BAFI1026 - Derivatives and Risk Management Assessment Answer

Trading Objectives

I wanted to trade on the Chicago Mercantile Exchange (CME) utilizing a starting amount of $100,000 USD because I'm a treasurer for an airline. The assignment was to acquire a long position on futures contracts for energy, including the West Texas Intermediate Equity Index(WTI), in order to protect against price risk and risk exposure associated with buying 10,000 barrels of jet fuel oil. 70% of the $100,000 was utilized to hedge WTI, and the remaining 30% was invested in gold and the S&P 500 Mini to speculate on energy futures. By speculating, I hoped to make a small profit while reducing the risk associated with potential changes in the price of jet fuel oil in the months to come. My position on hedging would be unaffected by any risks taken.;

First, I wanted to test out the CME software and transactions, and second, I wanted the price of jet fuel to go down so I could theoretically buy more jet fuel for less money. This would enable me to boost my futures trading on the Chicago Mercantile Exchange and, in turn, enable me to use my hedging techniques to limit any losses in Jet Fuel Oil. I've been trading Gold and the S&P 500 Mini to make a little money in the interim.

Summary of Hedging Strategy

A sort of derivative transaction is a futures contract, which is a written agreement between a buyer and a seller of a certain commodity item that enables them to foresee the asset's price at a future date (Jarrow & Oldfield, 1981). This derivative product's objective is to purchase the asset for less money than it would have cost on the execution date. By having an opposite position in similar assets, the trading method known as "hedging" seeks to reduce the risks associated with financial assets (Schrand, 1998). For the trading session, this would relate to the fact that since Equity Index and jet fuel have a high degree of similarity, they provide good hedge options. Hedging is distinct from speculating, another trading strategy. buying assets to profit from price fluctuations over a brief period of time, enabling people to generate modest profits while hedging.

I looked at all the options for hedging the risk associated with the price of jet fuel before starting my hedging and decided to use energy futures, namely, with about 80% of my original balance. WTI, one of three benchmarks for oil pricing, is the naturally occurring petroleum product that is later converted into other petroleum products, such as Jet Fuel (EIA, 2022). As a result of their strong correlation and the fact that one comes from the other, the Equity Index serves as an indicator for the position of Jet Fuel. Instructions for the task of hedging were provided on my contracts, to take a long position. In order to feel at ease and comprehend the CME's trading system, I bought 1 WTI Equity Index contract during the in-person trading session.;

As previously stated, on August 18, 2022, at the face-to-face trading session, I decided to take a long position on 1 contract of WTI Equity Index at a price of $87.75 for delivery in October 2022. (Appendix 2). This purchase represented about 9.13% of my $100,000 CME balance because we were told to use the "Margin Required" rather than the actual contract value. This contract had a value of $87,750, but it needed a margin of $9,130 for each contract.

As I want to acquire Jet Fuel in three months, it would be advantageous for the asset's price to drop. This would let me buy it for a lower cost and use the money left over to protect against any potential losses. Later that day, when I flattened and then completed my initial trade, the price of the WTI Equity Index had dropped to $87.47, thus I had lost -0.28%.;

I decided to open a new long position on August 31st, 2022, by purchasing 8 WTI Equity Indexcontracts at a trading price of $88.61. (appendix 3). This was equivalent to 75.6% of my remaining amount of $100,000, with a margin of $75,680. After these two purchases, I had about $15,000 left over.;

Market risk—a situation in which investors suffer losses as a result of variables impacting the performance of a whole financial market—was one of the key hazards I was exposed to when trading. This is the situation because WTI, which has various uses, is more in demand than Jet Fuel Oil. Due to the fact that it is bought by a wider range of investors than Jet Fuel, which is often purchased by airline firms and their affiliates, Equity Index is also traded more frequently on the market. The possibility of losses resulting from my failure to adequately hedge against the price of jet fuel on the futures market was another consideration, known as basis risk (Chen, 2020).

I had to slow down my hedging of energy futures in order to avoid losses if jet fuel costs rose. The prices fluctuated between $86 and $89 over the trading time, so my goal was to buy them when they were at their cheapest. This technique worked since I raised my balance to $104,500 at the close of trading on August 31st, 2022. (Appendix 1).;

Though I went into this trading session with a very cautious and risk-averse mindset, I think if given another chance I could have made far higher earnings. In addition, I would do more thorough study and wait until prices were at the best point for buying.;

Summary of Speculation Trading

The main objective of speculating is to make tiny, quick profits by taking advantage of changes in market price (Fisher, Wood & Monahan, 2019). Gold is a speculative asset because its value doesn't fluctuate over time, but you can make minor profits in the short term. This is true of the S&P 500 Mini, which enables investors to make predictions about the index's future value. With $15,000 still available for speculation, I bought two Gold contracts at a margin of $7,920 each. Since I only intended to buy one Gold contract, I unintentionally spent more than $100,000 because I also bought one S&P 500 Mini contract for $2,640. Even if it only yielded marginal earnings for;

I realise that I should have been more cautious when trading to avoid repeating these errors. I would do further research on trading tactics and other contracts, such trading in cryptocurrencies, in the future. As an insurance policy against potential losses in the energy futures market, these purchases did not prove to be as effective as I had hoped.

Appendix 1

Appendix 2

Price at 18th August 2022, 1 long position WTI Equity contract;for October 2022 at $87.75;

Appendix 3

References

[1] Catherine M. Schrand & Haluk Unal, 1998, ‘Hedging and Coordinated Risk Management: Evidence From Thrift Conversions’, The Journal of Finance, Vol. 53, Issue 3, pp 979-1013, https://repository.upenn.edu/cgi/viewcontent.cgi? article=1084&context=accounting_papers;

[2] CME Group, 2022, ‘Trading Simulation’, CME Group, https://www.cmegroup.com/trading_tools/simulator;

[3] James Chen, 2020, ‘Basis Risk’, Investopedia, Stock Trading Strategy and Education, https://www.investopedia.com/terms/b/basisrisk.asp#:~:text=Basis%20risk%20is;

%20the%20potential,concern%20than%20with%20others%20assets.;

[4] Jill A. Fisher, Megan M. Wood & Torin Monahan, 2019, ‘Speculating on precarious income: finance cultures and the risky strategies of healthy volunteers in clinical drug trials’, pp 464-484, https://doi.org/10.1080/17530350.2020.1850504;

[5] Robert A. Jarrow & George S. Oldfield, 1981, ‘Forward Contracts and Futures Contracts’, Journal of Financial Economics, Vol. 9, Issue 4, pp 373-382, https://doi.org/10.1016/0304-405X(81)90004-0;

[6] U.S Energy Information Administration,2022, ‘Oil and Petroleum Products Explained’, Independent Statistics and Analysis.

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