5. “BASIS RISK” AND HEDGE ACCOUNTING When hedging, it’s important that the derivative is closely matched to the underlying commodity. One reason for the success of the LME metals’ contracts is that much of the physical metals business worldwide is priced basis the official LME Settlement, so an LME price hedge covers the market price risk, and the physical premium adjusts for quality, grade, shape and location.

“Basis risk” is the difference between the price performance of the commodity and the hedging instrument, often due to differences in specification, location, currency and hedge timing.

Some hedgers may take basis risk to gain another advantage, e.g. an airline hedging jet fuel purchases using WTI crude oil derivatives, i.e. taking the crack spread, quality and location risks in exchange for the greater liquidity, depth and sophistication of WTI derivatives.

It’s essential to involve physical participants in the design and adoption of new commodity derivatives, because a contract which is used as the basis for physical pricing has an in-built flow of business which then can attract speculative liquidity.

Back in the late 1990s, some car companies embarked on significant 10 year forward aluminium hedge programs because environmental concerns encouraged the use of lightweight, but found that volatility of their derivative hedge positions impacted the P&L. US accounting standards FASB 133 allowed that, provided hedge positions were assigned to physical exposures and offset the underlying physical exposure by 80%-125%, the volatile derivative MTM swings could stay off the earnings statement.

US car companies were using the LME primary aluminium price to hedge aluminium alloy car parts in the US Mid-West, so encouraged the LME to launch a North American Special Aluminium Alloy Contract. Efforts to reduce basis risk also led to the growth of the OTC Mid-West aluminium premium (allowing hedgers to lock in the US location premium) and the launch of the NYMEX primary aluminium contract for the US market.

Source: LME / Reuters / ADMISI

6. “PUT/CALL PARITY” AND THE “BUILDING BLOCK” APPROACH TO DERIVATIVES A wide range of hedging strategies can be replicated using the “building blocks” of futures, call and put options, and delta is key to how they work.

This pay-off diagram 2 shows long and short positions for LME copper call and put options, (basis a market price of $5700/Mt, 3months to expiry, 16% volatility).

Note the delta at maturity, moving from left to right on the x-axis, e.g. a long call option has a delta of 0% rising to +100% as the market price increases, whereas buying a put has a delta of -100% increasing to 0%, and different strategies can be made by combining deltas.

Put – Call Parity At first glance, put and call options look very different. However, a call option can be replicated exactly through the purchase of put option of the same strike and the purchase of a forward:

Long Call = Long Forward + Long Put (same strike) These are identical so will have the same value, also: Long Call + Short Put (same strike) = Long Forward

Diagram 2

Chart 7

Source: LME / Reuters / ADMISI

18 | ADMISI - The Ghost In The Machine | Q1 Edition

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