Glencore Trading Question
Below is a derivative Q for a trading example for an interview. Why is the basis risk (which I thought to be only 50 as 350-300) & purchase price SB11 + 50/ton (which I thought to be 350-300), and how come the futures that were sold to hedge the position never accounted for / bought back? A bit confused so any help would be great?
Some assumptions:
SB11 = the world benchmark futures contract for raw sugar trading, we assume it is trading
at $300/tonLDN5 = the global benchmark future contract for white (refined) sugar trading, we assume it
is trading at $400/ton.I’m sitting at my trading desk in Geneva talking about the local cash (= physical) market with
my originator in Brazil. He mentions he can buy 5’000 metric tons of semi-refined sugar from
one of his contacts at $350/ton FOB Santos, Brazil.As a trader, I think the Brazilian market is undervalued and see the West African market is
tightening up due to an unexpected rise in demand from Sub-Saharan countries prior to
Ramadan. I tell my originator to buy the whole lot at $350/ton.Immediately after that purchase, I hedge by selling 89 lots (the equivalent of 5’000 metric
tons) of SB11 futures at $300/ton. I own that sugar at a basis of SB11 + $50/ton (physical
purchase price of $350 minus the futures price of $300). I am betting that this basis will
increase in value.Knowing that West African merchants are going to be wanting my product I go see my freight
traders and lock in a freight rate from Brazil to Benin of $25/ton loading 3 weeks from now.
Having followed the market for a couple of weeks, I’ve seen my thesis confirmed as Brazilian
sugar has been trading at higher values into West Africa. However, I’m growing anxious of
Thai sugar which, despite much higher freight costs, has been getting increasingly competitive
in the region. Once it reaches parity with my Brazilian sugar, there will be a lot more sugar
available in the region. I decide to get out of my position.I get on the phone and start dialling some of my contacts in West Africa. Half an hour on the
phone later I sell my whole 5’000 MT of sugar to one of my clients at LDN5 – $15/ton CFR
Cotonou, Benin.Great, I have just made $50’000 USD!
Let’s break it down:
Purchase = SB11 futures + $50/ton
Total per ton purchase price = $350/ton (350 – 300)
Sale = LDN5 futures - $15/ton
Total per ton sale price = $385/ton (400 – 15)
Gross profit = $35/ton (385 – 350)
Freight price = $25/ton
Total per ton profit = $10/ton (35 – 25)
Total profit = $50,000 (10 * 5,000)
Seems slightly as a badly written question. The key assumption that needs to be made is that LDN5 vs SB11 is trading at $100 diff at all times (400-300). So looking at from T ledger; you can explain that Brazilian Sugar can be priced two ways. 1) SB11+50 or 2) LDN5 - 50 to start. If you assume it the second way, you can see easily how we made just $10 ((LND5-15) - (LND5-50) - 25).
Likewise with your questions about the futures, we are hedging the futures solely to protect the price of all sugar worldwide losing value. This would mean that is SB11 fell $50, LDN5 also falls $50. So again if you use the assumption that spread between the two is $100 at all times. We do not need to worry about the futures, since are receiving back a futures price from the buyer.
I appreciate the help! With your explanation, I understand everything mechanically but wanted to make a couple of clarifying questions. First, would the basis risk then be $100 as the undervalued Brazilian commodity is represented by the LDN5 contract and the spread between this derivative and the other futures contract SB11 is $100? My other question is that hedging using either the LDN5 or SB11 contract leads to the same $10 profit, so is there is a specific reason why a trader might use SB11 over LDN? Thanks again!
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