Hedging

Commodity trading and futures

 What is hedging?
• Commodity hedging is when a company
offsets risks arising out of fluctuations in raw-
material prices.
 How does it work?
• For instance, if a manufacturer of copper wires
expects the copper prices to rise in the next
three months, he will buy a position in the
futures market at current prices to offset the
likely price increase. Similarly, if the prices are
likely to fall, he will sell in the futures market
at current prices against the physical goods he
holds.
 Who can 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)
 What are the 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.
 Is hedging risky?
•
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
 Types of hedge
• Short Hedge: Selling in futures contract hoping to
lock in a certain price in future.
• Long Hedge: Buying in futures contract hoping to
lock in a certain price in future.
• Note that the purpose of hedging is not to
make profits, but to lock on to a price to be
paid in the future upfront.
 Hedging Ratio
• Hedge ratio is the ratio of the size of position taken
in the futures contracts to the size of the exposure in
the underlying asset.
• In situations where the underlying asset in which
the hedger has an exposure is exactly the same as
the asset underlying the futures contract he uses,
and the spot and futures market are perfectly
correlated, a hedge ratio of one could be assumed.
In all other cases, a hedge ratio of one may not be
optimal.