All About Hedging

Futures are exchange traded derivatives where the counterparty is the exchange. The future transactions are subject to margin requirements and are settled on the particular settlement day. The credit risk associated with futures is comparatively low. Forwards are traded over the counter where the counterparty is the contracting party. The forwards are settled at the end of the period mentioned in the contract. The credit risk associated with forwards are higher than that of the futures.

Now exchange based market place is synonymous with the electronic exchange market platform. The biggest advantage of having an exchange-based platform is accessibility. Such market places are based on the technology of modern communication which allows the users to access the market from anywhere in the world without the time lags. Accessibility enables the multiple participants to get linked with the market from any place. A wider reach ensures greater participation, which results into a more efficient price discovery mechanism.

Futures contract in the commodities market can be used for various types of trading activities which includes speculation, hedging and arbitrage.

Speculation: It is about taking informed decision on the price direction of the commodities and accordingly initiate buy or sell transaction. Speculation is always done with a definite view on the price movement as per gut feelings, or fundamental (Supply and Demand) or technical (Chart and other sophisticated indicator) analysis. Speculators are not interested in physical possession of the commodity rather they trade on the price view. They hold the position temporarily.

Hedging: The people who have physical exposure of commodities uses the futures market for an effective hedging mechanism against price movements. For example a diamond merchant may go short in diamond futures by selling diamond futures contract, thus ‘locking’ his sale price and in the process hedging against any adverse price movements. On the other hand a diamond jewelry manufacturer may buy diamond futures and thus assure him a supply of diamond at a pre-determined price.

Arbitrage: Traders may exploit arbitrage opportunities that arise on account of difference in prices between the two market places or between different contracts of the same underlying.

Hedging is a risk management mechanism whereby downside risk is minimized by locking in the position. In trading and investing, hedging means fixing the price of underlying asset as per buying and selling exposure against the price uncertainty. Hedging is also about striking a balance between uncertainty and the risk of opportunity loss.

The word hedge means protection. A hedge is an investment to reduce the risk of adverse price movements in an asset. Assets may include foreign exchange rates, interest rates, commodity prices, and equity prices. Normally, a hedge consists of taking an offsetting position in a related security, such as a futures contract.

The person or institution that does hedging is called hedger. Example producers, manufacturers, exporters, importers, investors etc.

Example of hedging:
A farmer who has standing crop of basmati paddy would like to sell the crop in advance. Suppose in the month of August or September, the farmer sees the basmati paddy futures price for October contract and find the price favorable to sell. So he sells the October futures basmati paddy contract through broker and delivers the material in the exchange designated warehouse before contract expiry, let’s say in September last week. The contract settles on 5th of October and he will get the payment by 7th of October. Delivery process and final settlement usually completed within 5 to 7 days. Similarly a basmati exporter who requires paddy to make rice for export down the line in the month of October. He will buy basmati paddy futures contract at ICEX for October delivery by paying a small margin amount of only 5-10%. Upon contract settlement in the month of October he will make the payment to get the delivery.

When sell position is created at futures exchange it is called short position or short hedge and buy position is created at futures exchange it is called long position or long hedge.

Hedging employs various techniques but, basically, involves taking equal and opposite positions in two different markets (such as cash and futures markets).

A futures contract is a commitment to make or take delivery of a specific quantity and quality of a given underlying asset at a specific delivery location and time in the future.

The difference in cash or physical or spot price and futures price is called basis. The basis is factors of storage, quality difference, freight, handling charges and the local demand supply factors in cash price.