To hedge, or not to hedge?

Buyers can regret their forward hedging decisions when market prices fall, but can also regret non-hedging if market prices rise. So, many executives are asking: shall we hedge?
Hedging reduces the magnitude of swings in the P&L, but can be costly relative to other courses of action. So the right question to ask is: When, and how much volumes shall we hedge?

While traders can use the forward markets to stabilize their margins, they lock themselves in a price that might not be advantageous at time of delivery. One way to fix a maximum price for buying while taking advantage of falling prices, is to purchase call options that guarantee a ceiling price but do not oblige the buyer to use them if it is cheaper to buy elsewhere. Of course, such flexibility comes with a premium to pay to get hold of the option contract.

Therefore, it is natural to keep part of future purchase volume exposed to spot prices, another part locked-in at a forward price agreed today, and the rest of the volume hedged at a price that is applied only if the prevailing market price at delivery is higher.

All in all, the trader is faced with the decision of allocating today the purchase of future volumes between the spot, futures, and the option markets. Such decision-making under uncertainty can be modeled mathematically, in a simulation-based framework, taking into account the current market prices, historical market volatility/correlations and the trader’s risk appetite. This yields long-term optimal decisions compared to ad-hoc methods.

See an application of this framework to Refinery Margins Optimization Client Portfolio