What Is Hedging?

 
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.