Physical Trading Questions
Dear all,
I'm an intern currently doing Finance for a small physical trading house. It is my interest to slowly work my way up to try to get into a Junior Trader Role once I graduate but I'm quite stuck at the moment about the logic behind back to back trading hence seeking the experienced to hopefully work my brain into it. Please educate me if I am wrong about the terms.
Assuming a trader sold a contract 3000MT that has monthly shipments of 1000MT each for 3 months to USA with price basis US futures/index (Every shipment price is settlement price previous End of Month)
but bought 3000 MT from a Malaysian supplier with price basis Malaysia Futures market over three month shipping period, how does one hedge against risks involving this trade?
My understanding is there are:
1) Currency Exchange Risk - offset by FX hedging
2) Different Futures Market Risk - offset by longing US Futures & shorting equivalent in Malaysian futures
3) Freight Risk - offset by securing freight rates initially
4) Basis Risk - not sure how to offset
Think my understanding of physical trading is still very basic and I feel there are many loopholes in my explanation. Is there any way to make basis trading safer between two different future exchanges?
You actually did a very good job and basically have it all. That said no idea what the product is.
First, always figure out are we physically hedged, if both purchase/sale is same quality/product/spec we are good. In your example it is, and our settlement windows are the same so we gooe.
Basis risk, basis risk refers to the correlation of price A in reference to price B. So if in a contract it said, “I will sell product A in the usa at malaysia index”. Your sale now has inherent basis risk, as the malaysia index moves the overall price moves. On the other hand, maybe one market has less liquidity but trades off freight to another as there is open transport, then again we have basis risk.
Freight, you already mentioned it in your example.
Hedging, in your example you assumed both markets have liquid futures, and I am pricing “two seperate” floating cash flows; a buy and a sell. Therefore if I can find both futures index, I will have no basis risk.
FX, as you mentioned this is just FX hedging end of the day.
So my initial exposure is; +USA, -ML, -Freight. I buy ML futs, I sell USA futs. So no -Freight. I secure freight. So let with just fx risk.
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