Quote:
Originally Posted by d2_e4
Can you explain this example with actual numbers? I.e. counterparty A takes this position, counterparty B takes this position, then this happens? Assume zero cost of trade for simplicity please (unless it's material to the example).
Note that I did say initially that one of the counterparties either benefitted or avoided a loss, which I am counting as an equivalent benefit.
airline takes a position on oil price to lock in current future prices for the year (simplyfying). he commits for the quantity it expects to need for a year at $100 a Barrel.
if oil goes up the paper profit made there by the airline goes to pay for the higher price of kerosene and viceversa if the airline loses money on that bet (oil goes down later on in the year), the airline makes up for it paying less for kerosene (this is a simplification because kerosene price isn't perfectly correlated with oil and so on).
your pure trader is in the deal because he has a directional read that tells him oil will go up within the year with 60% probability, he enters the bet and loses or win based on how oil price moves.
but the counter party doesn't, it's consolodated finance are the same no matter where oil goes which is what it wanted to achieve.
usually reducing risk has a cost (in various direct or indirect forms) and viceversa so costs usually benefit the gambler and are a net cost for the hedging entity