Quiz - Hedging

A) John Dingleheimer must deliver 1MM barrels of oil each month for the next 12 months and would like to hedge his price risk. Should he utilize a stack hedge or a strip hedge and why? B) Describe an advantage and a disadvantage of each of the two methods.

Stack hedge? to reduce his transaction cost :expressionless:

Stack Adv: 1) can rebalance easily 2) Less transaction cost

I will say strip. It is a better match to the risk, since the price fluctuation can be very high during the entire contractual period. Stack may be failed to hedge out the market risk, or you will have to rebalance all the time which increases transaction costs.

Boris_7 Wrote: ------------------------------------------------------- > I will say strip. > > It is a better match to the risk, since the price > fluctuation can be very high during the entire > contractual period. Stack may be failed to hedge > out the market risk, or you will have to rebalance > all the time which increases transaction costs. Best answer so far - in short, there’s no “right” answer; it depends on whether he’s more interested in getting the cheapest hedge or the hedge with minimum basis risk.

The textbook touches on an oil hedge example in one of the blue boxes…they were using stack and ultimately had to unwind it because of the losses, but that was over a 10 year hedge if I recall. I think reading 38?

well actually that is what i am doing everyday. by doing strip i know almost all of my risk and pay-off at front. we are all ambiguous aversion, well i mean my boss is. :smiley: this is just a textbook question. in reality, it is always strip. it is ok to have some more expenses at front, but nobody can afford to lose big during the contractual period. tell risk management about that.

stack would be partially betting, correct Boris?

Yes you are betting the forward curve flat or monotone, which never happened in commodities. not like interest rates, as long as there is seasonality, forward curve will not be monotone. If it is a short period one, let’s say 2-3 months multiple deliveries, maybe you can do stack. For those longer than 1 year, it is automatic. remember 2008? in the middle of that year, oil hit 147? the info people usually omitted is the curve. it is not a typical contango, but peak in the middle, low in both tails. if you do stack, your hedge didn’t move, while spot is killing u. thanks for remind me this. I will add forward curve risk to my answer. also a smaller question is accounting. a trade needs to meet certain criteria to be qualified as hedge. all gain/loss from hedge are not in income statement but reported as oci in balance sheet. if the hedge is deemed ineffective, we need to eat the loss in current q’s earning. i hate risk management. i hate accountants even more. :smiley: Sponge_Bob_CFA Wrote: ------------------------------------------------------- > stack would be partially betting, correct Boris?

My first reaction to the question was to say strip hedge, because of the textbook example, but the 1 year was what gave me pause…didn’t know if it qualified as short period of time. Thanks for info.

hey guys, sorry for this question, but what is strip and what is stack? :(( any plain explanations would be welcome. thanks, M.

malek_bg Wrote: ------------------------------------------------------- > hey guys, > > sorry for this question, but what is strip and > what is stack? :(( > > any plain explanations would be welcome. > > thanks, > M. We could all explain it very clearly, but that’d be doing you a disservice. Check out reading 38.c.