Author Archives: Tim Bishop

Hedging Cryptocurrency

Hedging Cryptocurrency

In search of cryptocurrency hedging solutions

Bitcoin cryptocurrencySomeone stopped by my Fiverr hedging gig the other day shopping for a Bitcoin hedging solution. He described himself as a digital currency dealer. After I explained that my exposure to digital currency (or so-called cryptocurrency) was slim to none, I agreed to investigate further to see if I could help him. After all, traditional hedging concepts should apply regardless the currency.

I embarked on a crash course on crtypocurrency. Bitcoin and its cousin rivals such as Ethereum and Litecoin represent a growing trend to implement currencies that work well with today’s digital commerce. These digital currencies seek to avoid government interference, precious metal backing, and other traditional currency entanglements. After my jet-ski tour of the subject, I traded thoughts with my potential client. We concluded that the markets and the currencies were not mature enough to allow for a hopeful hedge.

Our “cryptocurrency waltz” was a reminder of some significant considerations when hedging any type of commodity price risk. While bitcoin may have received some bad press due to Internet banditry, trading exchanges gone belly up, and the new currency’s “Wild West” feel, that doesn’t mean that it is going away anytime soon. To the contrary, CME Group began tracking it in November 2016, a telltale sign that the currency is gaining legitimacy. If it continues to catch on, then an adequate hedging tool for it is as important as having one for the US Dollar, coffee, corn, or gasoline.

To understand why we concluded it was not yet time to hedge Bitcoin price risk, see this separate blog post that explains five hedging issues for thinly traded commodities.

Future considerations for hedging cryptocurrency

If you own some currency price risk pertaining to a digital currency like Bitcoin and you aren’t speculating on favorable price changes, then I suspect you’ll conclude, like we did, that it’s still early in the game to find an adequate hedging solution. However, one may be coming down the road at the same speed as the growth of these digital currencies. Hang in there. Your patience will be rewarded.

CME Group’s tracking of an index for Bitcoin bodes well for the prospect of a futures contract at a later date. US-based CME Group is the largest exchange for hedging instruments in the world, offering contracts in most commodities. It has time-tested measures in place to protect market participants and may provide more comfort than today’s Bitcoin hedging alternatives. Regardless, always do your homework on possible trading partners before trading with them.

Chart USD Hedging Issues

5 Hedging Issues for a Thin Commodity

Chart USD Hedging IssuesHedging can be difficult enough for mature products. However, with some commodities, hedging issues may prevent you from even attempting to protect against price changes. Sometimes, you can add more risk to what you’re already trying to manage. For lack of a better term, I’ll refer to these hard-to-hedge products as “thin commodities.”

Recently, I tried to help an individual find a hedging solution for Bitcoin. That exercise proved fruitless for the same reasons that any new or otherwise thinly traded commodity may prove difficult to hedge. Here are five hedging issues for anyone who is seeking to protect thin commodities:

Issue #1: Counterparty credit risk

When hedging instruments increase in value, you must be able to collect the proceeds in a timely fashion. What is the financial wherewithal behind the counterparty to your trade, whether it be an exchange or a one-off trading partner? Up-front due diligence can help establish that the entity on the other side of your hedging position has the capacity to honor its commitment.

If you are dealing with an exchange, what procedures and safeguards does the exchange have making it likely that you can receive timely and full payment? If you have a dispute, how will you settle it, especially in an international setting? Note that some Bitcoin trading exchanges have already left investors holding an empty bag.

Issue #2: Insufficient liquidity

Futures markets need enough trade liquidity to allow for fair pricing and the ability to trade on short notice. Trade timing must be flexible enough to allow the hedger to trade his hedge positions simultaneous with “physical” deals on the index at risk.

When the hedger takes on risk with Bitcoin, for example, she must simultaneously enter a hedging position to oppose and thus offset the risk. The same holds true when the Bitcoin risk changes or goes away. In the cryptocurrency markets, this trade liquidity appears suspect at present.

Issue #3: Inadequate price correlation

Price correlation is a critical aspect of an effective hedge. Sometimes, however, a hedging instrument is a poor proxy for the price of the commodity or index it is designed to protect.

For example, the price of a futures contract factors in both current and anticipated supply and demand imbalances as seen by market participants. A future price of a commodity or index may differ substantially from current pricing for a variety of unpredictable and uncontrollable reasons.

In the case of Bitcoin, the market may still lack sufficient participation to provide pricing that truly reflects the marketplace and is devoid of significant manipulation by deep-pocketed speculators.

As an example, last week I looked at the price of Bitcoin futures on one futures exchange, Deribit. The Bitcoin contracts are quarterly (and three months may be too much time for a reliable price proxy on a hedged index). The price between the June and September contracts differed substantially. Today, when I compared those same contracts, they were close in value. So in the past week, those two contracts had poor price correlation. One of them changed much more than the other. And at least one of them would have been a poor price proxy for spot market Bitcoin.

Issue #4: Cash requirements

Many counterparties to hedging transactions will require margin (collateral) to protect their price exposure if their positions go against them. Often, however, they will not afford their trading partner the same treatment.

Understand and negotiate, if possible, the cash flow that may be required to hold your positions if the price of the hedging instruments goes against you. Presumably, that price movement will result in gains in the spot market. When you add this gain to your hedging loss, you are made whole. However, you may be unable to convert the gain to cash fast enough to pay for the loss on your hedging position.

Issue #5: Execution costs

Factor the cost of any trading, exchange, or margining fees into your hedging analysis. Make sure these fees are reasonable and do not leave you wishing that you had self-insured the risk.

Help is on the way

For additional explanation of related hedging issues, including the risks associated with hedging, the role of futures exchanges, and how hedge instruments work, check out my e-book on Amazon entitled Hedging Commodity Price Risk. It will help you understand hedging better and guide you through some relevant issues on your hedging program, no matter the commodity.

If I can be of service for any of your hedging needs or questions, please don’t hesitate to contact me via the contact form on this website or, if you prefer, through my hedging gig on Fiverr.

Unwinding a Hedge

According to a recent Reuters article, Singapore Airlines has announced it plans to retain a hedge that locked in the cost of two-thirds of its jet fuel requirements through the end of March 2015. Other airlines have removed their hedges. Whether you are an airline, a farmer, a manufacturer, or a mining operation, what are the consequences of unwinding a hedge early? Continue reading

Ideas for Energy Users When Prices Have Tanked

Crude Oil Jan 11, 2015Have you noticed that it costs much less to fill your car with gasoline these days? Crude oil has plummeted in the last six months, bringing energy costs down with it. Hooray! It’s about time.

Everyone I know is an energy user. When you’re a business, energy is often one of the more significant expenses reducing your profit. Farmers, fishermen, and trucking companies consume substantial amounts of diesel fuel and gasoline to power their equipment. Retail entities must run lights, air conditioning, and heating systems, perhaps even refrigeration units. Manufacturers are powering machinery and equipment every single shift. And real estate companies may incur utility costs, depending upon the lease agreements with their tenants. Any businesses with substantial travel budgets are impacted by the cost of jet fuel to airlines, as well as diesel and gasoline costs to power their own fleets. You might say money AND ENERGY make the world go round.
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Ideas for Energy Marketers When Prices Have Tanked

Crude Oil Jan 11, 2015
In the past six months, the cost of crude oil has dropped in half! Such a large price change in such a small timeframe suggests that new risks and opportunities abound for any business affected by energy prices. And who can think of any that aren’t impacted to some degree? The implosion in pricing means it is time to reassess your business’ energy risk profile.
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Ideas for Energy Producers When Prices Have Tanked

Crude Oil Jan 11, 2015Unless you’ve just crawled out from under a rock, you’re well aware that the price of oil has declined over the past six months and, with it, the cost of energy. You see it when you fill up your vehicle with gasoline or when you pay your fuel bill to heat your home (unless you’re among the unfortunate who locked in a fixed price before the recent price collapse).

If you run a business, you’re even more familiar with this price change, including its effects on your bottom line. The change has impacted producers, marketers, and users. However, just because prices have plummeted does not mean that risk–and opportunity–have vanished. That proverbial horse may already have left the barn, but there are more awaiting their own escape. If you have a future interest in a commodity, the uncertainty of its price will always present you with the counterbalancing risk/opportunity dynamic. Rather than simply wallowing in the anguish of lost profits–or basking in the glow of unexpected gains–perhaps it’s time to move on, to consider what opportunities this new pricing environment presents for the future.
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Announcing the Release of Hedging Commodity Price Risk

HedgingCommodityPriceRiskOpen Road Press is pleased to announce the release of Hedging Commodity Price RIsk: A Small Business Perspective by Tim Bishop. This ebook will help small businesses that can’t afford to hire staff specifically to manage their commodity price risk. It will also serve as a helpful guide to others who have an interest in hedging.

Hedging Commodity Price Risk explains:
– What commodity price risk is and how it can affect your business
– What hedging is and how it minimizes risk
– Specific hedging examples
– Hedging pitfalls and opportunities
– How to reduce exposure to rising interest rates
– How to protect against changes in foreign currency exchange rates
– How to hedge weather risk

For more on the author’s credentials, check out About the author. To read testimonials about the book, click here.

For full details on the book’s release, read this news release. To pick up a copy of Hedging Commodity Price RIsk, go to the Open Road Press store.

Thank you to the many colleagues, family, and friends who helped make this possible.

Weather Risk for Farmers

I’ve been bicycle touring across America this summer with my lovely wife, Debbie. As you might imagine, we’ve cycled through many areas where farming is king. With gargantuan fields all around us, we knew we’d run into a few farmers! In Belgrade, Montana, just outside of Bozeman, we spoke at length with a dairy farmer. In Iowa, we spoke with a farming couple from South Dakota who grow soybeans and corn.

Our contacts with these farmers suggested that they were not hedging their businesses, but would like to better understand how hedging could help them. Our extended conversation with the South Dakota farmer and his wife really convinced us that farmers bear a lot of risk.

There’s currently a glut of corn on the market, which has caused a drop in price from $7 to $3 per bushel. They are looking at marketing their crops in China and India, where prices are much richer. However, they have a logistical problem. These markets are serviced by ships sailing from the US Pacific coast, and there’s no easy route to ship their grains from South Dakota to the Pacific. Rail cars headed west are hard to come by, thanks in part to this changing marketplace and the oil boom in North Dakota. Meanwhile, the crops can be stored indefinitely only if the weather cooperates.
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Coming soon!

Hedging Commodity Price RiskAre you having trouble sleeping at night worrying about how commodity costs will affect your business? Would you like to offer your customers price protection but you don’t know how to manage the risk? Or, are you just tired of watching your annual earnings bounce with the whims of commodity prices?

Hedging Commodity Price Risk: A Small Business Perspective by Tim Bishop is an ebook that explains hedging in plain, easy-to-understand language with practical examples. It’s coming soon to an ebookseller near you! Expected publication date in the summer of 2014.

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UPDATE: Hedging Commodity Price Risk was published in September of 2014. You can purchase it in the Open Road Press store.