To hedge is to take a futures position that is equal and opposite to a position held in the cash market. The objective is to mitigate the risk of an adverse move in prices.

Hedging works in mitigating price risk because futures prices and cash prices are highly correlated. For example, a producer of soybeans has the risk that the cash price will decrease before the beans are harvested and can be sold. Selling soybean futures mitigates this risk. If the cash soybean price in fact declines, the futures price will have decreased as well. Then, the producer can buy back (or offset) the futures contract for less than he sold it for, generating a profit. This profit can be applied to the revenue he gets from selling the soybeans on the cash market, thereby mitigating the cash price decrease.

Hedging using futures very seldom results in delivery against the futures contract; contracts are liquidated via offset and do not result in delivery. The purpose of the delivery provision is to ensure convergence between futures price and the cash market price. It is the threat of delivery that causes cash and futures to come together.

Market competition, regulatory changes & environmental awareness is enforcing utilities to review their risk management strategies without compromising customer experience. In consequence of customer’s inclination towards fixed price tariffs because of dynamic market prices and stringent regulations, future market trading has evolved as an inevitable option for utilities. Hedging precision for Volume & Price risk exposures plays decisive role for utilities profitability margins.

Hedging logic, customized tariffs plans, contracts consolidation, and differentiated profile amplify complexities from operations perspective.

Commodity hedging

Without any risk – a comprehensive risk management system should also take account of risks arising from commodity price trends. Forward transactions, options and option strategies as well as metal-indexed interest strategies for hedging or optimisation purposes can be used in this connection.

All contracts can be concluded in euros and US dollars with maturities of up to two years – in some cases even up to five years. As there is no physical delivery, a cash settlement takes place on maturity. In addition, you can profit from fluctuations in the commodity sector in the investment field.

Strategies

• Passing on of risk: securing flows and inventories of goods to smooth and improve predictability of corporate results
• Optimisation: strategies to compensate for rapid price movements; dampening the effects of the current price situation
• Commodity investments: investment strategies to complement and diversify an existing portfolio

You can currently trade the precious metals gold, silver, platinum and palladium as well as the base metals aluminium, copper, zinc, lead, nickel and tin. Alloys can be hedged on the basis of an appropriate weighting of the base metals. In the case of the base metals, the minimum trade size is one lot (e.g. copper 25 tonnes, nickel 6 tonnes). In addition, you can hedge crude oil (Brent) and gas oil.

We can also hedge so-called “soft commodities” (cotton, coffee, cocoa, live cattle, lean hogs, corn, feeder cattle, soybeans, soybean oil, wheat, red wheat and sugar) through forward transactions. We are still working on option-based hedging.

Why hedge

Any manufacturer that faces risks due to volatile commodity prices. Prior approval from the Reserve Bank of India is required. The products that are available for hedging are futures, options, and over the counter derivatives (where individual parties can strike a deal based on their requirements through a broker).

Costs involved

In case of futures, the party hedging would have to pay a margin – a percentage cost of the contract value (usually between 5-8%). For options, they would have to pay a premium, which is market-driven. Over and above this, a brokerage fee is due.

Hedging and risk

Hedging is generally not considered risky if it is based on covering short-term requirements. However, if the hedging party places a wrong bet, then they may miss out on potential savings. For instance, if a copper manufacturer has a capacity of 200 tonne and decides to sell 300 tonne on the futures exchange the remaining 100 tonne is considered as speculation in the market. If prices fall then he stands to benefit, however if prices go up the 200 tonne he produces can be delivered on the exchange but he would have to incur losses on the additional 100 tonne.

Hedging Using Futures

Types of hedges using futures

• Short and
• Long

Short Hedging

A short futures hedge is appropriate when you know you will sell an asset in the future & want to lock in the price.

A person who already owns or is in the process of producing a commodity has the risk that the price will fall. This risk can be mitigated by selling futures (short hedge), protecting the hedger from a decline in the price of the commodity/product owned or being produced.

Examples of short hedgers:

• A farmer with livestock on feed or a crop in the field.
• An elevator with grain inventory in the elevator.
• An elevator that has contracted to accept delivery of grain in the future at a fixed price.
• A meat packer who has contracted to accept animal delivery in the future.

• The risk here is that prices may fall before delivery.
• Take a short hedge position in the futures market.
• Appropriate when someone expects to sell an asset he already owns and wants to guarantee the price.

Example: Selling 1 million barrels of crude oil. The spot price for a barrel is $19 per barrel and the 3-month futures price is $18.75 per barrel.

• Spot price in three months proves to be $17.50: We gain $18.75-$17.50=$1.25 per barrel from the futures but I’m selling the oil for $1.25 less per barrel. We end up getting $18.75 per barrel.
• Spot price in three months proves to be $19.50: I lose $19.50-$18.75=$0.75 per barrel from the futures but I’m selling the oil for $0.75 more per barrel. I end up getting $18.75 per barrel.

Short Hedge Example

As an example, suppose it is May and a corn producer is considering pricing his corn crop. Based on history, the producer expects the basis at harvest to be $0.10 over December futures, which are currently trading at $3.50. The elevator is currently offering a forward price that is $0.05 over December. The producer’s risk is that corn prices will fall, so to hedge with futures, the producer takes a short futures position. As the corn is being harvested in November, the futures price has fallen to $3.00, and the local basis is still $0.05 over December. The producer buys back the short position, resulting in a $0.50 profit, which he combines with the $3.05 cash price to obtain a net price of $3.55, thereby mitigating the effect of the price decrease. Conversely, if the futures price had increased by $0.50, a loss on futures would result, and the net price would remain $3.55.

Long Hedging

A long futures hedge is appropriate when you know you will purchase an asset in the future and want to lock in the price

• Take a long position in the futures market
• Appropriate for someone who expects to buy an asset and wants to guarantee the price.

A person who does not now own the cash commodity but will require it in the future has the risk that the price will increase. Buying futures (long hedge) can mitigate this risk. A long hedge protects the hedger from a rise in price.

Examples of long hedgers:

• A food manufacturer, who will need product in the future, doesn’t own it now but wants to price it now.
• A processor who has offered to price product forward based on current ingredients prices but doesn’t own it now.

The risk here is that the price will rise before delivery.

Long Hedge Example

Alternatively, a flour miller is concerned about the risk of wheat price increases for wheat to be purchased in November. Wheat futures for December delivery are currently trading at $4.20/Bu, and the typical basis at the miller’s location is $0.15 over futures. The miller hedges this risk by taking a long position (buying) the December wheat future at $4.20. In November, the futures price has increased to $4.40, and wheat is selling locally for $4.55. The miller lifts the hedge by selling back the futures position at $4.40, resulting in a profit of $0.20/Bu This profit is then applied to the cash purchase cost of $4.55/Bu, resulting in a net cost of $4.35, which is the price expected when the hedge was placed.

In both of these examples, the basis component of pricing did not change. In practice, basis can be variable, but this variation is small, relative to that in the futures price. The basis risk cannot be protected through hedging.

What makes hedging work is the fact that cash and futures prices converge at the delivery point – when one goes up, the other goes up as well.

The hedger takes an equal but opposite position in the futures market to the one held in the cash market to avoid the risk of an adverse price move. However, by doing this, the hedger forfeits any advantage of a cash price improvement.

Basis and Basis risk

Perfect hedge does not always exist

• The asset we are trying to hedge may not be exactly the same as the asset underlying the futures.
• The time at which we sell the asset (which could be random) might not be exactly be the same as the delivery date of the futures.

Basis = spot price of asset to be hedged – futures price of asset being used for the hedge

bt = St – Ft

If the asset being hedged and used for the hedge are the same, then the basis will be zero at the expiration of the futures contract.

Basis risk

• If bt were known at t0, we would have a perfect hedge (because if bT is known, then bt is fixed. This means that St and Ft must always change by equal amounts, leaving income unchanged).
• When bt is unknown at time t0, the uncertainty about the period T income, captured by the uncertainty about the value of bt , hence called basis risk.

• Basis is the difference between spot & futures
• Basis risk arises because of the uncertainty about the basis when the hedge is closed out

Choice of Contract

• Choose a delivery month that is as close as possible to, but later than, the end of the life of the hedge
• When there is no futures contract on the asset being hedged, choose the contract whose futures price is most highly correlated with the asset price. There are then 2 components to basis

Hedging Using Index Futures

• To hedge the risk in a portfolio the number of contracts that should be shorted is

Beta (P/A)

• where P is the value of the portfolio, b is its beta (actually, with respect to futures fluctuations), and A is the value of the assets underlying one futures contract

Natural hedge

A hedge (risk reduction action) that occurs naturally as a result of a firm’s normal operations. For example, revenue received in a foreign currency and used to pay commitments in the same foreign currency would constitute a natural hedge.

The level of natural hedge, i.e. the (negative) correlation between price and yield levels, is an important determinant for farmers’ income risks and their demand for risk management instruments. The natural hedge is often approximated with correlations observed at more aggregated levels, e.g. the county level. This induces biases because the natural hedge at the farm-level is smaller than on more aggregated levels.

Hedging Interest-Rate Risk

Companies can hedge interest-rate risk in various ways. Consider a company that expects to sell a division in one year and at that time to receive a cash windfall that it wants to “park” in a good risk-free investment. If the company strongly believes that interest rates will drop between now and then, it could purchase (or ‘take a long position on’) a Treasury futures contract. The company is effectively locking in the future interest rate.

Hedging Foreign Exchange Risks

Small and large companies often conduct business transactions in one or more foreign currencies. Fluctuations in these currencies represent risks because they can negatively impact a company’s competitiveness and profitability. The absence of a foreign exchange management strategy can leave a company vulnerable to dramatic currency movements. Businesses can protect against these risks by hedging, which is the use of relatively low-cost financial instruments to anticipate and offset the impact of currency fluctuations.

When to hedge

• Risk and the optimal investment

Exchange rate
Commodity price
Interest rate
Property loss

• Claim

An oil company has less incentive to manage risk because investment opportunities are only good when oil prices are high.
An increase in commodity price risk reduces the optimal investment.

• Froot, Scharfstein, and Stein

“The goal of risk management is not to insure investors and corporate managers against oil price risk per se.  It is to ensure that companies have the cash they need to create value by making good investments.” p. 98

Hedging an Equity Portfolio

• Desire to be out of the market for a short period of time. (Hedging may be cheaper than selling the portfolio and buying it back.)
• Desire to hedge systematic risk (Appropriate when you feel that you have picked stocks that will outperform the market.)

Favor of Hedging

• Companies should focus on the main business they are in and take steps to minimize risks arising from interest rates, exchange rates, and other market variables

Against Hedging

• Shareholders are usually well diversified and can make their own hedging decisions
• It may increase risk to hedge when competitors do not
• Explaining a situation where there is a loss on the hedge and a gain on the underlying can be difficult