The Hidden Costs of Hedging: Rolling and Margin

Rolling isn't free

Far-month futures trade thinly, so long-term hedges often have to roll front-month contracts all the way. In contango, a long hedge buys higher at every roll, and this roll yield slowly adds up; in backwardation it's the opposite.

Losses paid today, gains collected next year

Futures are marked to market daily, so a loss means topping up margin that same day, while the gain on the hedged physical only arrives in the future. If you run out of cash and are forced to close, that's funding liquidity risk. In 1993 Germany's Metallgesellschaft suffered a huge loss exactly this way.

How much to hedge is a trade-off

Hedging buys certainty at the cost of roll costs, premiums, spreads, cash you must keep on hand, and the upside you give up. Many companies hedge only part of their exposure (say 50%–80%), choosing the ratio by how much cash strain they can bear.

Key takeaways

• When rolling near-month futures to hedge, contango makes longs pay extra at every roll and backwardation does the opposite: this is the roll cost / roll yield.
• Futures losses are settled in cash daily, while the gain on the hedged asset comes later. If you run short of cash, you may be forced to close the hedge at the worst moment.
• Hedging costs include premiums, rolling, spreads, tied-up capital and forgone upside. Match the hedge ratio to what you can bear.

Try it yourself

You can do these exercises in this lesson's interactive simulation:

1. Keep "Oil rises" + "Contango +$0.6" and press ▶ to the end: how much cash did the futures bring in? Why is the total −$720k rather than 0?
2. Switch the curve to "Backwardation −$0.6" and replay: what's the total at year end now? Why did the roll cost turn into a gain?
3. Switch to "Down, then rebound" and keep the reserve at $3 million: what's the most cash you had to put up? Did the hedge last to the end of the year?
4. Cut the reserve to $2 million and play again: on which day are you forced to close? How much more do you lose by year end than if you'd stuck with the hedge?

Quiz and explanations

1. In contango, you roll once a month and pay an extra $0.5 per barrel each month. Hedging 200,000 barrels for 12 months, roughly what's the roll cost?

Answer: $1,200,000.$0.5 × 12 months × 200,000 barrels = $1,200,000.

2. An airline hedges fuel prices with long futures. When oil prices crash, what's the most immediate pressure?

Answer: Futures losses must be paid daily in margin cash, while the benefit of cheaper fuel arrives only later.This is funding liquidity risk: the hedge works economically, but a cash shortfall can force it to be closed.

3. Which of these is NOT a cost of hedging?

Answer: Price swings having less effect on the outcome.A more certain outcome is exactly what hedging is for; the other three are the price paid for it.

Terms in this lesson

• backwardation (Backwardation): A market where futures (or later months) trade below spot (or nearer months).
• contango (Contango): A market where futures (or later months) trade above spot (or nearer months).
• funding liquidity risk (Funding Liquidity Risk): The risk of being forced to close a sound position because you can't raise cash in time (for example for a margin call); futures hedge losses are paid in cash daily, while gains on the hedged asset come later.
• margin (Margin): The deposit set aside when you open a position = position value ÷ leverage.
• mark-to-market (Mark-to-Market): Profit and loss is calculated at the settlement price every trading day and actually moved into or out of your margin account.
• roll yield (Roll Yield): The gain or loss from the price gap between months each time you roll a front-month futures position; longs keep paying a roll cost in contango and earn roll yield in backwardation.
• roll (Roll): Closing a contract that's about to expire and opening the next month's contract to keep the position going.