Introduction

In this chapter, we will explore the stack-and-roll strategy as a long-term hedging approach. The stack-and-roll strategy is commonly used to manage long-term exposure to price fluctuations, especially in commodities and other assets with extended delivery periods. We will delve into the mechanics of the strategy, its advantages, and potential risks that arise from its implementation.

Understanding the Stack-and-Roll Strategy

The stack-and-roll strategy involves building a long-term hedge using a combination of multiple short-term futures contracts. Instead of using a single futures contract with a distant expiration date, the hedger enters into a series of short-term contracts that are sequentially rolled over as they approach expiration. By doing so, the hedge is continually maintained over the long term.

Implementing the Stack-and-Roll Strategy

Let’s illustrate the stack-and-roll strategy with an example. Suppose a wheat farmer wants to hedge the price risk of his wheat crop, which will be harvested in six months. Instead of using a single wheat futures contract with a six-month expiration, the farmer enters into a series of successive monthly contracts. As each monthly contract nears expiration, it is closed, and a new contract for the following month is opened. This process is repeated until the final month when the wheat is ready to be sold.

Advantages of the Stack-and-Roll Strategy

• Flexible Duration: The stack-and-roll strategy allows the hedger to adjust the hedge’s duration as market conditions change. If needed, the hedger can extend or shorten the hedge period easily.

• Cost-Effective: Short-term futures contracts often have lower transaction costs compared to long-term contracts, making the stack-and-roll strategy more cost-effective.

• Rolling Opportunities: Rolling the contracts periodically provides opportunities to adjust the hedge based on new market information and price expectations.

Risks Associated with the Stack-and-Roll Strategy

• Contract Rollover Risk: The strategy relies on consistently rolling contracts, and if liquidity in the near-month contracts is low, it may lead to higher bid-ask spreads during rollover, potentially affecting hedge effectiveness.

• Market Disruptions: Unexpected market events or disruptions can impact the rolling process, leading to gaps between contracts and potential exposure to unhedged price fluctuations.

• Basis Risk: Like any hedging strategy using futures contracts, there is the risk of basis risk, where the relationship between the cash price and futures price may not perfectly align.