GF561 Unit 9 Hedge Residual Exposure Review Example

What the Crude Hedge Leaves Behind: A Unit 9 Residual Exposure Review for a Paving Contractor

[Student Name]

Purdue University Global

GF561: Derivatives and Hedging

Unit 9 Residual Exposure Review

[Instructor Name]

[Date]

The paving contractor and every figure are composite and illustrative, carried from the Unit 8 hedge design; the articles and textbook cited are real.

The Headline Figure

Before the hedge, a typical one-month move in asphalt prices, applied to the season's 54,000 tons, would swing purchase costs by about $1.51 million. With 109 crude contracts in place on the 60 percent hedged share, the combined swing of purchases and futures falls to about $1.06 million. The hedge removes about 30 percent of the season's total monthly swing, because it covers only 60 percent of the tons and only about 61 percent of the variance on those tons.

Residual 1: Basis Between Asphalt and Crude

Size. With a correlation of 0.78, about 39 percent of the variance in asphalt prices is unrelated to crude. On the 32,400 hedged tons, that leaves a monthly swing of about $17.50 a ton, or about $568,000.

Trigger. A widening of asphalt over crude, such as when refiners shift output toward higher-value products and asphalt supply tightens. A $20-a-ton widening would cost about $648,000 with nothing to offset it.

Rank. First, because it is the most likely to occur in any given season.

Residual 2: Cash for Margin

Size. A $15-a-barrel fall in crude would require about $1.63 million in margin over the period of the fall; a $25 fall, about $2.72 million.

Trigger. A crude price fall faster than the contractor's asphalt purchases can realize the offsetting savings. The $2 million margin line covers a $15 fall but not a $25 fall.

Rank. Second. It is not a loss in economic terms, since cheaper asphalt follows, but it is the largest single cash demand the program can create (Hull, 2022).

Residual 3: Volume

Size. The hedge assumes 54,000 tons. A wet season that cuts purchases by 30 percent, to 37,800 tons, still leaves purchases above the 32,400 hedged tons. A cut of 45 percent, to 29,700 tons, would leave about 2,700 tons, roughly nine contracts, hedging asphalt the contractor never buys.

Trigger. Purchases falling more than 40 percent below plan, at which point part of the futures position becomes a stand-alone bet on crude.

Rank. Third. Seasons that wet are rare but have happened twice in the past decade.

The residuals are not equally likely or equally costly: basis will move every season by modest amounts, while the margin and volume risks are rare but can each demand cash or create a speculative position larger than the basis loss in a typical year.

Residual 4: The Unhedged 40 Percent

Size. The 21,600 unhedged tons carry about $605,000 of monthly swing on their own.

Trigger. Price rises on the unhedged tons are mostly passed to the state through asphalt adjustment clauses, so the real exposure arises only if a clause's index or base month differs from the contractor's purchase prices.

Rank. Fourth, because the clauses absorb most of it.

Residual 5: Index Clause Mismatch

Size. Small, perhaps $5 to $10 a ton on affected purchases, from differences in timing between the state's monthly index and the contractor's actual purchase dates.

Trigger. A sharp price move within a single month, when the index lags the market.

Rank. Fifth.

How the Residuals Interact

The residuals are not independent. A wet season that cuts volume would usually coincide with weak demand for asphalt across the region, which tends to narrow the asphalt-to-crude spread and lower the basis loss. A crude price collapse, by contrast, would raise margin needs at the same time as it lowers the cost of the unhedged tons. Ranking the residuals separately is a starting point; the treasurer should also consider the combinations most likely to occur together, such as a crude fall during a wet spring, which would bring margin calls and over-hedging in the same weeks.

Why Residuals Deserve Their Own Review

Hedging programs are often judged by what they cover, but the risks that remain are where losses actually come from. Research on hedging effectiveness shows that cross-hedges leave substantial residual variance, and that the size of that residual depends on how closely the hedged price and the futures price move together (Ederington, 1979). Research on corporate risk management adds that firms hedge to avoid costly cash shortfalls, which is why the margin residual matters even though it is not an economic loss (Froot et al., 1993).

What Is Not a Residual

Counterparty risk on the futures is minimal, because the exchange clearinghouse stands between buyers and sellers and collects margin daily. Rollover risk is also absent this season, since each month's contracts are held only until that month's purchases and none need to be rolled forward.

Recommendations

1. Report the asphalt-to-crude spread monthly and review the hedge ratio if the correlation over the latest twelve months falls below 0.70.

2. Raise the margin line to $3 million before May.

3. Reduce futures by one contract for each 300 tons that monthly purchases run below the 5,400 hedged tons.

References

Ederington, L. H. (1979). The hedging performance of the new futures markets. The Journal of Finance, 34(1), 157-170. https://doi.org/10.1111/j.1540-6261.1979.tb02077.x

Froot, K. A., Scharfstein, D. S., & Stein, J. C. (1993). Risk management: Coordinating corporate investment and financing policies. The Journal of Finance, 48(5), 1629-1658. https://doi.org/10.1111/j.1540-6261.1993.tb05123.x

Hull, J. C. (2022). Options, futures, and other derivatives (11th ed.). Pearson.