Corporate Strategies to Hedge Commodity Price Risks Applying Derivatives

Topics: Futures contract, Derivative, Option Pages: 9 (2475 words) Published: March 20, 2013
Table of contents
List of abbreviationsIII
List of figuresIII
List of tablesIII
1.1Problem and objective1
1.2Structure of this paper1
2Background Information2
2.1Definitions of fundamental terms2
2.2Commodity price risk in different firms2
3Explanation of derivatives3
4Hedging strategies with derivatives7
4.1Hedging with options7
4.2Hedging with futures7
4.3Hedging with forwards8
4.4Hedging with swaps8
5Pros and cons of hedging strategies with derivatives8
5.1Pros and cons of options9
5.2Pros and cons of futures9
5.3Pros and cons of forwards10
5.4Pros and cons of swaps10
6Practical example of corporate commodity price risk hedging10 6.1Introduction on firm's practical hedging strategy10
6.2Analysis on this strategy11
Appendix 1: Amounts outstanding of over-the-counter (OTC) derivatives by risk category and instrument——in billions of US dollar13 Appendix 2: Derivatives financial instruments traded on organized exchanges by instrument and location——in billions of US dollar14 Bibliography15

Internet Source16

List of abbreviations
CHClearing House
IMInitial Margin
MBMargin Balance
NMaintenance Margin
OTCOver The Count
YVariation Margin

List of figures
Figure 1: Structure of this paper2
Figure 2: P&L of each option position4
Figure 3: Flow chart of marking-to-market process5
Figure 4: P&L of each future position6
Figure 5: Hedging model on fuel oil of Air China11

List of tables
Table 1: Summary for 4 option positions4
Table 2: Summary for future positions6
Table 3: Summary for 4 derivatives9

1.1Problem and objective
The risk of commodity price is a ferocious topic in corporate operation. Corporate profit is equal to total revenue minus total cost. For firms, because of the high volatility on commodity price, their inputs and outputs relating to commodity are unpredictable. As a consequence corporate profit will be immensely volatile, which will possibly lead the firm to go bankruptcy if no any preventive actions are taken. For example, producers of commodities probably need to assume unexpected losses, when the price of outputs goes down or the price of necessary raw materials goes up. The situations are similar to wholesale buyers, retailers, exporters and even governments. Volatility of commodities price has great impacts on corporate daily operation. The objective of this term paper is to introduce derivative hedging strategies for corporate managers to reduce or even eliminate future unpredictability, mainly from the perspectives of the role commodity price risks play, what the typical derivative instruments are, where and how to apply these different derivatives in terms of hedging principles thereof, and both advantages and disadvantages when applying each derivative in real business transactions.

1.2Structure of this paper
Firstly, this term paper highlights problems existing in real world. Secondly, it introduces advanced derivatives theory that can be applied to solve these problems. Thirdly, specific details on the theory will be presented, including explanation, application, as well as pros and cons of each derivative instrument. Then, an example is analyzed to show how companies apply derivatives to hedge commodity risks practically. Last is a summary of this term paper. Following figure shows the body of this paper.

2Background Information
2.1Definitions of fundamental terms
In financial markets derivative is a contract or security whose value is derived from the value of other more basic underlying variables . One of its most important functions is hedging. In corporate operation, hedging is to secure the companies against potential loss caused by variable risks that arise in...
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