The stack hedge is premised on the changes in present value in the larger number of shorter contracts being sufficient to fund the rollover purchases that will have to be made at the current market price. This results in lower basis risk.
Page 70 - book 4 schweser
I don’t get this. Any simple explanation please?
Dont have the books im front of me but what I remember is a stack hedge is a group of future contracts with 1 maturity date managed so that the pv of this stack equals the pv of what is being hedged.
confused
why lower basis risk? compared with what?
As long as I read lots of questions, the strip hedge actually has lowest basis risk indeed.
Dont see how strip hedges can have more basis risk than stack hedge as well when its a more precise instrument/derivative used to hedge the underlying…any info that we might be missing here?
My understanding was that strip hedges involve purchasing multiple contracts over many maturities so that your underlying commodity exposure is fully hedged. However, since longer-dated contracts can be less liquid and thus have wider bid-ask spreads, this can drive your hedging costs up relative to stack hedges.
STRIP HEDGE PROS: Fully hedged, i.e. no basis risk
STRIP HEDGE CONS: Higher costs
On the other hand, stack hedges use only short-dated futures contracts, meaning there may be some residual commodity price risk where some commodity price exposure extends beyond the term of the short-term futures contracts on the initial implementation date. However, since only short-term contracts are used over the life of the commodity exposure, hedging costs are lower relative to strip hedges.
STACK HEDGE PROS: Lower costs
STACK HEDGE CONS: Not fully hedged, i.e. some basis risk.
Is this inaccurate?
^ I think that sums it up pretty well…that’s how I understand stack and roll vs strip hedges also. The only comment I would make is regarding your claim that a strp hedge = “no basis risk”.
This is not strictly true - a strip hegde definitely means less basis risk that a stack and roll hedge but its very rare for the futures contract months/settlement dates to line up perfectly with the timings of the in/outflows of the underlying that you are attempting to hedge - therefore some basis risk still exists.