What is Stack & Roll Hedge?
Hedging is a risk management technique used to reduce investment risks by taking the opposite position in the associated asset. When people plan to hedge, they are insured against the adverse effects of an incident on their finances. That doesn’t preclude all bad things from occurring, but there’s something going on and you’re adequately covered, the effect of the incident is minimized.
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A simple example to explain hedging is as follows:
Consider a corporation that knows it will benefit $1000 for every 1 cent rise in commodity prices for the next 3 months and lose $1000 for every 1 cent decrease in commodity prices for the same period. In order to hedge, the treasurer of the company should take a short-term position designed to compensate for this risk. The hypothetical condition post hedging would result in a loss of $1000 for every 1 cent rise in the price of the commodity for a period of 3 months and a gain of $1000 for a 1 cent reduction in the price of each product over that time. When the price of the product falls, the gain on the future position reduces the loss of the rest of the company’s profits. If the price of the product increases, the loss of the futures position is offset by the gain on the remainder of the company’s market.
Stack & Roll Hedge.
Often the date of expiry of the hedge is longer than the date of execution of all the futures contracts that may be used. The hedger will then move the hedge forward by closing a futures contract and taking the same position in a futures contract with a later date of delivery. Hedges may be flipped over a number of times. The method is referred to as a stack and roll.
Consider a business that intends to use a short hedge to minimize the risk associated with the price to be paid for an asset at time T. If there are futures contracts 1, 2, 3, …, n with increasingly later delivery dates, the firm may use the following hedging strategy:
Difference between Strip hedge and Stack & Roll Hedge
A stack hedge piles up the entire futures portfolio in the front month and then rolls over to the next front-month option, while a strip hedge sets up futures positions in a sequence of futures that have successively further expirations. The former has lower liquidity costs due to the aggressive selling of the underlying futures but is correlated with a higher monitoring loss. The reverse is true for the latter because strip hedges are typically correlated with a lower monitoring risk but have higher valuation costs due to the probability that more distant contracts will not be involved.
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The Debacle at Metallgesellschaft
Often rolling hedges forward will lead to pressures in cash flow. The issue was vividly demonstrated by the activities of the Metallgesellschaft. MG sold a large amount of 5-to 10-year fixed-price heating oil and fuel supply contracts to its customers at 6 to 8 cents above-market prices. It has secured its exposure by taking short-term futures contracts that can be rolled forward.
As it turned out, the price of oil was dropping and there were margin calls for futures positions. Considerable short-term cash flow pressures have been imposed on MG. The MG representatives who formulated the hedging strategy argued that such short-term cash outflows were offset by positive cash outflows that would eventually be realized by long-term fixed-price contracts that were issued to the customers.
However, the senior management of the company and its banks were worried about the large cash flow. As a result, the firm closed all the hedge positions and negotiated with its customers that fixed-price contracts would be abandoned. The result was a $1.33 billion loss to MG.
Author: Abhay Kanodia.
About the author: An undergraduate student from the Birla Institute of Technology and Sciences, Pilani(BITS Pilani). Exploring the fields of finance and data analytics and its applications in other different domains.
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