.
   
3. Hedging floating price risk
   Hedging floating price risk is less intuitive, but it's also simple. If your price risk is floating price, for instance if you are buying Platts related, you are also exposed to market gyrations. If you sell the oil to another party at $30/bbl, for instance, it may easily happen that by the time the cargo is priced on Platts quotations the market has moved up and you will book a loss. The way to hedge a floating price purchase is to buy a fixed price swap, and the way to hedge a floating price sale is to sell a fixed price swap. Here's how it works. Buy Platts-related and buy a fixed price swap at $30.00/bbl. If the market drops, your physical purchase will get cheaper, as Platts moves in line with the market. But you will book a loss on the swap, as although you paid $30/bbl for it, the swap will be priced out at market. The opposite happens if prices rise.

The above can be summarized in the following simple grid:

Example 1: Hedging a jet fuel purchase using futures

An airline buys jet fuel at $280/mt CIF NWE. The airline then sells gasoil futures at $250/mt on the IPE futures exchange in London.

If the CIF NWE jet fuel price drops $20.00, the original purchase price will be too high and the airline will book a loss. But the gasoil futures position should offset that by returning a similar profit: - the sale was made at $250 and the price then fell, so the airline can buy at the lower price and show a profit.

But the airline will be exposed to any change in the spread between jet fuel and gasoil prices.

In this example, the spread started at $30/mt. But if jet fuel dropped $20/mt and gasoil dropped only $10.00/mt the cash flow would be as follows:

• Jet fuel bought at $280, sold at $260/mt - loss is $20.00/mt (A)
• Gasoil futures sold at $250.00, bought at $240.00/mt - gain is $10.00/mt (B)
• The result loss is $10.00/mt (A-B). This is less than the outright change in the market, ie. $20.00/mt (A), but is still significant.

This type of risk is known as basis risk.

Example 2: Hedging a jet fuel purchase using swaps

An airline buys jet fuel basis CIF NWE with the price on a quotes-linked (that is agreeing to price based on an assessment published by Platts or a similar service). The airline hedges by buying a fixed price jet/gasoil swap at $20.00/mt. The airline also buys gasoil at the fixed price of $250.00/mt on the IPE.

If jet fuel prices drop $20/mt, the purchase price quotes-linked will be cheaper, and the airline will make a $20/mt profit. But if gasoil futures drop $10/mt, the airline will book a $10.00/mt loss on its IPE fixed-price deal. The net profit is $10.00/mt.

However, with jet at $260.00/mt and gasoil at $250.00/mt, the jet-gasoil swap bought at $20/mt can be sold at only $10/mt, offsetting that net profit of $10/mt.

If the opposite were to happen, the airline would equally offset his loss: jet fuel prices rise $20/mt, making the quotes-linked purchase more expensive and the airline will make a $20.00/mt loss on the quotes-linked deal.

However, if gasoil futures rose only $10.00/mt, the airline will book a $10.00/mt profit on that leg of the deal. The net loss is still $10.00/mt.

With jet at $280+20/mt and gasoil at $250+10/mt, the jet-gasoil swap bought at $20 can be sold at $40/mt, offsetting the $10.00/mt loss.