FINS3635 Assignment 1: Hedging Natural Gas – Direct Hedging, Cross- Hedging, and Strategic Differences

Background

Natural gas futures contracts are actively traded and provide a direct hedging

instrument for natural gas exposure. However, firms may engage in cross-hedging

using related energy futures contracts when:

 Liquidity differs across contracts,

 Exposure is imperfectly matched,

 Or risk management focuses on broader energy price movements.

This assignment progresses from direct hedging to cross-hedging, and then to

strategic hedging across different market participants.

Data Sources

Data are available from the following sources.

For spot prices:

 Natural Gas spot price (Henry Hub): U.S. Energy Information Administration

(EIA): https://www.eia.gov/dnav/ng/hist/rngwhhdD.htm

For futures prices:

 Natural Gas futures: EIA: https://www.eia.gov/dnav/ng/ng_pri_fut_s1_d.htm

 Petroleum futures (for cross-hedging): EIA:

https://www.eia.gov/dnav/pet/pet_pri_fut_s1_d.htm

Futures contract specifications are available from the CME Group website. Contracts

used include front-month (e.g., Contract 1) natural gas futures for direct hedging, and

front-month crude oil (WTI), heating oil, and RBOB gasoline futures for cross- hedging.

Download daily spot and daily front-month futures data from the links provided above

over the sample period from March 1, 2018, to March 1, 2024. Once the original data

are downloaded, remove missing observations from the spot and each futures price

series separately, then merge the datasets by date. This merged dataset will be used

for Tasks 1 and 2.

Task 1 – Direct Hedging Using Natural Gas Futures

In this task, construct a benchmark hedge using natural gas futures.

1.1 Exposure Identification

Assume a firm is exposed to natural gas price fluctuations.

 Clearly define whether the firm is naturally long or short natural gas (e.g., a

producer might be long, while a consumer is short).

 Explain how the firm's profits change when natural gas prices rise or fall.

1.2 Minimum-Variance Hedge

 Estimate the minimum-variance hedge ratio using regression (e.g., ΔSpot = α

+ β ΔFutures + ε, where β is the hedge ratio).

 Construct the hedged return series.

 Compare the return volatility (standard deviation) of the hedged vs. unhedged

positions.

 Evaluate hedge effectiveness as the percentage variance reduction

((Var_unhedged - Var_hedged) / Var_unhedged).

Round all numerical results to four decimal places.

1.3 Interpretation

 Does the hedge significantly reduce risk? Provide evidence from your

calculations.

 Under what conditions can a direct hedge eliminate risk completely (e.g.,

perfect correlation and no basis risk)?

This task establishes the benchmark case of a nearly “perfect” hedge.

Task 2 – Cross-Hedging Using Related Energy Futures

Now assume natural gas futures are unavailable or illiquid. Construct cross-hedges

using the following front-month contracts:

 Crude Oil (WTI)

 Heating Oil

 RBOB Gasoline

2.1 Hedge Construction

For each contract:

 Estimate the minimum-variance hedge ratio (as in Task 1.2).

 Construct the hedged return series and evaluate hedge effectiveness (variance

reduction).

 Compare hedge effectiveness across the three contracts (e.g., using a table of

hedge ratios and variance reductions).

2.2 Basis Risk

 Explain why cross-hedging cannot eliminate risk completely.

 Discuss the role of correlation in hedge performance.

 Compare the cross-hedge performance with the direct natural gas hedge from

Task 1.

This task highlights the costs of imperfect hedging and the importance of basis risk.

Task 3 – Strategic Hedging Across Market Participants

In this task, analyse how hedging strategies differ depending on the role of market

participants. Consider three market participants exposed to natural gas price

movements:

1. End-User (e.g., an electricity generator purchasing natural gas as input)

2. Producer (e.g., a natural gas firm extracting and selling output)

3. Financial Institution / Fund Manager

3.1 End-User

 Is the firm naturally long or short natural gas?

 What risk does it primarily face (e.g., input cost volatility)?

 Would full hedging be optimal?

 Discuss whether the minimum-variance hedge ratio from Task 1 would be

appropriate for this participant.

3.2 Producer

 Is the producer naturally long or short natural gas?

 How does revenue respond to price changes?

 If the firm operates both upstream and downstream, can vertical integration

create natural hedges? Explain.

 Explain how the optimal hedge ratio for a producer may differ from that of an

end-user.

3.3 Financial Institution / Fund Manager

Consider a financial intermediary that:

 Provides hedging services,

 Holds trading inventory,

 Or manages a commodity-focused investment fund.

Discuss:

 How might the institution dynamically adjust exposure?

 Does basis risk affect it differently from commercial firms?

Explain how hedging for financial institutions differs from hedging for commercial

producers or consumers.

Conclude by comparing across all three participants in a table or summary:

 Exposure type (long/short),

 Business model and hedging objective,

 Hedge intensity (full vs. partial),

 Risk preferences.

Learning Outcomes

By completing this assignment, you should be able to:

 Construct direct and cross-hedges,

 Understand basis risk,

 Compare hedge effectiveness across instruments,

 Distinguish between mechanical hedge estimation and strategic hedging,

 Explain how hedging decisions differ across producers, consumers, and

financial intermediaries.

Submission

Submit a 2-page report (plus an optional 1-page appendix), Excel workbook (showing

all calculations and data), and answers to questions on GA1 via Moodle. There is no

specific requirement for spacing or font size, but the report must be clear, well- organized, and easy to read. Use headings, bullet points, and tables where appropriate

for clarity.

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