Strip Hedge vs Stacked Hedge
Suppose a firm faces a series of dates (or periods) during which it faces price risk. That is, it has a year (or longer) of production. It can:
Use a strip of future contracts, each with a different delivery date.
Use a stack hedge, in which the most nearby and liquid contract is used, and it is rolled over to the next-to-nearest contract as time passes.
An oil distributor agrees to deliver $1mn of crude oil in each of the next 10 years, at a fixed price from 1st Jan, 2011. The firm faces the risk that crude oil prices will ___ (rise or fall?), and therefore will enter into a ___ (long or short?) hedge.
At the initiation of the contract i.e. 1st Jan, 2010, the firm can hedge its position by:
Trading contract of $1mn for delivery in each of the next 10 years (This process is known as a strip hedge)
Trading contracts worth $10mn in Jan, 2011. Then, in 2012, offset the 2011 contracts and trade $9mn worth of 2013 contracts. Then, in 2013, offset the 2012 contracts and trade $8mn 2014 contracts and the process goes on till next 2021. (This process is known as a stacked hedge.)
Metallgesellschaft Refining and Marketing (MGRM) entered into a forward contract wherein they will sell the oil for next 5-10 years at the fixed price which was higher than the spot price of the oil.
To hedge the exposure MGRM entered into stack and roll hedge because the long term futures in oil were very illiquid.
To analyze what went wrong in the strategy of MGRM which was said to be a sound strategy by experts, let us take an exhaustive set of cases to study net effect on the position of MGRM.
In effect MGRM was to have two position of say $10mn:
Short position in forwards worth $10mn of 10 different maturities at the price of $18
Long position in futures of short term maturity worth $10mn
When MGRM entered into stack and roll hedge, market was in backwardation and the spot price of oil was increasing as described by the 3rd quadrant of the figure below. The net payoff for MGRM when the stock price rose by $6 was $63.
But suddenly the oil price started to decrease due to OPECs problems sticking to quotas and market moved from backwardation to Contango. This led MGRM to the conditions of 2nd quadrant, which piled in huge losses for subsidiary.
Now in remaining two quadrants if you see, the net payoff was in between the payoff of two extremes.
To guarantee your success at passing the FRM exam at one go, follow the link to FRM Concept Checkers for many more concepts!