HEDGING - A RISKLESS STRATEGY?


NOT REALLY Although hedging with derivatives can reduce price risk, other risks can arise from this strategy which should not be underestimated.


    generally consist of entering into an opposite position using derivatives  asset.


For example, an upstream company such as an oil producer is exposed to a drop in crude oil prices. Let’s suppose that the oil producer is producing 1 million barrels of crude oil per month and wants to eliminate  as future contracts for the equivalent of 1 million barrels per month.


 derivative is 100% correlated to the initial position (the physical asset). In reality, this is not always the case. Oil producers and any other physical  physical exposure. As soon as the correlation between the physical and  


 assumption that the above oil producer has found a derivative where the price is 100% correlated to the price of the crude oil that it is actually  the oil producer will face is to align the volume of the natural positions (number of barrels produced) and the volume of the hedge (number of futures contracts sold) perfectly in line. Volumes actually produced can  if the company produces 1.1 million barrels instead of the 1 million that was forecasted and hedged, one hundred thousand barrels will actually remain unhedged. Another challenge arises with the standardisation of the future contracts which are exchange-traded products with pre- 


As hedging can be very costly, some companies such as airlines may decide to hedge only a part of their physical exposure leaving them partially exposed to adverse price move. This strategy can end-up   third of airlines costs.


Now, let’s assume that the oil producer manages to enter in a perfect hedge by completely eliminating    gain of $1 in the short future positions which will be     going up. If crude oil prices increase by $1, this gain will be cancelled by a $1 loss on the futures positions.  receive a margin call on the day or the following morning. In a perfect world, the oil producer could sell its oil inventory to generate cash and be able to pay the margin call. In practise, this could be more challenging if the oil inventories cannot be sold on time to pay the daily margin call. In other words, the   margin call.


As highlighted in the previous example, liquidity issues are liable to arise when companies hedge illiquid assets which are subject to margin requirements. There are few case studies where companies collapsed or had to be restructured, as they could not pay margin calls as they were unable to liquidate their assets on time. Metallgesellschaft 


LIQUIDITY ISSUES ARE LIABLE TO ARISE WHEN COMPANIES HEDGE ILLIQUID ASSETS WHICH ARE SUBJECT TO MARGIN REQUIREMENTS.


14 | ADMISI - The Ghost In The Machine | May/June 2019


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