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in this video what I'd like to do is walk through an example of hedging with futures contracts and be a relatively specific example so what we're going to look at here is assume you're a delivery company whose expenses are tied to fuel prices you're making deliveries those fuel prices go up your expenses are going to rise you anticipate that you use 90,000 gallons of gasoline per month it's currently July 1st and you want to hedge your next three months of fuel costs and you're going to use the are Bob gasoline futures contract in order to do that so let's get a little bit of information on the are Bob gasoline futures contract first of all each contract is for 42,000 gallons so one contract 42,000 gallons two contracts 84,000 gallons and so on contracts expire at the end of the prior month so for example if we were to buy an August contract that would expire at the end of July so if we bought an August contract we're taking delivery at the end of July if we sell an August contract we're delivering at the end of July the initial margin is 11,000 $475 and maintenance margin is 8500 so for each contract rebuy are short we have to put up that initial margin of 11,000 475 and if we lose money on our contracts so that the margin balance falls below 8500 then we have to put in additional cash flows bring it back up to that initial margin of 11,000 475 now in our example that we go through we're not going to go through the mark-to-market on a daily basis so we're not going to worry about that margin call but that is something that you'd have to deal with in a real-world scenario so the first question that we have is we want to hedge our gasoline exposure should we buy a contract go own or should resell a contract go short in order to initiate our futures position the way to think of this is our exposure is to gas prices we're a delivery company so as gas prices go up what that's going to do is cause our expenses to go up and as our expenses go up our profit is going to go down so if we want to hedge that risk exposure and protect our profits we need a situation where our futures position is going to increase in value when gas prices go up so if we go along the contract buy gasoline futures then we will make a profit on those futures when gas goes up and that's going to offset our natural risk exposure so our hedge position here is to go long or to buy the contracts next thing we have to think about is how many contracts should we use well we use 90,000 gallons of gas every month remember each contract was for 42,000 gallons so we need two contracts to get a hedge and that's going to hedge 84,000 gallons of gas notice we don't have a perfect hedge we still have 6,000 gallons on hedged that's something we're going to have to deal with if we buy three contracts that's going to push us well over what we need to head you're going to be at 126 thousand gallons so the closest we can come is to contracts so how many contracts should we used to next question what is our initial cash flow remember in order to initiate these positions we need to put up that initial margin the initial margin we said was eleven thousand four hundred and seventy five dollars now we need two contracts and Rehab three months that we're trying to hedge so we have two times eleven thousand four hundred seventy five it's going to give us twenty two thousand nine hundred and fifty for each month we have three months that we're going to be hedging so initially we're going to have to put sixty eight thousand eight hundred fifty dollars into our margin account in order to establish these positions that gives us two contracts art for each month for August September and October that's going to be our next three months now our next question assume the price of gasoline is currently 350 gallon and the August futures is two point eight nine seven four and these were actual prices at the time that I made this example but they fluctuate daily so they're probably not what's in place right now as you're viewing this September futures is two point eight seven nine eight dollars per gallon and October futures were two point seven six five eight why the discrepancy first thing I want to notice is that in this situation our futures contracts were in backward ization contango is when futures prices are higher than the current spot price backward ization is when futures prices are lower than the current spot price we can see that as we go out few further the futures drop so that we're in a situation of backward ization in the gasoline futures market the other difference is why the big difference in the price at the pump three-fifty versus the are Bob futures contract and the reason for that is partly distribution futures contracts have to be delivered to a certain spot not to each gasoline are each gas station so the gas station is going to have to get that gas delivered to them that's going to be a distribution cost sometimes you might notice if you're in a rural area gas prices might be a little bit higher there aren't many gas stations part of that could be competition part of it could be the distribution costs get a little bit higher we also have profits the gas station has to make a little bit of a profit most gas stations actually don't make too much profit on their gasoline but a couple cents a gallon profit on their gasoline that's going to tack it up but one of the big factors is also taxes and that's why you see a big difference between various states on fuel prices for instance I live in Missouri kind of on the border of Missouri and Kansas and typically gas prices in Kansas are 15 to 20 cents a gallon higher than they are in Missouri so when we get to price at the pump we see things like distribution costs profits and different state taxes on gasoline that end up resulting in different prices at the pump from the our Bob futures however what you're typically going to see is if you watch the gasoline futures contract as the are Bob drops prices at the pump we'll also drop now there's probably going to be a little bit of a delay on that prices at the pump typically drop two to seven days after the contract goes down on the flip side when the our bond futures go up prices at the pump tend to rise relatively quickly typically one to three days you'll notice those prices have already gone up so a little bit of an explanation on the difference between the futures contract and prices at the pump now let's look at average gas prices for the next three month are 325 3.2 80 how much is your firm's save compared to current price type o there when I was writing a question so we want to make it compared to the current price now we're not looking at the futures here we're just looking at what actually happened this was our risk exposure that we were trying to hedge against is gasoline prices changing going forward gasoline prices are currently 350 a gallon and so what we're seeing here is that they're going to be dropping over the next few months which should save us money on our expenses fuel savings each month remember we use 90,000 gallons a month difference between the current price and the price average price in July is 25 cents a gallon times 90,000 means we saved twenty two thousand five hundred in fuel costs in July in August prices dropped to three dollars a gallon on average so we save 50 cents a gallon 90,000 gallons received 45,000 in fuel costs and in September prices dropped all the way down to 280 a gallon saved 70 cents a gallon on 90,000 gallons total savings of 63,000 over the three months received twenty two thousand five hundred forty five thousand 63,000 net savings one hundred thirty thousand five hundred so if we would not have hedged our position we would have actually ended up with higher than expected profits due to the decline in fuel costs however we hedged our position so now we have to look at what we lost on our fuel on our futures contracts let's assume that the futures contracts closed at the following prices to 6813 in August to 4140 and September and two oh nine nine nine in October remember the August contract gets settled at the end of July September at the end of August and October gets settled at the end of September so how much did we lose on our futures contracts well the august futures contract re initially paid to eighty nine seventy four for it ended up closing at two sixty eight thirteen so we lost the difference between those values times eighty four thousand net loss of eighteen thousand one hundred fifty two dollars and forty cents on our august futures our September futures again re initially paid to eighty seven ninety eight it closed at two forty one forty so we took a loss again on that position thirty nine thousand one hundred twenty seven twenty and our October futures re initially paid to 76 fifty eight they closed out at two oh nine ninety nine eighty four thousand gallons we lost fifty five thousand nine hundred thirty-five which means we took a total loss on our futures of one hundred and thirteen thousand two hundred fifteen dollars twenty cents that's just adding up the three individual losses so in this example we ended up really getting hit on our hedge we lost one hundred thirteen thousand two hundred fifteen dollars on our hedging activity which brings us to the final question was it a good hedge the answer is despite the appearances yes this was a great hedge because remember what we were trying to do with our hedge we were trying to reduce our natural risk exposure if gas prices went up our hedge would have went up so this would have hurt our profitability we would have offset that by making money on our futures position instead what happened was gas prices went down we lost money on our hedge that's okay our business is delivery business it's not gasoline prediction business we do a good job at delivering build in a reasonable profit margin make our customers happy now we've just eliminated a risk exposure that we can't control a gasoline are a delivery company whether it's a big company like UPS or a small local delivery company can't control the cost of gas so that's a risk that they want to hedge away instead what they want to control is make sure they take on the risk of timely delivery setting good prices making sure their customers are satisfied if they do a good job on those things and they hedge their gas that's what they're trying to accomplish in this case remember we're trying to offset our risk exposure well the natural risk exposure resulted in one hundred thirty thousand five hundred an additional gain from fuel savings but we offset most of that 113 thousand two hundred fifteen twenty with a loss our net impact of gas prices was less than twenty thousand dollars that's what we're trying to do we're trying to eliminate the impact of gas prices so it was it a good hedge yes gas price fluctuations add little impact upon our profits and that's what we're trying to do with our hedging is to reduce that risk exposure in this case the hedge ended up taking away some of our potential profits we had an opportunity cost but if gas prices would have went up that would have helped us protect those profits again the hedge is not designed to be an income producing activity it's designed to be risk reduction and that's what we accomplished here