A risk management strategy designed to reduce or offset price risks using derivative contracts, the most common of which are futures, options and averages.
- For consistent and stable cash flows.
- To determine a sale/purchase price of a commodity/security.
- To reduce risk exposure.
- To reduce transaction costs.
In essence, when operating in futures markets hedging implies taking a position opposite to that in the physical market. Hedging is the opposite of speculation - hedgers are not trying to "win" and make money on the actual price movements. Locking a price today allows for better focus on planning and business development with minimum exposure to an unwanted business risk. Hedging can vary in complexity from relatively simple "off-setting trades" through to complex derivative structures.
How does a hedge work?
A producer takes opposite positions in two different markets, for example physical and futures markets, that move together in order to mitigate loss in one, for a favourable movement in another.
Key principles behind hedging
An open hedge arises when a futures position is opposite to physical market. A closed hedge refers to the case when a futures position is closed when the physical risk is no longer present. Producers are naturally long physical the commodity so to hedge they normally sell futures, protecting their profit margin against a price fall. Consumers are naturally short physical the commodity, so to hedge they normally buy futures, protecting against a rise in prices.
- Arbitrage involves taking opposite positions on two markets, in order to hedge physical pricing on different markets for the same or similar products.
- Averaging is a strategy whereby, instead of hedging against a single price fixed on a single date, average transactions settle against average prices observed over a certain period of time.
- Offset is a simple offsetting of the physical market exposure.
- Price Fixing involves taking advantage of the current favourable market levels for the future physical transactions.
Benefits versus opportunity costs
- Ability to manage the price risk to a necessary degree, better planning, business development and more flexibility with regard to pricing policies.
- Potentially foregoing any potential profits from market fluctuations, the temporary cash outlay and a broker fee.
- A producer is reliant on the cash market, where he needs to sell his finished product. A producer doesn't know what would be the market price for his product in the future when it will be ready to sell. He can then enter the futures market and sell his produce at a desired price in the future.
- If the price goes up he makes up for his losses in the futures market by selling his produce in the cash market.
- If the price goes down he makes up for his losses in the cash market by closing out his position in the futures market.
- As a result, the price is fixed and risk of price fluctuations is significantly reduced.
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