To hedge is to take a futures position that is equal and opposite to a position held in the cash market. The objective is to mitigate the risk of an adverse move in prices.

Hedging works in mitigating price risk because futures prices and cash prices are highly correlated. For example, a producer of soybeans has the risk that the cash price will decrease before the beans are harvested and can be sold. Selling soybean futures mitigates this risk. If the cash soybean price in fact declines, the futures price will have decreased as well. Then, the producer can buy back (or offset) the futures contract for less than he sold it for, generating a profit. This profit can be applied to the revenue he gets from selling the soybeans on the cash market, thereby mitigating the cash price decrease.

Hedging using futures very seldom results in delivery against the futures contract; contracts are liquidated via offset and do not result in delivery. The purpose of the delivery provision is to ensure convergence between futures price and the cash market price. It is the threat of delivery that causes cash and futures to come together.

Market competition, regulatory changes & environmental awareness is enforcing utilities to review their risk management strategies without compromising customer experience. In consequence of customer’s inclination towards fixed price tariffs because of dynamic market prices and stringent regulations, future market trading has evolved as an inevitable option for utilities. Hedging precision for Volume & Price risk exposures plays decisive role for utilities profitability margins.

Hedging logic, customized tariffs plans, contracts consolidation, and differentiated profile amplify complexities from operations perspective.

Without any risk – a comprehensive risk management system should also take account of risks arising from commodity price trends. Forward transactions, options and option strategies as well as metal-indexed interest strategies for hedging or optimisation purposes can be used in this connection.

All contracts can be concluded in euros and US dollars with maturities of up to two years – in some cases even up to five years. As there is no physical delivery, a cash settlement takes place on maturity. In addition, you can profit from fluctuations in the commodity sector in the investment field.

• Passing on of risk: securing flows and inventories of goods to smooth and improve predictability of corporate results
• Optimisation: strategies to compensate for rapid price movements; dampening the effects of the current price situation
• Commodity investments: investment strategies to complement and diversify an existing portfolio

You can currently trade the precious metals gold, silver, platinum and palladium as well as the base metals aluminium, copper, zinc, lead, nickel and tin. Alloys can be hedged on the basis of an appropriate weighting of the base metals. In the case of the base metals, the minimum trade size is one lot (e.g. copper 25 tonnes, nickel 6 tonnes). In addition, you can hedge crude oil (Brent) and gas oil.

We can also hedge so-called “soft commodities” (cotton, coffee, cocoa, live cattle, lean hogs, corn, feeder cattle, soybeans, soybean oil, wheat, red wheat and sugar) through forward transactions. We are still working on option-based hedging.

Any manufacturer that faces risks due to volatile commodity prices. Prior approval from the Reserve Bank of India is required. The products that are available for hedging are futures, options. and over the counter derivatives (where individual parties can strike a deal based on their requirements through a broker ).

Costs involved

In case of futures, the party hedging would have to pay a margin – a percentage cost of the contract value (usually between 5-8%). For options. they would have to pay a premium, which is market-driven. Over and above this, a brokerage fee is due.

Hedging and risk

Hedging is generally not considered risky if it is based on covering short-term requirements. However, if the hedging party places a wrong bet, then they may miss out on potential savings. For instance, if a copper manufacturer has a capacity of 200 tonne and decides to sell 300 tonne on the futures exchange the remaining 100 tonne is considered as speculation in the market. If prices fall then he stands to benefit, however if prices go up the 200 tonne he produces can be delivered on the exchange but he would have to incur losses on the additional 100 tonne.

Hedging Using Futures

Types of hedges using futures

Short Hedging

A short futures hedge is appropriate when you know you will sell an asset in the future & want to lock in the price.

A person who already owns or is in the process of producing a commodity has the risk that the price will fall. This risk can be mitigated by selling futures (short hedge), protecting the hedger from a decline in the price of the commodity/product owned or being produced.

Examples of short hedgers:

• A farmer with livestock on feed or a crop in the field.
• An elevator with grain inventory in the elevator.
• An elevator that has contracted to accept delivery of grain in the future at a fixed price.
• A meat packer who has contracted to accept animal delivery in the future.

• The risk here is that prices may fall before delivery.
• Take a short hedge position in the futures market.
• Appropriate when someone expects to sell an asset he already owns and wants to guarantee the price.

Example. Selling 1 million barrels of crude oil. The spot price for a barrel is $19 per barrel and the 3-month futures price is $18.75 per barrel.

• Spot price in three months proves to be $17.50: We gain $18.75-$17.50=$1.25 per barrel from the futures but I’m selling the oil for $1.25 less per barrel. We end up getting $18.75 per barrel.
• Spot price in three months proves to be $19.50: I lose $19.50-$18.75=$0.75 per barrel from the futures but I’m selling the oil for $0.75 more per barrel. I end up getting $18.75 per barrel.

Short Hedge Example

As an example, suppose it is May and a corn producer is considering pricing his corn crop. Based on history, the producer expects the basis at harvest to be $0.10 over December futures, which are currently trading at $3.50. The elevator is currently offering a forward price that is $0.05 over December. The producers risk is that corn prices will fall, so to hedge with futures, the producer takes a short futures position. As the corn is being harvested in November, the futures price has fallen to $3.00, and the local basis is still $0.05 over December. The producer buys back the short position, resulting in a $0.50 profit, which he combines with the $3.05 cash price to obtain a net price of $3.55, thereby mitigating the effect of the price decrease. Conversely, if the futures price had increased by $0.50, a loss on futures would result, and the net price would remain $3.55.