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Hedging - Series 3 - National Commodities Futures - Investopedia

This document provides an overview of hedging in commodities futures trading. It discusses how hedging is used to reduce risk from price fluctuations by entering offsetting transactions. Specifically, it describes long hedging where a buyer purchases futures contracts to lock in prices for future needs, and short hedging where a seller uses futures to guarantee a price for their inventory if prices decline. An example is given of each where a food processor long hedges corn needs, and a farming cooperative short hedges existing corn supplies. The key purpose of hedging is stabilization of prices rather than speculation.

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109 views2 pages

Hedging - Series 3 - National Commodities Futures - Investopedia

This document provides an overview of hedging in commodities futures trading. It discusses how hedging is used to reduce risk from price fluctuations by entering offsetting transactions. Specifically, it describes long hedging where a buyer purchases futures contracts to lock in prices for future needs, and short hedging where a seller uses futures to guarantee a price for their inventory if prices decline. An example is given of each where a food processor long hedges corn needs, and a farming cooperative short hedges existing corn supplies. The key purpose of hedging is stabilization of prices rather than speculation.

Uploaded by

sam001040
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PDF, TXT or read online on Scribd
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Series 3 - National Commodities Futures

Chapter13

Chapter46

Chapter79

1.Preface

3.6Hedging

2.GettingStarted

3.7Leverage

3.GeneralTheory

3.8GeneralFuturesTerminology

AAA

Chapter1011

3.9GeneralOptionsTerminology
3.10SummaryAndReview

General Theory - Hedging


Hedging
Notallfuturestradingisaboutmovinggoodstomarket.Hedging,orenteringintoatransactioninordertoreduceexisting
exposuretopricefluctuations,isalsoamajorcomponentoftradingvolume.
SEE:ABeginner'sGuideToHedging
RiskReduction
Justaboutanytradercanbeahedgeratsomepointintimeitisafunctionmorethanajobdescription.Ifatraderalreadyholds
thephysicalgoodsorthefuturescontractstodeliverthem,orelsehastheoffsettingshortposition,thenshemightactasahedger
onhernexttrade.Hedgingisdonetodecreaserisk.
Whenyoubuyafuturescontract,youagreetopayacertainpriceforagivenquantityofagood.Thecounterpartywhosellsthe
contractisagreeingtothesameterms.However,overthemonthslongcourseofthecontract,circumstancesbeyondthecontrol
ofeitherpartycanoccurthataffectthespotpriceonthedeliverydate,causingittovarywildlyfromthepriceanticipatedinthe
contract.Whenthathappensandneitherthebuyernorsellerhashedgedpositions,thensomeoneisgoingtoendupwithawindfall
andtheotherisgoingtobepayingforit.
Hedging,then,hasastabilizingeffectoncommoditiespricing.
LongHedging
Inalonghedge,thehedgerbuysafuturescontract.Typically,thisisdonebysomeonewhoaddsvaluetothecommodity:
processors,manufacturers,exportersoranyonewhoisgoingtoneedaknownquantityofacommodityatafairlyspecificpoint
inthefuture.Thesetypesofenduserarecommercialhedgers.
SupposealargesnackfoodcompanyknowsinJulythat,inSeptembertwomonthshence,itwillneed50,000bushelsofcornto
keepitstortillachipfactoryrunning.TheCBOTreportsthefollowingpricesfor5,000bushelcontracts,denominatedin
cents/bushel:
Spot:235
SEP:246
DEC:260
Domesticdemandforcornisgrowingatafairlyconstantratesupplycouldkeepup,butnewmarkets,unfavorableweatherand
anynumberofotherfactors,coulddeterminehowmuchofthecropwouldbeavailabletothetortillachipmarketandatwhat
price.Oursnackfoodcompanydoesn'thavethefacilitiestostorethecornavailableonthespotmarketat$2.35/bushel,but
decidesthatthe$2.46priceforSeptembercornstillprovidesareasonableprofitmargin.The$2.60Decemberprice,though,
indicatesthatthespotpriceofcornwillkeepclimbingatanacceleratingrate,and$2.60isfarmorethantheprocessoriswillingto
payforabushelofcorn.
Sothecompanybuysten5,000bushelSEPcontractsat246cents/bushel.InSeptember,itturnsoutthatthenewspotpriceis
248cents/bushel.Becauseofalltheproceduralcomplicationsoftakingdeliveryofafuturescontract,thecompanywillsellthe
contractjustbeforeitexpires.Bythispoint,thefuturespricewillequalthespotpriceandthecompanywillbeabletoengagein
what'scalledareversingtradeandsellthecontractat248cents/bushel.
Thecompanywillthenbuythe50,000bushelsofcornonthespotmarket.

Ifyoudothemath,you'llseethatthehedgerhasapparentlybought$124,000worthofcorninSeptemberforaninvestmentof
$123,000inJuly.Still,that'snotareal$1,000profitifyouconsiderthecompanycouldhaveboughtthesameamountofgrainfor
thelowerpriceonthespotmarketatthetimeitboughtthefuture.Itmerelyeliminatedthecostofstoragewhileaddingon
transactioncosts.
LOOKOUT!
Theprofitandlossinadeallikethisistypicallynegligible.Thetransactionismoreaccuratelyviewedasaninsurancepolicy.Along
hedgeprotectsatraderagainstunanticipatedpricerises.Thatdidnotoccurinthisexample.TheSeptemberspotpricewasonlya
couplecentshigherthanthemarketthoughtitwouldbetwomonthsearlier.IftherehadbeenarashoftornadoesintheMidwest
orahugeorderplacedbyalargeoverseastradingpartner,thenSeptemberspotpricecouldhaverisento260cents/bushel,or
evenhigher,andthecompanywouldhavebeenveryhappyithadthelonghedge.
ShortHedging
Inashorthedge,thehedgersellsafuturescontractinordertolimitexposuretoapriceshortfall.Typically,thisisdoneby
farmers,minersoranyonewho,forwhateverreason,isholdingtheinventory(commercialhedgers).
Inashorthedge,thehedgersellsafuturescontract.Assumeyou'reanagentforthefarmingcooperativeinNebraskathatgrows
thecornunderlyingthecontractdescribedabove,inthesectiononlonghedging.Youwouldenterintothesamedealasthetortilla
chipmaker,butyourincentivewouldbetolimittheriskifcornpricesdeclinedsharply.Ifalargeexpectedorderdidnot
materialize,ifadevelopingnationshouldsuddenlydumplowercostcornontheworldmarketorifunusuallyfavorablesummer
weathershouldcauseasupplyglut,youknowthatthereareatleast50,000bushelsyoucansellatapriceyoucanlivewith.
LOOKOUT!
Mechanically,theshorthedgersellsthecontractsatthefuturespricetoopenthehedge,then,essentially,buysitbackatthe
prevailingspotpricetocloseit.

Next:Leverage

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