Question

Question 3. Assume that it is now October 2014 and a company anticipates that will need to purchase 1 million kilogram of copper in each of February 2015, August 2015, February 2016, and August 2016. The Chief Finance Officer has decided to hedge 80% of the company's exposure using copper futures. The size of one copper futures contract is 25,000 pounds of copper. The initial margin and the maintenance margin for each copper contract are $2,000 and $1,500, respectively. Contracts with maturities of up to 13 months into the future are considered to have sufficient liquidity

Answer 1

To hedge the February 2015, purchase the company should take a long position in March 2015 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 2015 contracts is required to hedge the August 2015 purchase.

For the February 2016 purchase the company could take a long position in 32 September 2015 contracts and roll them into March 2016 contracts during August 2015.

As an alternative, the company could hedge the February 2016 purchase by taking a long position in 32 March 2015 contracts and rolling them into March 2016 contracts.

For the August 2016 purchase the company could take a long position in 32 September 2015 and roll them into September 2016 contracts during August 2015.

Hence, the strategy can be:

Oct 2014: Enter into long position in 96 Sept. 2015 contracts

Enter into a long position in 32 Mar. 2015 contracts

Feb 2015: Close out 32 Mar. 2015 contracts

Aug 2015: Close out 96 Sept. 2015 contracts

Enter into long position in 32 Mar. 2016 contracts

Aug 2015: Close out 96 Sept. 2015 contracts

Enter into long position in 32 Mar. 2016 contracts

Enter into long position in 32 Sept. 2016 contracts

Feb 2016: Close out 32 Mar. 2016 contracts

Aug 2016: Close out 32 Sept. 2016 contracts

  With the market prices shown the company pays (for copper in February, 2015):

  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 2015.

For February 2016 purchase, it loses 372.80 - 364.80 = 8.00 on the September 2015 futures

and gains 376.70 - 364.30 = 12.40 on the February 2016 futures

Hence, the net price paid is:

77.00 + 0.8 x 8.00 - 0.8 x 12.40 = 373.48

For the August 2016 purchase is concerned, it loses 372.80 - 364.80 = 8.00 on the September 2015 futures and gains 388.20 - 364.20 = 24.00 on the September 2016 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 2014 the initial margin requirement on the 128 contracts is:

128 x $2,000 = $256,000

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

This happens to the March 2015 contract between October 2014 and February 2015, to the September 2015 contract between October 2014 and February 2015, and to the September 2015 contract between February 2015 and August 2015.

Please note: Under the plan above the March 2016 contract is not held between February 2015 and August 2015, but if it were there would be a margin call during this period.