Charta is on Google Play: practise on the go. Get the app
Charta

Describe how a stack-and-roll strategy builds a long-term hedge and outline the risks it brings.

FRM® Part I · Financial Markets and Products · Using Futures for Hedging · FRM1.FM.8.h

The idea

Stack and roll builds a long-term hedge from short-dated futures. The whole exposure is hedged in the nearest contract, which is closed out and replaced by the next contract as expiry approaches, and so on until the exposure ends. A strip hedge, by contrast, matches each future cash flow with its own maturity. The first risk is rollover basis risk, because the price gap between expiring and new contracts is unknown. A short hedger gains from contango at the roll and loses in backwardation. A long hedger gains and loses the other way round. The second risk is funding risk. Futures losses are settled in cash through margin, while the gains on the hedged exposure are not yet realised. Metallgesellschaft in 1993 is the standard cautionary example.

Formulas

Price locked in by a stack-and-roll short hedge

effective price = F₁ + Σ (Fnew − Fold)

F₁
the price of the first futures contract sold
Fnew
the price of the next contract sold at a roll
Fold
the price of the expiring contract bought back at that roll

Ignores tailing and the final basis. Each roll in contango adds to a short hedger's price and each roll in backwardation subtracts; for a long hedger the effect on cost is the reverse.

A practice question

From the question bank, with the reason each wrong option is wrong.

A stack-and-roll strategy to hedge a long-dated exposure involves:

  1. hedging with a single long-dated futures contract held until the exposure endsWhy not: This is a one-contract hedge, not a stack and roll; the strategy exists because such long-dated contracts are often unavailable.
  2. hedging the whole exposure with short-dated futures that are closed and replaced by new short-dated contracts as they near expiry - correct
  3. holding contracts in many maturities, each matched to one dated cash flow of the exposureWhy not: Describes a strip hedge, which matches each cash flow to its own maturity.
  4. closing the hedge when the basis strengthens and reopening it when the basis weakensWhy not: Describes active basis trading, which is not the stack-and-roll method.

Stack and roll: put the hedge in the nearest contract (the stack), then roll it forward into the next contract at each expiry until the exposure ends.

A harder one

A refiner must buy 600,000 barrels of crude spread equally over the next 12 months and hedges with a stack-and-roll long position in the front-month contract (1,000 barrels each). The initial hedge position is:

  1. long 600 front-month contracts - correct
  2. long 50 contracts in each of the next 12 maturitiesWhy not: Describes a strip hedge, which matches each month's purchase to its own maturity instead of stacking.
  3. long 50 front-month contractsWhy not: Hedges only one month's purchases, leaving the rest of the exposure unhedged.
  4. long 12 front-month contractsWhy not: Counts months rather than barrels; contracts must cover the whole 600,000 barrels.

Stack and roll puts the entire exposure, 600,000 / 1,000 = 600 contracts, in the nearest contract and rolls it forward; the position shrinks as purchases are made.

The hardest tier

A firm is long 1,000 front-month contracts of 1,000 barrels each, bought at USD 18.00, as a stack-and-roll hedge of a fixed-price delivery commitment. Before the roll the futures price falls to 15.50. The firm then rolls into the next contract at 15.90. Ignoring tailing and the final basis, which statement is correct?

  1. Variation margin paid is USD 2.5 million and the effective locked price is USD 17.60 per barrelWhy not: Subtracts the roll cost instead of adding it; buying the new contract above the expiring one raises a long hedger's locked price.
  2. Variation margin paid is USD 2.5 million and the effective locked price is USD 18.00 per barrelWhy not: Ignores the roll spread, treating the locked price as unchanged by the roll.
  3. Variation margin received is USD 2.5 million and the effective locked price is USD 18.40 per barrelWhy not: Sign error on margin: a long position loses, and therefore pays, when the futures price falls.
  4. Variation margin paid is USD 2.5 million and the effective locked price is USD 18.40 per barrel - correct

Margin paid = (18.00 - 15.50) x 1,000 x 1,000 = 2,500,000. Locked price = 18.00 + (15.90 - 15.50) = 18.40. The cash drain comes while the gain on the commitment is unrealised.

In the app: 6 practice questions on this outcome, spaced review that brings it back before you forget it.

Start free →

More in Using Futures for Hedging