Hedging—What It Is And

How It Works

Training, Certification, and Education Department

Multi Commodity Exchange of India Ltd.
Exchange Square, 255 Suren Road, Chakala,
Andheri (East) Mumbai 400093

Set in 11 pt Myriad Pro

Website: www.mcxindia.com
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Introduction

Throughout history, it has been the unending struggle of

mankind to reduce or eliminate risks. They have devised
ways and means to protect themselves from uncertainty by
transferring their risks to those who are willing to assume
them. The most prominent risk mitigation tool is insurance,
which developed initially for maritime trade—providing cover
for loss of or damage to ships and cargoes at sea. That paved
the way for protection from
every transportation hazard
Insurance of risks,
by land, sea, or air. Other however, in whatever
kinds of insurance from theft, form, is merely the
burglary, and embezzlement transference of a risk
too cropped up.
from one party to
Commodity trade brings very another—from one
unique risks not inherent who desires to be freed
in other asset classes. There from it to another who
could be risks of non-
availability, non-shipment, is willing and able to
variety or grade mismatch, assume it
risks of non-payment by either
buyer or seller, risks of failure to take or give delivery, and most
importantly, risks of price volatility or price fluctuations amongst
many more.

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Compounding these risks there could be:
Market risks
Geopolitical risks
Environmental risks
Regulatory risks
Weather and force majeure risks
Terrorism risks
Knowledge and expertise risks

The big question?

How does one contain or deal with these risks that are so
inherent in commodity trade?

For centuries commodity markets have struggled with the

question, and two types of risk-takers have evolved over time;
the insurance companies, which are scientific risk-bearers,
and commodity dealers who are calculated risk-bearers. Both,
for a consideration, voluntarily assume risks which others are
eager to transfer to them. Both perform essential and valuable
economic functions which directly result in the lowering of the
costs of production and distribution of the economic goods of
the world.

The key risk-mitigating tools used today are diversification,

contracts, insurance, and hedging.

Hedging provides insurance against risks arising out of price

fluctuations. Economists from Keynes to Kaldor have defined
and discussed hedging as a risk mitigation tool. Thus the price
risk mitigation argument remains central to hedging.

That brings us to the main question: what is a hedge?

Slobodan Jovanovic in his book Hedging Commodities lucidly

puts it:

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“The contemporary use of the word hedge—in view of its
lexical association with modern financial markets jargon—
derives its meaning from its original roots: it implies some
kind of protection. In … financial markets the term has very
specific meaning. Among the myriad hedge definitions… (the
one simply put says): “Hedge=
Reduce risk.” It is short … and
it is correct; it tell you the
essence of what a financial
hedge is. But the problem with
the definition is that it does
not tell you what it is not.

“So, we can say that every

hedge is reducing risk, but
conversely, we cannot say that
every reduced risk is a hedge.
For example, there are back-
to-back arrangements that
cannot only reduce your risk
but eliminate it completely.
Although you are perfectly protected and insured, this instance
of price protection cannot be considered a hedge. Others
may seek to reduce risk—and they often do—by limiting or
diminishing the scope of investment, by diversifying their
portfolio, by predicting the market following sophisticated
charts and market analysis or listening to smart market
wizards—but still they are not hedging their positions.”

“What we should have in mind when hedge transactions are

concerned is that every hedge must comply with certain rules—
characteristics that differentiate the hedge from other risk-
reducing activities. Here are those that are inextricably implied
in all hedge transactions.

The main distinctive features of hedge are:

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i. That assets are registered and tradable in exchange markets:
securities, stocks, currencies and some intangible assets—that
is, commodities such as metals, oils, grains, livestocks, and so
on.
ii. That the asset at risk is counterbalanced by a hedge
instrument—either futures or options—at the exchange.
iii. That all trade transactions are subject to the exchange’s
governance and regulations.

IF YOU ARE MISSING ANY OF THE ABOVE FEATURES YOU DO

NOT HAVE A HEDGE.

In financial lingo “hedging” is the act, exercised by exchange-

market participants, of taking an offsetting position in a related
commodity (or a security) in order to reduce or eliminate the
risk of adverse price changes.

Taking into consideration the aforementioned presumptions, (a

broad definition of hedge is):

“Hedging is a transaction initiated to offset the risk of an adverse

price change emanating from a position held in the physical
market by establishing an equal and opposite position in the
futures market.”

Hedging Mechanics
“Every hedge is a risk-reduction or risk-elimination strategy.
Therefore, it necessarily includes two different transactions:
1. One performed in the physical market—the sale or purchase
of a physical commodity based
on a relevant current exchange
(MCX) price.
2. The other, an offsetting
transaction entered in the
financial-exchange market. This
is done through the mechanism
of a futures trade—that is,

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by buying or selling an equal and opposite futures positon
which matches the delivery date anticipated from the physical
transaction.

“Holding two different assets—”tangible goods” on the one side,

and “paper-based” assets on the other, inversely correlated—
puts a hedger in a rather fortuitous position, as losses in one
asset will be compensated by gains in the other. In that respect
we may designate the general concept of hedging as a “zero-
sum game.”

NOTHING’S GAINED AND NOTHING’S LOST

Thus hedging describes the process undertaken by users of the

market to lock-in the prices they will pay (or receive) for future
deliveries. This is done because the hedger wants to lock-in the
known price on a particular operation…. Hedgers will start with
price risk exposure from their
physical operations, and will buy
or sell a futures contract to offset
this price exposure in the futures
market. It is important to note
that the financial positions are
taken on an exchange….

Long Hedge

KEY TERMS
Long hedge is a position initiated by buying a futures, benefits if the
underlying market price increase (in futures market).
Short physical position is not owning a commodity for which you
have a forward position.

Every hedge begins either as a purchase of a sale of a specific

quantity of futures depending on a position held in a physical
market.

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Long hedgers in general seek to protect a short position in the
underlying commodity against a possible price rise.

For instance, a metal fabricator makes a firm commitment on

May 1 to sell copper wire rods to his regular customer, at a price
fixed now, for delivery on June 30. He needs 30 days to convert
the raw material (copper cathodes) into a finished product
(copper wire). He has
not yet purchased the
necessary quantity of
copper cathodes but
he hopes to do so in
the next 30 days. The
fabricator is therefore
said to hold a SHORT
PHYSICAL POSITION.
In the meantime, he is exposed to price fluctuations, and will
generate a loss if the price rises. The risk—being short of physical
metal—is offset by opening a long futures position; that is, by
buying the equivalent quantity of futures to hedge.…

HEDGE BUYING (LONG HEDGE) IS DESIGNED TO PROTECT AGAINST

POSSIBLE PRICE RISE. IT APPRECIATES IN VALUE WITH THE PRICE
RISE: BUY LOW, SELL DEAR.

Short Hedge

KEY TERMS
Short hedge initiated by selling a futures, benefits if the underlying
market price decrease (in futures market).
Long physical position is owing a commodity for which you do not
have a forward commitment.

On the other side of the coin we have those who are seeking
protection against a possible price fall. Short hedgers sell
futures to protect a long position in the underlying commodity
against a possible price fall.

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The metal on stock, which has been bought but remains unsold,
will generate a loss if metal prices fall. Normally the most
sensitive participants in the metal business to price decline are
miners and metal producers—smelters or refiners, namely, all
those who are, by the nature of their business, holding a LONG
PHYSICAL POSITION.

“The risk which investors incur by being long in physical metal

is therefore offset by initiating a SHORT FUTURES POSITION (on
May 1), that is, by selling the equivalent quantity of futures as a
hedge. Their pricing policy has to be insured in every possible way
as the fixed costs of their operation do not allow for sudden and
unpredictable price fluctuation.”

HEDGE SELLING (SHORT HEDGE) IS DESIGNED TO PROTECT

AGAINST A POSSIBLE PRICE FALL. IT APPRECIATES IN VALUE WITH
THE PRICE FALL; SELL HIGH, BUY LOW.

An interesting example that clarifies hedging in different

scenarios for gold.

GOLD

THE SITUATION
Gold BOX, a company in the jewellery design business, has been
competing in the overseas market. Its designer jewellery has a steady
but growing market. To develop its market share the management has
realized that it needs to price its designer products competitively. In
the past, the company resorted to buying and storing gold bars. This
strategy led to many problems relating to raw-material procurement
decisions, especially timing of decisions and storage concerns.

Although the highly experienced personnel have been astute in most

decisions, the recent movements in gold prices caused by currency
movements (Quantitative easing, interest rate movements in Europe,
and import duty structure), have led to reduced margins. A consultant
appointed by the management has recommended that price risk

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should be mitigated by taking up
positions on the MCX commodity
exchange.

GOING LONG: Scenarios where prices

either rise or fall

On 1st January, Gold BOX, enters into

a contract for delivery of finished
designer jewellery after three months.
Based on experience, the company has put together the following
facts and observations.
• The selling price of finished product and gold content in these
products cannot be altered
• Raw material (gold bars) will be required for actual use in mid-
March
• Risk of change in gold prices is perceived
• Estimated requirement or consumption is 80 kg per quarter
• Going long means buying the futures contract

HOW CAN THIS ‘GOLD BOX’ HEDGE AGAINST PRICE RISK?

We will look at both possibilities, that is, price rise and price fall. Let’s
take the situation when prices rise first.

DETAILS MCX PLATFORM PHYSICAL MARKET

1st January BUY Gold Futures
Contract
15th March SELL Gold Futures BUY the required
Contract quantity of in the
physical market

The net position of the above transactions will negate price risk

(Rs/10 grams)
DATE GOLD SPOT PRICE GOLD FUTURES
PRICE (expiry 5th
April 201X)
01-01-201X 29186 27842

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 15-03-201X 27900 27300

Futures 01-01- BUY 27842 15-03- SELL 27300 542

201X 201X (loss)
Spot 15-03- 15-03- BUY 27900
201X 201X

Net purchase price : Rs 28,442 (Rs 27900 + Rs 542)

EXPLANATION
The treasury department of Gold BOX buys a futures contract on 1st
January and squares up or sells the contract on the 15th of March
thereby making a loss of Rs.542 on the contract. Then they buy in the
spot market the required physical quantity at Rs. 27, 900. The net cost
for 10 g. being Rs. 28,442.

Note: Although both the scenarios in the above example result in a small
profit, the objective is to lock in the price so that whichever direction the
price moves Gold BOX is not adversely affected. Loss in one market is offset
by a gain in the other. Profits are only incidental.

THE SITUATION

Gold CHEST is a bullion dealer which imports and sells gold biscuits
and bars to a number of users. This market has been extremely
unpredictable due to price volatility, a reflection of international and
domestic fundamentals. Although Gold CHEST has customers based
only in the local market, it is severely affected by currency fluctuations,
and customers have become non-committal, resulting in an increase
of stocks in its vaults. In a recent board meeting, the management’s
suggestion, based on international practices, to hedge its stocks
against price movement on the MCX platform has been approved.
A treasury team has been put in place, besides a broker has been
identified after a critical assessment of alternative service providers.
Gold CHEST is now ready to take the plunge.

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GOING SHORT: Scenarios where prices either rise or fall
On 1st January, ‘Gold CHEST’, a bullion dealer, enters into a futures
contract for protecting its rising inventory against adverse price
movement. Experts have put forward the following facts and
observations.
• Falling prices would adversely affect the bottom line as
inventory ‘valuations’ would fall
• Valuation will take place at the end of March and inventory has
been estimated at 50 kg
• Risk of change in gold prices is perceived
• Going short means selling the futures contract

HOW CAN ‘GOLD CHEST’ HEDGE AGAINST PRICE RISK AND PROTECT ITS
BALANCE SHEET?

We will look at both possibilities, that is, price fall and price rise. Let’s
take the situation when prices fall first.

SCENARIO 3

IF PRICES WERE TO FALL

DETAILS MCX PLATFORM PHYSICAL MARKET
1st January SELL Gold Futures
Contract
31st March BUY Gold Futures Values inventory on
Contract hand, based on the
ruling spot price

The net position of the above transactions will negate price risk and protect
value

(Rs/10 grams)
DATE GOLD SPOT PRICE GOLD FUTURES
PRICE (expiry 5th
April 201X)
01-01-201X 26850 26900
31-03-201X 25950 25700

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 Futures 01-01- SELL 26900 31-03- BUY 25700 1200
201X 201X (profit)
Spot 31-03- 31-03- B U Y 25950
201X 201X PRICE

Net Valuation /10 g: Rs 27150 (Rs 25950+Rs 1200)

EXPLANATION
The treasury team Gold CHEST short sells a 5th April futures contract
on 1st January and squares the contract on 31st March. Its inventory
valuation will be based on March 31 spot price of Rs 25950; however,
this fall in value (Rs 26850- Rs 25950) will be partially offset by the
profit of Rs 1200 on the MCX futures platform. Hence, the bottom line
will enhance by Rs 300 per 10 g. The effect on the bottom line is Rs 15
lakh (Rs 300/10 g x 50 kg).

SCENARIO 4

IF PRICES WERE TO RISE

DETAILS MCX PLATFORM PHYSICAL MARKET

1st January SELL Gold Futures
Contract
31st March BUY Gold Futures Values inventory on
Contract hand, based on the
ruling spot price

The net position of the above transactions will negate price risk and protect value

(Rs/10 grams)
DATE GOLD SPOT PRICE GOLD FUTURES
PRICE (expiry 5th
April 201X)
01-01-201X 26850 26900
31-03-201X 27250 27150

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 Futures 01-01- SELL 26900 31-03- BUY 27150 250
201X 201X (loss)
Spot 31-03- 31-03- B U Y 27250
201X 201X PRICE

Net Valuation /10 g: Rs 27000 (Rs 27250 - Rs 250)

EXPLANATION
The treasury department of Gold CHEST sells a futures contract on 1st
January and squares up the contract on 31st March thereby making a
loss of Rs 250 . The valuation in its books will be at Rs 27250. This rise
in value will be tempered by the loss of Rs 250 on the MCX futures
platform. Hence, the bottom line gets enhanced by Rs 150 (Rs 27250-
Rs 26850 less Rs 250).

Note: In the first case the prices fall as per expectations, resulting in
an overall gain. In the second, prices rise unexpectedly, resulting in a
minor loss on the futures platform; however, overall valuations rise. The
objective to lock into the price is achieved and, ‘Gold CHEST’s, balance
sheet remains protected. Profits are only incidental.

The large economic benefits of hedging

• Independently evolved benchmark pricing

• Indicates the direction of the prices in future as expected
by the market
• Price dissemination to other players
• Help producers decide their product range e.g. for
farmers: choice of crop, time to sell
• Awareness about quality standards acceptable in the
market
• Warehouse-based funding

Some hedging benefits at the micro level

• Acts as insurance against price risk

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 • Facilitates better inventory management
• Ensures continuity of cash flow
• Encourages capital investment
• Essential for firms with small market power
• Enhances firm’s value by reducing risks

Some benefits at the macro level

Essential for trade-intensive countries? How? A large number of
trade-intensive countries rely heavily on commodities for their
export revenue or
import demand. Many
developing countries’
export baskets consist
primarily of raw
material commodities,
such as crude oil
(Venezuela, Nigeria,
and the Republic of
Congo), copper (Chile
and Zambia) and agricultural commodities, such as tobacco
(Malawi). These export led economies are highly susceptible to
the price volatility of the two or three commodities that feature
in their export basket.

Any supply bottlenecks or shortages in these vital commodities

have negative consequences on the countries’ economies and
GDP rates. First, a fall in price of these commodities adversely
affects a country’s export earnings along with its national
income.

The impairment in export earnings and fluctuations in revenue

collections would also affect the fiscal balances of economies
whose revenues rely heavily on commodity-related taxes,
royalties, and dividend income (in heavily state-owned
commodity sectors).

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Notes

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