Hedging is a future commitment to buy or sell a set quantity of a commodity at a set price. By creating this future contract, manufacturers ensure they get the commodities they need for production and sellers know they have a buyer for crops they are growing. Hedging reduces risk for both buyers and sellers of commodities.
To hedge is to take a futures position that is equal and opposite to a position held in the cash market. The objective is to mitigate the risk of an adverse move in prices. Hedging does not carry any of the risks from the physical market and enables commodity traders to guarantee a minimum profit for each transaction.
Hedging works to mitigate price risk because futures prices and cash prices are highly correlated. For example, a coffee producer has the risk that the cash price will decrease before the beans are harvested and can be sold. Selling coffee futures mitigates this risk.
If the cash price does decline, the futures price will also decline, and the producer can buy back the futures contract for less than he sold it for, generating a profit. This profit can be applied to the revenue he gets from selling the coffee on the cash market, thereby mitigating the cash price decrease.
Fluctuating commodity prices can cause cash flow fluctuations. Cash flow issues can force the company to undertake short-term financing arrangements to address the liquidity deficit, increasing costs. Hedging commodity price risk minimizes cash flow fluctuations caused by commodity price movements, insulating the company from the impact of volatile price movements.
Hedging using futures seldom results in taking delivery of the product. The contracts are liquidated via offset and do not result in delivery.
Understanding commodity price risk
Commodity price risk is the financial risk companies trading commodities face because of fluctuations in commodity prices – usually driven by external market forces.
Volatility in commodity prices impacts different players in different ways. A fall in commodity prices can decrease sales revenue for producers, reducing their profits, while also decreasing input costs for manufacturers, increasing their profits. Commodities held as inventory lose value if the price goes down, and gain value if the price increases.
A rise in commodity prices increases revenue for producers if companies are willing to pay the higher price. The entire market could grow, as new entrants get in on the higher value commodity. At the same time, manufacturers using the commodity will have lower profit margins since their costs have gone up.
Futures contracts for hedging
Futures contracts are traded on organized exchanges by open outcry where traders and brokers shout bids and offers from a trading pit at designated times and places. This allows producers, users, and processors to establish prices before commodities are traded.
Futures contracts have standardized terms established by the exchange. These include the volume of the commodity, delivery months, delivery location, and accepted qualities and grades. The contract specifications differ based on the commodity being traded.
This standardization makes it possible for large numbers of participants to trade the same commodity, which also makes the contract more useful for hedging.
A farmer is one example of a hedger. Farmers grow crops and carry the risk that the price of their crop will decline by the time it is harvested. Farmers can hedge against that risk by selling futures, which can lock in a price for their crops early in the growing season. Then, if the price does decline, they can still secure a profit on their crop.
Very few futures contracts are ever delivered upon.
Options are contracts that give the holder the right, but not the obligation, to buy or sell an underlying asset once its price reaches a certain level – known as the strike price – at or before an expiry date.
There are two types of options:
- Call options give the holder the right, but not the obligation, to buy an asset. You buy a call option if you believe the market price will rise from its current level, and you sell a call option if you think it will fall
- Put options give the holder the right, but not the obligation, to sell an asset. You buy a put option if you believe the market price will fall from its current level, and you sell a put option if you think it will rise
Put options are more commonly used in hedging strategies, as opening a position to sell the same asset you currently own can help prevent downside risk.
Examples of hedging
A trader buys cocoa beans at specified price to be delivered in five months and simultaneously sells an equivalent quantity in the form of futures contracts. If the price of cocoa goes up, the trader loses on the futures sale, but earns a compensating profit with the gain made on the purchase of the cocoa beans. Later, when the trader finds a buyer for the cocoa, the trader buys back their short futures contracts while selling the cocoa, thereby lifting up their hedge. The trader does not really care how the market behaves between the time the cocoa beans are purchased and the time they are sold.
A producer expects a crop of 100 tons of cocoa beans to be shipped six months from now. The market has been in a downward trend. The producer sells the crop at the current market price to ensure they receive today’s price. However, they don’t want to lose out if the market turns around, so they buy 10 call options at the current price. If the market continues to fall, the producer lets the options expire and receives the original sale price for the crop. If the market goes up, they sell the crop at the original contract price, call in the 10 contracts at the original price, and sell the 10 contracts at the now higher market price.
Hedging helps both producers and buyers protect themselves from fluctuations in commodity prices and enables them to lock in a worst-case scenario price to reduce potential losses, benefitting both producers and buyers.
Contact iRely today to learn how we can help you better manage your hedging strategy.