" Strip hedges and stack hedges are prevalent in industries where producers sign agreements to deliver amounts of oil or other commodities in a sequential fashion. For example, an oil producer might have signed an agreement to deliver a fixed amount of oil each month for the next year. One method of hedging the price risk is to immediately go long in a series of forward contracts (i.e., a strip hedge) with delivery dates and amounts matching the agreement. In this fashion, the producer effectively locks in the monthly forward curve for the next year. Bid-ask spreads tend to widen as the contract maturity increases, however, because longer-term contracts can be very thinly traded (or even non-existent). This can make the strip hedge costly or even impossible to implement. To help reduce transaction costs, the oil producer might instead utilize a stack hedge. To form a stack hedge, the oil producer would enter into a 1-month futures contract equaling the total value of the year’s promised deliveries. As transactions costs are less for short-term (e.g., 1-month) contracts, the total cost of implementing this strategy is less than for a comparable strip hedge. At the end of the first month, the producer rolls into the next 1-month contract, and so forth, each month setting the total amount of the contract equal to the remaining promised deliveries. This strategy of continually rolling into the next near-term contract is referred to as stack and roll."
I always thought rolling short term futures has higher transaction cost, don’t they?
Normally when you think of rolling short-term futures as having a higher transaction cost, you’re comparing that to a one time long-term future. In that case, yes, the relatively small transaction costs of the ST futures will usually outweigh the one large LT future transaction cost. But in the case of a strip hedge, you’re actually purchasing multiple long-term futures, each with an increasingly larger transaction cost as maturity increases (in theory, of course. In reality, these futures probably don’t exist, I’m guessing).
So for the purposes of the original post, a strip hedge has multiple transaction costs ranging from ST all the way to LT for the longest maturity, whereas a stack hedge has multiple transaction costs but only for ST contracts. As a result, the stack hedge should have smaller costs overall.
Probably just to lock in the current yield curve. With a stack hedge, the ST futures you purchase down the road may be unfavorably priced relative to today’s prices. With the strip hedge, you guarantee today’s LT futures prices at the cost of heavy transaction costs.
Perfect strip hedge matches forwards with all liabilities cashflow. For stack, the underlying’s maturity won’t match the liability. See Metallgeschaft for real life case study.