Hedging means reducing or controlling risk. This is done by taking a position in the futures market that is opposite to the one in the physical market with the objective of reducing or limiting risks associated with price changes.
Hedging is a two-step process. A gain or loss in the cash position due to changes in price levels will be countered by changes in the value of a futures position. For instance, a wheat farmer can sell wheat futures to protect the value of his crop prior to harvest. If there is a fall in price, the loss in the cash market position will be countered by a gain in futures position.
How hedging is done
In this type of transaction, the hedger tries to fix the price at a certain level with the objective of ensuring certainty in the cost of production or revenue of sale.
The futures market also has substantial participation by speculators who take positions based on the price movement and bet upon it. Also, there are arbitrageurs who use this market to pocket profits whenever there are inefficiencies in the prices. However, they ensure that the prices of spot and futures remain correlated.
Example - case of steel
An automobile manufacturer purchases huge quantities of steel as raw material for automobile production. The automobile manufacturer enters into a contractual agreement to export automobiles three months hence to dealers in the East European market.
This presupposes that the contractual obligation has been fixed at the time of signing the contractual agreement for exports. The automobile manufacturer is now exposed to risk in the form of increasing steel prices. In order to hedge against price risk, the automobile manufacturer can buy steel futures contracts, which would mature three months hence. In case of increasing or decreasing steel prices, the automobile manufacturer is protected. Let us analyse the different scenarios:
Increasing steel prices
If steel prices increase, this would result in increase in the value of the futures contracts, which the automobile manufacturer has bought. Hence, he makes profit in the futures transaction. But the automobile manufacturer needs to buy steel in the physical market to meet his export obligation. This means that he faces a corresponding loss in the physical market.
But this loss is offset by his gains in the futures market. Finally, at the time of purchasing steel in the physical market, the automobile manufacturer can square off his position in the futures market by selling the steel futures contract, for which he has an open position.
Decreasing steel prices
If steel prices decrease, this would result in a decrease in the value of the futures contracts, which the automobile manufacturer has bought. Hence, he makes losses in the futures transaction. But the automobile manufacturer needs to buy steel in the physical market to meet his export obligation.
This means that he faces a corresponding gain in the physical market. The loss in the futures market is offset by his gains in the physical market. Finally, at the time of purchasing steel in the physical market, the automobile manufacturer can square off his position in the futures market by selling the steel futures contract, for which he has an open position.
This results in a perfect hedge to lock the profits and protect from increase or decrease in raw material prices. It also provides the added advantage of just-in time inventory management for the automobile manufacturer.
Understanding the meaning of buying/long hedge
A buying hedge is also called a long hedge. Buying hedge means buying a futures contract to hedge a cash position. Dealers, consumers, fabricators, etc, who have taken or intend to take an exposure in the physical market and want to lock- in prices, use the buying hedge strategy.
Benefits of buying hedge strategy:
- To replace inventory at a lower prevailing cost.
- To protect uncovered forward sale of finished products.
The purpose of entering into a buying hedge is to protect the buyer against price increase of a commodity in the spot market that has already been sold at a specific price but not purchased as yet. It is very common among exporters and importers to sell commodities at an agreed-upon price for forward delivery. If the commodity is not yet in possession, the forward delivery is considered uncovered.
Long hedgers are traders and processors who have made formal commitments to deliver a specified quantity of raw material or processed goods at a later date, at a price currently agreed upon and who do not have the stocks of the raw material necessary to fulfill their forward commitment.
Understanding the meaning of selling/short hedge
A selling hedge is also called a short hedge. Selling hedge means selling a futures contract to hedge.
Uses of selling hedge strategy.
- To cover the price of finished products.
- To protect inventory not covered by forward sales.
- To cover the prices of estimated production of finished products.
Short hedgers are merchants and processors who acquire inventories of the commodity in the spot market and who simultaneously sell an equivalent amount or less in the futures market. The hedgers in this case are said to be long in their spot transactions and short in the futures transactions.
Understanding the basis
Usually, in the business of buying or selling a commodity, the spot price is different from the price quoted in the futures market. The futures price is the spot price adjusted for costs like freight, handling, storage and quality, along with the impact of supply and demand factors.
The price difference between the spot and futures keeps on changing regularly. This price difference (spot - futures price) is known as the basis and the risk arising out of the difference is defined as basis risk. A situation in which the difference between spot and futures prices reduces (either negative or positive) is defined as narrowing of the basis.
A narrowing of the basis benefits the short hedger and a widening of the basis benefits the long hedger in a market characterized by contango - when futures price is higher than spot price. In a market characterized by backwardation - when futures quote at a discount to spot price - a narrowing of the basis benefits the long hedger and a widening of the basis benefits the short hedger.
However, if the difference between spot and futures prices increases (either on negative or positive side) it is defined as widening of the basis. The impact of this movement is opposite to that as in the case of narrowing.