22.2Hedging Short-Term Commitments with Maturity-Matched

Forward Contracts

Forward contracts are among the most popular tools for hedging. We begin with a

review of forward contracts. Next, we analyze a firm, such as Metallgesellschaft, which

is exposed to oil price risk. We assume that it wants to minimize that risk by using for-

ward contracts that mature on the same date as the obligation the company wishes to

hedge.

Review of Forward Contracts

As discussed in Chapter 7, a forward contractis an agreement to buy or sell a secu-

rity, currency, or commodity at a prespecified price, known as the forward price,at

some future date. In contrast, the spot marketfor a commodity is the market for imme-

diate delivery and payment. The amount paid for the commodity in the spot market is

the spot priceor, in the case of currencies, the spot rate.Generally, the forward price

is set so that the contract is a zeropresent value (zero-PV) investment; thus, no cash

need exchange hands at the contract’s inception. An exception to this takes place in

what is known as an off-market contract.Generally, when a reference is made to the

market’s forward price, it is to the forward price of a generic zero-PVcontract.

How Forward-Date Obligations Create Risk

Metallgesellschaft sought to mitigate oil price exposure from a series of forward con-

tracts which, in essence, locked in the selling price at which its customers could pur-

chase heating oil. Forward contracts are inherent in many business contracts and have

been around for hundreds of years. It is not surprising that Metallgesellschaft would

enter into forward contracts as part of its business strategy.

In the absence of these commitments, Metallgesellschaft’s profit was tied only to

the spread between the prices of heating oil and crude oil because the company was a

purchaser of crude oil and a supplier of heating oil. However, by locking in its cus-

tomers’heating oil prices, Metallgesellschaft exposed itself to fluctuations in the price

of crude oil. These fluctuations are much more volatile than the spread between the

price of heating oil and the price of crude oil. Hence, to minimize its oil price expo-

sure, the company needed to lock in the crude oil prices it pays to its suppliers. An

additional series of crude oil forward contracts seemed to be a natural vehicle by which

Metallgesellschaft could offset the effect of locking in the prices at which it sold its

heating oil.

Using Forwards to Eliminate the Oil Price Risk of Forward Obligations

The future payoff at date Tof the long forward contract for oil is the difference between

˜

an uncertain number, S, the future spot price of oil, and a certain number K,the for-

T

ward price agreed on today.

Combining a Forward Commitment to Sell with the Acquisition of a Forward

Contract.Consider an oil refiner that needs to buy crude oil and, like Metallge-

sellschaft, has locked in the price of its output. The operations of this business produce

a constant gross revenue of G,but require the purchase of oil at date Tat the then pre-

vailing oil price, S˜. The combination of the risk of this business operation, which has

T

Grinblatt1571Titman: Financial	VI. Risk Management	22. The Practice of Hedging	© The McGraw1571Hill
Markets and Corporate			Companies, 2002
Strategy, Second Edition

780Part VIRisk Management

EXHIBIT22.2Hedging Business Risk with a Forward Contract