Hedging is an insurance method for commodity traders, producers and end-users to cover themselves against negative price movements. Hedging is not used to make profits but rather to prevent or at least minimize possible losses. The futures exchange is commonly used to hedge against price risks. Market participants obtain derivatives on the exchange to cover themselves against price movements.
The futures contracts and options on these exchanges are rarely executed. The position will be offset, which means obtaining an opposite contract to settle the contract. The commodity will then be sold on the cash market and the profit or loss made by offsetting the futures position will be added to the final cash price. The possible profit or loss is then covered by the profit or loss made by the futures contract.
(If you want to know more about hedging with options, click here)
You may encounter different problems when hedging a price risk. The first problem may occur when there is no corresponding futures market. This can be resolved by implementing a Cross hedge. This type of hedge is executed by obtaining a derivative on a related market, where the prices are correlated to the non-futures market.
A second problem can occur when the maturity dates of a futures contract and the actual delivery date for a commodity. A so-called Delta hedge will be implemented, which will hedge the futures maturity date closest to the physical delivery date. This minimizes the risk to the cash flow.
When planning to hedge a commodity it is important to calculate what portion of the sell or purchase you need to hedge. The percentage of the investment which is protected by the hedging activities is called the hedge ratio. There are different reasons why a prefect hedge ratio is not achieved. The first reason is the hedger decides not to hedge the entire investments considering the costs of a complete hedge are not in accordance with the level of risk involved. Another reason can be the imbalance between the amount of products to hedge and the standardized quantity of a futures contract. A standardized futures contract may not exactly match the amount of products that need to be hedged. This can result in either an under or over hedging a price risk.
The basis is an indicator for the difference between the local cash price and the futures price for a specific commodity. The basis for a commodity can play an important role in determining a hedging strategy and can help predict a final price for a commodity when using a hedge.
A basis for a commodity is calculated using the following formula:
Basis = Cash price – Futures price
A basis can be influenced by the following factors: transportation costs, local supply and demand conditions, interest and storage costs and profit margins. The basis can change depending on these factors.
When the basis is becoming more positive it is called strengthening and when it is becoming more negative it is called weakening. It is important to monitor the developments of the basis, because it provides an indication for both buyers and sellers how to hedge their price risk and predict a final price for their product. The basis tends to be consistent despite and can be considerably accurately predicted using historical patterns. It is therefore very useful for determining when and what portion of your risk to hedge, or perhaps not to hedge at all.
When a basis is strengthening this is advantageous to a seller or short hedger of a commodity. This means the difference between the cash and futures price is becoming more positive and thus a seller will receive a higher cash price when selling his product on the cash market.
When a basis is weakening this is advantageous to a buyer or longer hedger of a commodity. Because the difference between the cash and futures price is becoming more negative. This results in the option to buy the product at a lower price and thus generate an extra profit.
When hedging price risks it is important to be aware of the margins that apply to a futures contract. A margin is a money deposit which is required to obtain a buy or sell position on a futures contract. This is usually only a small percentage of the total value of the contract. The margin deposited at the start of futures contract is called the initial margin. A maintenance margin is a minimum deposit which is required to maintain a futures position, this is usually less than the initial margin.
The value of a futures contract may decrease over time, which causes the margin to increase, to cover the loss on the futures contract. The maintenance margin may exceed the money deposited in the account. When this happens the account holder will receive a margin call for additional funds to bring the account back to the required maintenance level. Another option is closing out the position and take the losses before they increase even more.
Margins are important in hedging because the positions on the exchange are balanced daily, which may result in margin calls, when a position is out of balance at the end of a trading day. Hedgers may then be required to answer a margin call and deposit additional funds. When there are a number of these margin calls, this can put pressure on the cash flow of a firm. If the hedge is placed correctly it will eventually earn back its investment upon the time of offset. Thus until the moment of settling, the position can influence the demand for liquid funds.