Commodity Futures Exchanges offer primary producers and consumers of commodities, an excellent opportunity to protect themselves against the adverse price moves. Taking advantage of hedging on the futures exchanges shall enable corporate and other spot market players to protect their margins and cushion themselves against unexpected moves.
Hedging involves the practice of offsetting the price risk inherent in any cash market position by taking an equal but opposite position in the futures market. Success of the futures market can actually be defined by the increased participation of hedgers though arbitrageurs and speculators also help in increased liquidity of the market.
Here, the objectives of hedgers are different from those of other players. The hedger's goals are to lock in a price that will assure a profit or prevent a loss for his business, either the production or consumption of some product. Remember, hedgers are not trying to make a killing in the market; they wish to offset price risks. When trading the futures, holding a position for months is generally the exception (although big money can be made with longer term positions) .
Hedgers try to reduce the inherent risk in a commodity price by hedging. However, the arbitrageurs and speculators take advantage or speculate in the market. Though hedgers in the futures market operate on the same general principle, they take a futures position that is roughly equal and opposite to the position they have in the cash market. This acts as a substitute for a later cash transaction. Normally the cash and futures prices tend to go up or down together and therefore, the loss on one side is cancelled by gain on the other.
It is to be noted that the loss on the cash side /futures side will only be notional. It is compensated by the profit in the futures/cash market.
It is important to note that generally, the spot price (or cash price) of any commodity responds to supply and demand fundamentals while the futures price responds to changes in the cash price and expectations of the market. It is not necessary that spot and futures prices must move in the same direction. The future price of a commodity is a function of the spot price and the cost of carry adjusted for any return. However, due to some uncertainty, there may be an imbalance. In such a case, the futures market may not reflect the expected spot price in future.
(1) The Short Hedge: It is entered into to protect the value of an inventory. A short hedge is used by the owner of a commodity to essentially lock in the value of the inventory prior to the transferring of title to a buyer. A decline in prices generates profits in the futures market on the short hedge. These profits are offset by depreciation in the inventory value. Here, the hedger sells futures contracts to protect against possible declining prices of commodities that will be sold in the future. At the time the cash commodities are sold, the open futures position is closed by purchasing an equal number and type of futures contracts as those that were initially sold.
Say, a sugar company has 10,000 MTs of sugar lying at its warehouses which it plans to sell in the near future. To protect itself against price moves, the company sells 1000 Sugar Futures (1 Contract is worth 10 MTs). The day the company sells off its sugar from the warehouse, it also squares off its Futures position. This way, Loss/Profit on the Futures Side is offset by Profit/Loss on the Cash Side.
(2) The Long Hedge: Here, the company buys futures contracts to protect against a possible price increase of cash commodities that will be purchased in the future. At the time the cash commodities are bought, the open futures position is closed by selling an equal number and type of futures contracts as those that were initially purchased. This is also referred to as a buying hedge.
Say, a Chocolate manufacturing company has requirements of 10,000 MTs of sugar in the coming months. To protect itself against price moves, the company buys 1000 Sugar Futures (1 Contract is worth 10 MTs). The day the company buys sugar from the spot market, it also squares off its Futures position (i.e. Sells off the Futures contracts). This way, Loss/Profit on the Futures Side is offset by Profit/Loss on the Cash Side.
