• Dr. Andy Schell, DBA (Ph.D.), MSML, MBA, CPA/CFF, CMB

Hedging Explained: by Trading Places

In the 1983 movie Trading Places, Louis Winthrope (Aykroyd) and Billy Ray Valentine (Murphy) attempt to “get rich quick” while at the same time putting the bad guys in the “poor house” through a series of commodity trades.


The bad guys try to capture insider information about the Orange crop report. They hope to launch a commodity trade to profit from insider information.


Louis and Billy Ray (good guys) intercepted the crop report and exchanged it with false information saying there is a shortage of Oranges. The good guys know there is no shortage of Oranges.


When the market opens on the day the crop report is announced on TV, the bad guys launch a massive buying spree to profit from Orange Juice commodity activity as a commodity trading scheme. Their buying activity causes the price to climb as many brokers speculate on the trade and keep buying more.


Knowing the false crop report will cause the bad guys to buy as much as possible, Winthrop waits until the price climbs to $130 per contract and then starts selling.


The new report appears and says the Orange Crop is fine - there is no shortage. This new information about the Orange harvest triggers a massive selling effort, which causes prices to fall. Winthrop waits for the price to fall and then starts buying at $30 a contract.


The good guys sold contracts at $130 and bought at $30: A profit of $100 per contract.


The bad guys bought contracts at $130 and sold at $30: A loss of $100 per contract.


The key point is, selling before buying is a “short” position. A short position may result in a trading gain based on the difference between the selling price and the buying price.


Both the good guys and the bad guys were speculating in the commodity market.


In real life, Orange grove farmers use commodities to lock-in a sale price as they plant their crops. When the crops are harvested, they sell the Orange crop at the market and use the commodity contact to preserve the expected gain.


In the same way, Mortgage lenders sell commodity contracts in mortgages to lock-in the gain on the loans in process. The mortgage commodity is called a To Be Announced (TBA) Mortgage Back Security (MBS). Mortgage lenders sell TBA-MBS to preserve their pipeline risk until the Mortgages are harvested (closed) and available to be sold in the market. This is hedging. It is not speculating because Lenders own the crop of mortgages they will sell in the future.


And, this is how Louis and Billy Ray from Trading Places explain hedging….


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