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.
The macroeconomic outlook is deteriorating, and in our view, Europe and the UK are in recession already, and the US will be 6 months behind. Higher interest rates, in conjunction with elevated energy and electricity prices, are squeezing households’ disposable income, and new mortgage rates are considerably higher and are now a fixed cost to the consumer. We expect end-user demand to decline, and this will have an impact across the whole supply-chain; although material availability is poor for metals with bonded and exchange warehouses low in stock, this will lead to a dislocated market and volatile price action in spreads, while the macro impacts the flat price. The 20th Party Congress has ended, and their COVID policy is here to stay. As a result, sentiment in China has declined, and if the output of refined materials rises, this will put further pressure on prices. The Fed has increased the rates by 75bps with 50bps to come, but investors are looking at where they pivot, and any dovish language will cause a selloff in the dollar, giving rise to metals prices. If Chinese demand returns and the dollar weakens, this could present significant volatility and price rises, compounded inflationary pressures.
Monthly commentary covering the FX markets, providing insights on recent developments on select currency pairs. This month we look at the correlation between Singapore and the Chinese economy and if China's re-opening trade will continue to provide tailwinds to the Singapore Dollar.
Our analysis takes a deep dive into the coffee market and how there is a large disconnect between flat price movements and spreads. The macroeconomic issues are causing the flat price to consolidate and whipsaw around, as the spreads highlight the low inventory and tight fundamentals. Currency risk and higher rates have dominated markets as the global economy slows, but where do we see prices heading?
Our analysts provide an insight into the Electric Vehicle and Battery Material Market. They give an update on how the energy industries in major regions are transitioning towards renewable alternatives, new policies to support EV sales, and a fundamental outlook for Nickel, Cobalt, and Lithium. Supply-chain bottlenecks and strong EV consumption have meant a sharp increase in the prices of materials and chemicals. Will this continue?