Financial Services in Laguna Beach, CA
During the years of Three Lake’s tenure in the industry, we have come across many areas of hedging needs for our clients which are either users or producers of commodities and/or financial products. While Three Lakes Advisors does the execution and set up of the hedge transactions and accounts, we strongly advise that you work with a hedge consultant or hedge advisory specialist who can analyze your business cash-flows and price risks and determine what the best strategy would be and if hedging is even necessary in your specific case. We have resources and contacts that we can refer you to. Some of the common areas include:
- Interest Rates: borrowers and lenders might use treasuries, eurodollar and swap futures and options contracts to hedge rising and falling interest rates and for those who wish to make a fixed rate variable or a variable rate fixed through these exchange traded futures and futures options contracts. A simple hedge would use futures contracts as a straight hedge where options on futures might be used when you want to create floor and ceiling price of the interest rate product being hedged. PLEASE READ BELOW OUR NEW SECTION ON INTEREST-RATE HEDGING CONCERNING RECENT DODD-FRANK LEGISLATION.
- Currency Risk: Companies that have operations overseas may use currency or FX futures to hedge against the currency price fluctuation of other countries.
- Energy: Companies and individuals which are users of energy wanting to lock in lower prices of heating oil, gasoline and natural gas may use energy futures and options on futures to hedge.
Example #1: A delivery company with a fleet of 200 trucks might have their largest expense in gasoline. If the Price of Gasoline is relatively “low” to the point where the company is satisfied with their current profit margins, they may want to to attempt to lock in these prices with buying futures contracts for the amount of gas they use each month going out for a period of time. Since RBOB Gasoline trades in 42,000 gallon contracts, if the delivery company uses approximately 85,000 gallons per month, they may buy 2 contracts per month for each month they want to hedge price in the future. If the price of Gas rises, then their hedge account will make money to offset their extra cash expense. If the price of Gas declines further, then they have less cash expenditure but they lose that amount in their hedge account; thus this creates a “lock” at the time the hedge is executed.
Example #2: A midstream oil company that acts as a middle man between oil drillers and oil refineries may have to buy from the oil driller, then store and insure the oil for a period of time before they sell and ship the oil to refineries or its end users (the midstreamer makes a spread and fees in this process of buying and selling). During the time that the midstream oil company has to hold the oil, they may have to hedge the price at which they bought from their supplier either by selling futures, buying put options or entering into a forward contract with their end user so they are not at extreme time and price risk. The longer they hold inventory, the longer they have to store it, insure it and have price risk. This makes hedging a potentially crucial part any logistics company like this, that deals in physical commodities such as crude oil.
- Grains, Meats and Softs: Crop farmers (producers) that grow corn, wheat and soybeans know that at the end of their growing season they must harvest their crop and usually sell it to an elevator which will buy their crop for cash. If the crop farmer sees that prices are unusually high (and happy with their profit margins at those prices) due to varying market forces, they may want to sell futures contracts with the “futures month” being around the time they harvest and sell to the elevator so that if prices decline, they would make money in their hedge account to offset the lower cash price they would receive at harvest. If the price continues to rise from where they shorted the commodity, they most likely receive more cash for their crop but lose money in their hedge account, thus creating a “lock” in price at the time the hedge is executed. We have seen hedging in this situation done by both the individual farm OR they ask their elevator to lock in prices for them and pay a fee for it.
A Food company like Hershey Company (Users) might buy sugar and cocoa if they feel prices are low enough where they are making a nice profit margin and want to lock in low prices for the future.
Interest Rate Hedging using Swap Futures.
Three Lakes Advisors is happy to educate and bring attention to interest rate hedgers on the affects of the Dodd-Frank legislation that just went into effect June 9, 2013 with the full enforcement of the new Dodd-Frank rules on October 1, 2013.
Traditional interest rate hedging using OTC Swap trades has just changed dramatically due to the new Dodd- Frank Act which has recently just taken effect. Hedging interest-rate risk used to be pretty simple: a company would issue debt and simultaneously enter into a custom-fit over-the-counter (OTC) interest rate swap with a financial institution. But the Dodd Frank Wall Street Reform and Consumer Protection Act has just put an end to that simplicity:
Dodd Frank now required most OTC- traded derivatives contracts to go through a clearinghouse – so all transaction are handled by a central counterparty (i.e. a Futures Commission Merchant).
The requirements which have just taken effect, pertain to end-users of swaps, such as nonfinancial companies. But now, the Chicago Mercantile Exchange’s (CME) interest rate swap futures and options are adding something else new to the mix: futures contracts which are tied to interest rate swaps that allow companies to lock in the terms of a swap for a future date.
CME Group has launched “deliverable” interest-rate swap futures in early December, 2012. The instruments will have maturities of 2 years, 5 years, 10 years and 30 years to start, with calendar-quarterly contracts. At maturity, the futures contract will convert into the underlying interest-rate swap of the selected tenor. Before maturity or delivery of the swap futures contract, the holder could offset the contract and/or roll over its position.
CME traded swap futures offer standardized contracts which offer more capital and transaction cost efficiency. Centrally cleared swaps and futures products will provide nonfinancial companies more options for hedging their interest-rate risk. This is a good thing, because, although bilateral OTC interest-rate swaps aren’t going away, they could get more expensive.
For example: On an OTC Swap transaction, now the end user or nonfinancial company must put up approximately 3.50% initial margin to support the trade. On a $10,000,000 notional hedge, this would equate to the company putting up: $350,000 in margin (that it did not have to put up before). In addition, the OTC transaction must be cleared through an FCM which charges transaction fees on the trade. The OTC swap trade that has been placed will tie up CFTC net capital requirements for the intermediary FCM, in which it will pass on those interest charges to the client (which potentially equates to 6% interest on approx. 10% of the initial margin posted or $2,100 APR).
With Futures, The “hedge initial margin” is about 1.3% of the notional value of the hedge (which is 50% less than the OTC Swap trade). The transaction costs for the swap trade would also be less compared to an OTC Swap trade. The added risk that you get with futures-based hedging vs. the OTC Swap trade is the “time-frame” in which you lift (or take off the hedge), which can be deemed as “time & price” risk that you don’t have with an OTC Swap transaction.