Hedging: Controlling price risk using futures markets

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Producers and consumers of commodities use the futures markets to protect against adverse price moves. A producer of a commodity is at risk of prices moving lower. Conversely, a consumer of a commodity is at risk of prices moving higher. Therefore, hedging is the process of protecting against financial loss.

Futures

Futures exchanges offer contracts on commodities. These contracts offer producers and consumers alike a mechanism, a futures contract, with which to hedge future production or consumption.

Futures contracts trade for different time periods -- therefore, producers and consumers can choose hedges that closely reflect their individual risks. Additionally, futures contracts are liquid instruments. Aside from producers and consumers -- speculators, traders, investors and other market participants utilize these markets. The exchanges also offer clearing; this means that the clearinghouse becomes the transaction partner of a trade. This removes credit risk. The exchange requires those who hold long and short positions to post margin, which is a performance bond. Producers and consumers often receive special treatment on commodity exchanges, as hedgers their margin rates are often lower than other market participants. When a producer or consumer uses a futures exchange to hedge a future physical sale or purchase of a commodity they exchange price risk for basis risk.

Reducing Risk

Producers or consumers of commodities, who do not wish to assume the risk of price fluctuations, can reduce their total risk by hedging their cash positions in the futures markets.

To hedge, it is necessary to take a futures position of approximately the same size, but opposite in price direction, from the cash or physical position. Therefore, a producer who is naturally long a commodity hedge by selling futures contracts. The sale of futures contracts amounts to a substitute sale for the producer.

A consumer who is naturally short commodity hedges by buying futures contracts. The purchase of futures contracts amounts to a substitute purchase for the consumer. A producer is a short hedger while a consumer is a long hedger.

While supply and demand for commodities fluctuate, so does price. A producer or consumer who does not hedge assumes price risk.  Producers and consumers who use futures markets to hedge transfer price risk. If a one holds a commodity, they assume the price risk as well as the costs associated with holding that commodity. Carrying charges is an important concept for hedgers. The holding costs are the carrying charges that include interest, insurance and storage costs. The price of a commodity for a future delivery reflects carrying costs. In a normal market, the price of deferred futures is higher than nearby futures prices. Normal markets are the same as premium or contango markets. An inverted market is the same as a discount market or a market in backwardation.

Hedging in the futures market is far from perfect. Futures markets depend upon standardization. Commodity futures contracts represent certain qualities or grades for set delivery dates and delivery locations.

Sometimes, hedgers produce or consume commodities that do not conform to the specifications of future contracts. In these cases, hedgers will assume additional risks by using standardized futures. However, hedgers have different options.

Alternatives to Futures Markets

Futures markets are not the only choice for hedgers. They can also use forward markets, fixed price pre-export finance transactions and swaps to hedge. These markets entail principle-to-principle transactions with each party assuming the credit and performance risk of the other. However, these tailor-made transactions often meet the specific needs of consumers and/or producers with respect to the commodities at risk.

Hedging is an important tool when it comes to running a business from many perspectives. A hedge will guaranty a consumer a supply of a required commodity at a set price.

A hedge will guaranty a producer a known price for commodity output. Hedging is a mechanism that aids raw material suppliers and buyers so that they can plan ahead and cover the costs of running their business.