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MUTUAL FUNDS ESSENTIALS
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DIRECTORIES
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RESEARCH & TOOLS
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What is Hedging |
Hedging is the process of managing the risk of metal price change by offsetting that risk in the futures market. Hedging can vary in complexity from a relatively simple activity, through to highly complex strategies, including the use of options.
The ability to hedge means that industry can decide on the amount of risk it is prepared to accept. It may wish to eliminate the risk entirely and can generally do so quickly and easily using the Mismanaging price risk means achieving greater control of either the cost of inputs, or revenues from sales, or both; planning for the future based on assured costs and revenues; and eliminating concerns that a sharply adverse move in a metal's price could turn an otherwise flourishing and efficient business into a loss maker. Hedging by trade and industry is the opposite of speculation and is undertaken in order to eliminate an existing physical price risk, by taking a compensating position in the futures market. Speculators come to the futures market with no initial risk. They assume risk by taking futures positions. Hedgers reduce or eliminate the chance of further losses or profits, while the speculators risk losses in order to make profits.
Before starting a hedging programmed it is essential to assess the risk due to exposure to metal prices. Once the hedger has an understanding of the tools available at the LME, it is relatively easy to select the appropriate action to manage this risk. It is important that this action is properly managed at all times and that the appropriate controls and approval procedures are in place. It is generally advisable to work with an LME broker so that expert advice can be taken in devising a hedging programmed.
The best way to understand hedging is to think of it as insurance. When people decide to hedge, they are insuring themselves against a negative event. This doesn't prevent a negative event from happening, but if it does happen and you're properly hedged, the impact of the event is reduced. So, hedging occurs almost everywhere, and we see it everyday. For example, if you buy house insurance, you are hedging yourself against fires, break-ins or other unforeseen disasters.
Portfolio managers, individual investors and corporations use hedging techniques to reduce their exposure to various risks. In financial markets, however, hedging becomes more complicated than simply paying an insurance company a fee every year. Hedging against investment risk means strategically using instruments in the market to offset the risk of any adverse price movements. In other words, investors hedge one investment by making another.
Technically, to hedge you would invest in two securities with negative correlations. Of course, nothing in this world is free, so you still have to pay for this type of insurance in one form or another. |
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How Do Investors Hedge?
For the most part, hedging techniques involve using complicated financial instruments known as derivatives, the two most common of which are options and futures. We're not going to get into the nitty-gritty of describing how these instruments work, but for now just keep in mind that with these instruments you can develop trading strategies where a loss in one investment is offset by a gain in a derivative.
Let's see how this works with an example. Say you own shares of ABC Corporation. Although you believe in this company for the long run, you are a little worried about some short-term losses in the industry. To protect yourself from a fall you can buy a put option (a derivative) on the company, which gives you the right to sell at a specific price (strike price). This strategy is known as a married put. If your stock price tumbles below the strike price, these losses will be offset by gains in the put option.
The other hedging example involves a company that depends on a certain commodity. Let's say ABC Corporation is worried about the volatility in the price of agaves, the plant used to make big quantity of products. The company would be in deep trouble if the price of agaves were to skyrocket, which would eat into profit margins severely. To protect (hedge) against the uncertainty of prices, you can buy a futures contract that allows the company to buy the share at a certain price. Now you can budget without worrying about the fluctuating commodity. |
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Hedging Advantages vs. Forward Cash Contracting
- Hedging allows flexibility to later select the appropriate physical delivery point. This may be important for producers with several buyers competing for the grain or oilseed.
- Hedging provides the flexibility to reverse a market position because of changes in crop growing conditions, changes in the condition of stored grain, or changes in price outlook. Once a forward cash contract commitment is made, it may be difficult to cancel or to alter. A position in the futures market can be terminated by offsetting the position. Financial compensation, of course, must be made for any adverse price change occurring while the futures position was held.
- Hedging allows the producer to speculate on a basis improvement. As shown in earlier examples, if the basis appreciates more than expected, the final price will be higher than originally anticipated.
- Hedging generally lengthens the potential pricing period for a crop to 20 to 24 months, including about one year before harvest and one year after harvest. This may be a longer period than for forward cash contracting.
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Hedging SummaryHedging can greatly reduce the exposure to price risk. It is an important marketing tool for establishing price while retaining considerable marketing flexibility. However, hedging does not guarantee a profit. The hedging decision must still take into account production costs and market outlook. For many producers, deciding when to hedge is one of the most difficult aspects of grain marketing. Pricing indecision often leads to a “do-nothing- until-forced-to-sell strategy,” with the crop sometimes sold at low prices. An understanding of market alternatives such as hedging can help avoid such problems and lead to a more successful grain marketing program. |
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