Hedging is a tool for minimising the possible loss in any investment. In an unpredictable market, investors can hedge to reduce price risk associated with their investments.
In the commodity market context, hedging is taking a position of the same quantity of commodity in the futures market just opposite to the position in the physical market. The idea behind establishing equal and opposite positions in the cash and futures markets is that a loss in one market should be offset by a profit in the other market. Hedging helps a trader to lock-in the price and margin in advance and this helps reduce the risk pertaining to unexpected price moves. A perfect hedge could reduce the price risk to zero, except for the cost of inflation. Hedging works because cash prices and futures prices tend to move in tandem, converging as the futures contract reaches expiration.
Volatile commodity prices
Commodity prices are typically volatile in nature. There are various factors like global economic conditions, geopolitical issues, etc. affecting the demand and supply of a commodity that leads to price volatility. In general, most companies directly interact with the broader commodity market in some way or the other. Traditional cost control techniques and raw material sourcing strategies may fail in markets with high volatility. Wide fluctuations in raw material cost may impact the profitability of companies since most of them find it difficult to quickly transfer the higher cost to their customers.
Managing commodity price risk through hedging
Managing price risk means minimizing the market-driven price uncertainties which may have an adverse effect on business operations. Depending on the nature of the business, one can initiate hedging through commodity derivatives. Different quality and quality specifications with multiple time period contracts are available for trading in exchanges. Traders can initiate a position (Buy/Sell) with a nominal margin, say five percent, and can hold the position till the contract expiry. On contract expiry date, the trader can either take physical delivery or it can be settled in cash.
Hedging in real market
In October, a confectionery company estimated a demand for 1MT of Cardamom which will be processed in December. To meet the requirement, the company entered into an agreement with a planter to supply 1MT at current market price (spot). However, they are worried of fall in cardamom prices in December. By hedging, the company can lock-in a price for their expected intake in October itself and protect themselves against the possibility of falling prices.
Assume, the spot price of Cardamom in October is Rs 900 a kg and price of December contract at futures platform is Rs 950 a kg. The company sells (shorts) 10 lots (1 lot = 100kg) of December futures in October at Rs 950 per kg. He pays only 5% of the contract value as initial margin to the exchange for taking a position.
Scenario 1: on 5th December spot prices fell to Rs 790 and futures to Rs 800
The company short sells 10 lots of 15th Dec 2018 contract on 20th October and squares the contracts on 5th December. The value realized from the actual sale of cardamom in the physical market is Rs 7.9 lakh (790*1000) and cash inflow from futures exchange due to fall in prices is Rs 1.5 lakh (150*10*100). Thus the net value realized from the sale of cardamom is Rs 940,000 (790,000+150,000), making the net selling price Rs 940 a kg (940,000/1,000) which is close to the locked in price.
Scenario 2: On 5th December spot prices raised to Rs 990 while futures to Rs 1,000
The company short sells 10 lots of 15th December 2018 contract on 20th October and squares the contracts on 5th December. The value realized from the actual sale of cardamom in the physical market is Rs 990,000(990*1000) and cash outflow from exchange due to rise in price is Rs 50,000(50*10*100). Thus the net value realized from the sale of cardamom is Rs 940,000(990,000-50,000), making the net selling price Rs 940 per kg (940,000/1,000), which is close to the locked-in price.
Hedging in Currency
Currency risk is associated with international trade. The USD/INR volatility usually impacts the financials of importers and exporters. A strong rupee makes imports cheaper while depreciating rupee makes exports attractive. Price uncertainties in overseas trades can be properly managed by currency hedging through exchanges.
Hedging and corporates
For firms engaged in manufacturing, operating risk is embedded in the nature of such businesses and are unavoidable. Financial risks are associated with commodity and currency fluctuations. It is asserted that most of the financial risks could be hedged as it has a direct impact on cash flow to business. For corporates, applying hedging techniques can raise the value of the firm. It will help in lowering tax liabilities, better inventory management and ensuring continuity in cash flows. Also, they can avail advantages like extended trading hours, increased open position limits and financing facility from banks etc.
Where should I Hedge
Hedging in commodities can be done through national level exchanges viz. MCX, NCDEX and NMCE which facilitates commodity futures trading in India. Futures positions in currency derivatives are facilitated by NSE. These exchanges are regulated by SEBI.
Commodity exchanges offer transparent price discovery mechanism, lower margins and facilitate risk management. Actual price discovery happens when a buyer’s and seller’s intention on price and quality of the commodity match, resulting in a trade. The buyer and seller remain anonymous in such trades, thereby enabling a very transparent price discovery. The near-absence of counter party risk helps investors reduce the risk associated with price uncertainties and volatilities. With the clearinghouse standing as a legal counter party between the buyer and the seller, it ensures limiting the risk factor as the clearing house becomes buyer to every seller and seller to every buyer. Through state-of-the–art facilities like online trading, clearing and settlement of futures transactions and prudent risk management practices, the exchanges provide an investor with a completely monitored trading platform.