Classroom: Hedging

The key benefits of the commodities futures market are price discovery and price risk management. In this classroom, we take a look at the price risk management mechanism — hedging.

What is it?

Commodities hedging refers to the process of reducing or controlling risks arising out of adverse price movements. It is a strategy for offsetting the price risk that is inherent in the spot market by taking an equal but opposite position in the futures market.

Why hedge?

Hedging is considered to be one of the most preferred methods for reducing price risks for market participants who have exposure to physical commodities. Commodity producers or manufacturers can hedge by taking long or short positions against the physical product. Companies or producers take a long hedge position to protect themselves against prices going up in the future, when they have to source an asset at a future price. On the other hand, a short hedge is taken when you already have the product and you have to protect yourself against prices falling in the future.

In both cases, hedging will offset the loss of rising and falling price movements of the market participants.

Hedging is better understood with examples.

Consider X, a jewellery designer. X imports gold bars to make and sell jewellery in the market. Considering the currency fluctuations, the management expects the prices to move up. X needs raw material of 100 kg of gold in three months. The risk of rising prices can be mitigated by taking up positions in the futures market in exchanges such as Multi-Commodity Exchange (MCX)). How?

On September 1, X buys a futures contract for ₹27,842 per 10 grams. The gold spot price on that date is ₹29,186 per 10 grams. At the beginning of December, the futures contract of gold stands at ₹30,202 per 10 gm and the spot price is ₹30,900 per 10 gm. By selling in the futures market, X will make a profit of ₹2,360 per 10 gm. Then, in the physical market, when the company buys the raw material at ₹30,900 per 10 gm, the net costs will work out to ₹28,540 per 10 gm (30,900-2,360).

What if prices fall? If a producer of a commodity, say, crude palm oil, expects the prices to fall in the next two months, it can hedge its stock in October itself in the futures market. How?

Suppose the spot price of crude palm oil in October is ₹500 per 10 kg, while the futures price for December contract is ₹510 per 10 kg. To mitigate the price fall, the company sells (short) the December contract in October for ₹510 per 10 kg. In December, the crude palm-oil price declines and the company sells the same in the market at ₹480 per 10 kg. The potential loss is ₹20 per 10 kg (500-480).

The company buys the December contract in the exchange at ₹485 per 10 kg in December as the crude palm-oil prices have declined. The company gains ₹25 per 10 kg (510-485). Thus, it will be selling at an effective price of ₹505 per 10 kg (480+25), while the market price rules at ₹480 per 10 kg.

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