|Rediff India Abroad Home | All the sections|
What is hedging & how it helps you trade
Chiragra Chakrabarty, Commodity Online | June 23, 2007 08:56 IST
Hedging means reducing or controlling risk. This is done by taking a position in the futures market that is opposite to the one in the physical market with the objective of reducing or limiting risks associated with price changes.
This presupposes that the contractual obligation has been fixed at the time of signing the contractual agreement for exports. The automobile manufacturer is now exposed to risk in the form of increasing steel prices. In order to hedge against price risk, the automobile manufacturer can buy steel futures contracts, which would mature three months hence. In case of increasing or decreasing steel prices, the automobile manufacturer is protected. Let us analyse the different scenarios:
But this loss is offset by his gains in the futures market. Finally, at the time of purchasing steel in the physical market, the automobile manufacturer can square off his position in the futures market by selling the steel futures contract, for which he has an open position.
This means that he faces a corresponding gain in the physical market. The loss in the futures market is offset by his gains in the physical market. Finally, at the time of purchasing steel in the physical market, the automobile manufacturer can square off his position in the futures market by selling the steel futures contract, for which he has an open position.
Understanding the meaning of buying/long hedge
A buying hedge is also called a long hedge. Buying hedge means buying a futures contract to hedge a cash position. Dealers, consumers, fabricators, etc, who have taken or intend to take an exposure in the physical market and want to lock- in prices, use the buying hedge strategy.
The purpose of entering into a buying hedge is to protect the buyer against price increase of a commodity in the spot market that has already been sold at a specific price but not purchased as yet. It is very common among exporters and importers to sell commodities at an agreed-upon price for forward delivery. If the commodity is not yet in possession, the forward delivery is considered uncovered.
A selling hedge is also called a short hedge. Selling hedge means selling a futures contract to hedge.
Uses of selling hedge strategy.
Short hedgers are merchants and processors who acquire inventories of the commodity in the spot market and who simultaneously sell an equivalent amount or less in the futures market. The hedgers in this case are said to be long in their spot transactions and short in the futures transactions.
The price difference between the spot and futures keeps on changing regularly. This price difference (spot - futures price) is known as the basis and the risk arising out of the difference is defined as basis risk. A situation in which the difference between spot and futures prices reduces (either negative or positive) is defined as narrowing of the basis.
A narrowing of the basis benefits the short hedger and a widening of the basis benefits the long hedger in a market characterized by contango - when futures price is higher than spot price. In a market characterized by backwardation - when futures quote at a discount to spot price - a narrowing of the basis benefits the long hedger and a widening of the basis benefits the short hedger.