What You Don't Know Can Hurt You:

Price Volatility and Hedging with Futures

by

Charles Tooman

Charles Tooman is a risk management associate based in Denver, Colorado. He has masters degrees in economics and political science, with an emphasis in international political economy. He retains the copyright of this paper. Contact him at ctooman@aol.com. 

Abstract

Although futures are widely used in the mitigation of price risk, using futures without a clearly defined risk management strategy can threaten the accomplishment of a firm’s long-range objectives. Specifically, futures may not always be the most appropriate choice when attempting to reduce risk and keep transaction costs low when considering extreme price volatility. Measures that address operation and price risk are central to an effective overall trading and risk management program. Such risk management guidelines and limits provide an important framework within which transactions may be executed and business opportunities considered.

 

The role of risk management has evolved dramatically in the last two decades. Risk management has expanded its role from “in-house police” to a role concentrating on overall portfolio management (Shirreff). As a result of this evolution, more and more companies have elevated their risk management teams to positions of prominence at the corporate level. This in turn has led to the development of a risk-savvy culture at the highest levels of business. Not coincidentally, this change has been accompanied by an unprecedented growth in the tools that risk managers use to both mitigate risk and optimize profits. Specifically, growth in the market for financial derivatives has paralleled the changing role of risk management; derivatives are a multi-trillion dollar market at least in part because futures, swaps, options and other more exotic financial tools play a significant price risk mitigation and portfolio optimization function.

The evolution of risk management has been characterized by the intersection of traditional risk mitigation and overall portfolio optimization. More than ever, risk management teams now recognize two primary sources of risk - price risk and operation risk - to most effectively address both hedging needs and portfolio optimization. Stated differently, the “who,” “what,” “when,” “why,” and “how” of derivatives-use (operation risk) has grown in importance in direct proportion to the increased use of derivatives to mitigate the effects of volatility (price risk). Thus, risk mitigation and portfolio optimization are separate but related risk management functions.

Commodity trading businesses have embraced the use of financial derivatives (specifically, futures) for speculative as well as hedging purposes. The natural gas industry is no exception. In fact, the volume of natural gas futures contracts traded has increased dramatically each year since the inception of the contract. This increase is due at least in part to the use of futures in risk mitigation. Risk managers use derivatives such as futures to hedge (or “offset”) transactions that, left unhedged, might result in large losses. Hedging minimizes the probability of catastrophic outcomes in the event of extreme price volatility (Collins and Fabozzi). In addition, hedging makes it possible for companies to engage in activities that might not otherwise be pursued (Siems). Insofar as the risk associated with a portfolio of hedged transactions is presumably lower than the risk associated with a portfolio of unhedged transactions, hedging risk through the use of derivatives is an important risk management function.

In addition to the mitigation of price risk, a primary risk management directive is operation risk mitigation. Generally, operation risk guidelines address allowable business practices and processes through the establishment of an overall risk management schema. Specifically, operation risk is mitigated through clear articulation of permissible activity, and the establishment of a strong risk management culture at the macro- (business-wide) and micro- (transaction) level. At the macro-level, allowable business activity is regulated through general guidelines and principles (or an “operating band”) established by the risk management desk. At the micro-level, limits and controls are established on a business unit and individual basis. Some of the most familiar limits and/or checks on activity include net and absolute value volume limits (whether in MMBtu’s, barrels or megawatts), loss limits of various time horizons, and daily (and intra-day) value-at-risk computations. In addition, mark-to-market accounting of all transactions is the trading industry standard, as is individualized documentation of allowable activity. In the aggregate, these measures create a strong risk management culture and ensure risk mitigation and compliance. In short, the importance of operation risk management measures has grown as the use of derivatives by traders and risk managers alike has grown.

As the traditional roles of price risk abatement and portfolio optimization have merged, so have price and operation risk mitigation functions. This is true whether one is determining an overall business strategy, or a particular hedging plan. In particular, risk managers must choose the most appropriate hedging strategy with both risk mitigation and portfolio optimization in mind, especially when considering price volatility.

As risk management teams and their functions become more prominent, the intersection of risk management and portfolio optimization is guaranteed. The intersection of these tasks is most apparent during periods of market volatility; the need for flexible strategies that attend to price and operation risk, as well as portfolio optimization, is most apparent during periods of market volatility. Strategies that address these sources of risk and the overall profitability of the portfolio are central to successful risk management.

Derivatives (in particular, futures) are a valuable part of any business risk management hedging strategy. However, there are real costs to using futures in the context of price volatility. To the extent that large losses may be associated with the use of futures for hedging, how and with what tools a hedge is constructed is the concern of risk management. For example, managing price risk with futures contracts carries overhead. One such overhead cost is related to the capital required to maintain futures margins accounts (Kase). Maintenance or variation margin is the cash transfer that takes place in most futures markets after each trading day (and sometimes intra-day) to mark long and short positions to the market. Unlike a forward contract that settles only when the contract matures, most futures contracts are settled daily by the payment of variation margin from the party who has lost money that day to the party who has made money. Therefore, in addition to potential outright hedging losses, there are other non-trivial costs to consider when hedging with futures contracts in an environment of market volatility.

Finally, hedging presumably allows one to be indifferent to volatile price movements. Stated differently, by acting as a temporary substitute for a transaction that must take place in the cash market at a later time, futures hedges are employed so as to reduce profit uncertainty and take advantage of price risk. However, this strategy presumes that price movements in the physical (cash) market resulting in a loss will be offset by a corresponding gain in the futures market. Yet in the event that cash market movements do not mirror movements in the futures markets perfectly over the life of a hedge, large and unforeseen losses (exacerbated by the payment of margin monies) may result. That is, when prices in the physical (cash) market do not track perfectly with prices in the financial market, the hedge becomes costly and less effective.

The following example will reveal the importance of using price and operation risk management policies and procedures to combat price volatility. In fact, the example will show that hedging strategies combined with operation risk guidelines most effectively address extreme market movements and potential catastrophic outcomes. Consider the following example from the natural gas industry:

1. On September 23rd, Trader A buys Northwest Rockies fixed-price natural gas for January, 1997 delivery.¹

2. To hedge the fixed price obligation related to this transaction, the risk management desk sells 15 January futures contracts at a price of $2.316.

3. Appendix 1 shows the mark-to-market log of the 15 short futures position from inception (September 23rd) to settlement (December 24th).

By examining the life of the January 1997 natural gas contract, one can see the dilemma facing the risk manager who hedged this January transaction using futures contracts. Chart 2 shows the characteristics of the January 1997 natural gas contract across time. The contract shows considerable price volatility beginning after approximately March 26. In fact, the contract price history appears to have two very different “price periods.” The first price period (from the contract inception through approximately March 26) shows a contract with fairly stable price movements and a mean of $1.9962. The second price period (from March 27 through the contract termination) shows a contract with extremely volatile price movements and a mean of $2.6189. Note that as futures prices continued to increase, the loss on the futures hedge also increased (Appendix 1 reveals the mark-to-market loss related to this particular hedge). In addition to outright losses on futures contracts, this price movement necessitated multiple payment of margin monies.²

Although the volatility of this contract is apparent from Chart 1, one can quantify the difference between the two groups or periods of price data statistically. A paired-samples t test reveals that these price groups are seemingly from two different, unrelated price distributions.³ Stated differently, the two sets of prices are so disparate that they seemingly are unrelated to one another. This finding suggests that this price movement was exceptional, and probably unforeseen by Trader A or the risk manager. Therefore the hedge (entered early in the life of the January 1997 natural gas contract) yielded significantly different results than expected when the contract terminated.

In addition, a very strong correlation between the required margin per contract and price is reflected in Chart 3. This correlation (92%) reflects an almost one-to-one relationship between price movements in the January contract and the margin requirement for the contract. This relationship is consistent with the thesis that volatility leads to potentially high hedging costs, as well as costs related to the required margin. Finally, Chart 3 shows the relationship between trade equity and mark-to-market price. In the context of this example, as the mark-to-market price increased (and became more volatile), the total trade equity decreased (and became more volatile). This elementary relationship further shows the effect that volatile prices can have on a hedge and on the total value of a transaction.

While this is a stylized example, it is representative of the potential cash obligation associated with a futures hedge during extreme price volatility. These results are important insofar as evidence from recent financial engineering literature suggests that volatility of a time horizon of longer than a few days is difficult to forecast (Christoffersen, Diebold, Schuermann). Indeed, volatility forecastability seems to decline quickly with horizon and seems to disappear altogether beyond horizons of ten or fifteen trading days (Christoffersen, Diebold, Schuermann). Alternative forecasting methods, such as extreme value theory, are most appropriate when considering long-term volatility and, specifically, price events in the “tails” of the distribution. In the absence of accurate forecasting methods, how can we hedge appropriately, and how can we choose the most appropriate tool with which to hedge? This question is very important insofar as traditional risk management tools do not accurately forecast certain volatile price events.

Clearly, limits and checks on trading activity that protect a company from questionable transactions are important risk management tools. For example, price movement limits (a risk management tool often associated with speculative transactions) may be used to evaluate futures hedges. Price limits represent a “pain threshold,” beyond which the merits of a transaction may come into question. As portfolio optimizers, risk managers must take into consideration price movements that undermine the profitability of the primary as well as hedge portion of a transaction. Parameters or limits are not necessarily intended to restrict or curtail potential revenue-generating activity. However, a risk manager must act as an independent evaluator of the company’s business activity by overseeing the risk profile of each trader, as well as trading activity in total, with particular attention paid to the potential risks and rewards related to any specific transaction. These guidelines and limits are applicable to speculative trading positions, as well as hedges in the context of a volatile market. This is especially true to the extent that periods of price volatility are extremely difficult to forecast. Thus, operation risk measures may be used to protect hedges from volatile price movements.

Insofar as risk management is concerned with extreme events that are not easily forecasted, the need for limits on all unhedged as well as hedged transactions in a portfolio is clear. While some companies have reduced their futures hedging activity as a result of unexpectedly large losses, leaving transactions unhedged is a strategic decision to be entered into cautiously. Rather than leaving transactions unhedged, volatility can be controlled by constructing business obligations with pricing optionality so as to reduce the need for potentially unprofitable hedging. Indeed, creating customized contracts that do not expose a company to excessive risks represents an important development in financial engineering (Tufano).

The use of derivatives by risk managers has increased dramatically in the last two decades. Financial derivatives are central to both portfolio optimization and risk management. As risk management teams and their functions have become more prominent, the language of derivatives has become more familiar at the highest levels of business. This has assured the development of a risk-savvy culture throughout all levels of trading companies, and continued growth of the market for financial derivatives.

Although futures are widely used in the mitigation of price risk, using futures without a clearly defined risk management strategy can threaten the accomplishment of a firm’s long-range objectives (Siems). Futures may not always be the most appropriate choice when attempting to reduce risk and keep transaction costs low when considering extreme price volatility. Therefore, measures that address operation and price risk are central to an effective overall trading and risk management program. Such risk management guidelines and limits provide an important framework within which transactions may be executed and business opportunities considered. In general, all relevant costs must be considered before using derivatives for hedging or speculating. One must consider the opportunity cost of holding futures contracts used to hedge existing business obligations, whether or not the underlying investment is “in the money.”

Footnotes

Footnote 1: To complete this hedge, Northwest Rockies Basis would have also been sold.

Footnote 2: Refco provided historical data.

Footnote 3: A paired-samples t test compares the means of two groups for a single variable. The test computes the differences between the values of the two groups and tests if the average differs from zero. The "Data Split" Point on Chart One represents the point at which two groups of prices were established. See Appendix 2 and Appendix 3.

References

Christoffersen, Peter F., Diebold, Francis X., Schuermann, Til “Horizon Problems and Extreme Events in Financial Risk Management.” Federal Reserve Bank of New York Economic Policy Review, Oct 1998, v4 n3, p109 (10).

Collins, Bruce M., and Fabozzi, Frank J. “Derivatives and Risk Management: A Tool to Bridge Investment Portfolio, Portfolio Risk, and Strategy Implementation.” Journal of Portfolio Management, May 1999, p16 (1).

Kase, Cynthia “Hedging without Futures.” National Petroleum News, Oct 1993, v85 n11,p86 (1).

Shirreff, David “The Rise and Rise of the Risk Manager.” Euromoney, Feb 1998, n346, p56 (5).

Siems, Thomas F. “10 Myths About Financial Derivatives.” Cato Institute, [CD ROM]. Available: Current Issues SourceFile. Record: S001-12.

Tufano, Peter “How Financial Engineering Can Advance Corporate Strategy.” Harvard Business Review, Jan-Feb 1996, v. 74 n1, p136 (11).

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