Hedging is often considered an advanced investing strategy, but the principles of hedging are fairly simple. With the accompanying criticism and popularity of hedge funds, the practice of hedging is becoming more widespread.
A hedge is an investment position intended to counterbalance potential gains/losses, which might be incurred by a companion investment. In simple terms, hedging is used for reducing any substantial gains/losses suffered by an organization or an individual. It can be constructed from different kinds of financial instruments such as stocks, options, exchange traded funds, swaps, forward contracts, insurance and many kinds of futures contracts and derivative and over-the-counter products. Public futures contracts were founded in 19th century to enable efficient, standardized and transparent hedging of agro commodity prices; since then they have expanded to include futures contracts to hedge values of interest rate fluctuations, energy, foreign currency and precious metals.
Hedging is basically a practice of taking position in one market to balance and offset against the risk adopted by assuming a position in contrary or opposing investment or market. Hedging is often considered to be a sophisticated investing strategy; however the principles of hedging are fairly simple. With accompanying criticism and popularity of hedge funds, the hedging practice is becoming more widespread. In spite of this, it isn’t yet widely understood. Hedging basically means controlling or reducing risk and this is done by taking position in futures market, which is opposite to one in cash market (physical market) with the aim of limiting or reducing risks associated with price changes.
Hedging is 2-step process. A loss or gain in physical position because of price level changes will be countered by changes in futures position value. For example, the rice grower can market rice futures for protecting the value of his crop before investing. If the price of the rice falls, the loss in physical market position will be countered by gain in futures position. In this kind of transaction, the hedger tries to fix the price at a certain level with the aim of ensuring certainty in the revenue of sale and cost of production. Futures market has substantial participation by speculators who take positions based on price movement. There are also arbitrageurs who use this market for pocketing profits, whenever there are inefficiencies in the prices.
Example – Automotive Industry
An automobile manufacturing company buys huge quantities of steel as raw material for the production of vehicles. It enters into contractual agreement for exporting automobiles 3 months, therefore to dealers in East European Market. This assumes that contractual obligation has been fixed at the time of signing contractual agreement for exports. The automobile manufacturing company is now exposed to risk in the form of rising steel prices. In order to hedge against price risk, the automaker can purchase steel futures contracts that would mature 3 months. In case of decreasing and increasing steel prices, the automaker is protected.
Understanding the meaning of long/buying hedge
A long hedge is also known as buying hedge. Long hedge means purchasing futures contract for hedging cash position. Fabricators, consumers, dealers etc who have taken or planning to take exposure in cash market and want to lock-in prices, use the long hedge strategy.
Advantages of Long Hedge Strategy:
To protect uncovered forward sale of finished products
To replace inventory at lower prevailing cost
The aim of entering into long hedge is to protect the purchaser against price increase of commodity in spot market, which has already been marketed at specific price; however not yet purchased. It’s quite common amongst importers and exporters for selling commodities at an agreed price for forward delivery. Long hedgers are processors and traders who have made formal commitments for delivering a specified quantity of processed goods or raw material at price agreed upon, who don’t have raw material stocks essential for fulfilling their forward commitment and at later date.
Understanding the meaning of short/selling hedge
Short hedge is also known as selling hedge. Short hedge means selling futures contract to hedge.
Advantages of Short Hedge Strategy:
To protect inventory not covered by forward sales
To cover finished products price
To cover prices of estimated production of finished products
Selling hedgers are processors and merchants who simultaneously market an equivalent amount or less in futures market and who need inventories of commodity in spot market. In this case, hedgers are said to be short in their futures transactions and long in spot transactions.
Understanding the basis
Typically, in the business of purchasing and selling a commodity, the spot price is different from the price quoted in futures market. Futures price is a spot price adjusted for costs including handling, freight, quality and storage, together with impact of demand and supply factors. The price difference between futures and spot keeps on changing frequently. This price difference is called the basis and risk arising out of the difference is called basis risk. A condition in which the difference between futures and spot prices reduces is called narrowing of basis. Nonetheless, if the difference between futures and spot prices increases, it’s defined as widening of basis.
How Do Investors Hedge?
Generally, hedging techniques involve the use of complex financial instruments called derivatives, the 2 most common of which are futures and options. We are not going to get into fundamentals of explaining how these instruments work, but for now just remember that with these instruments you can develop trading plans where a loss in one investment is offset by gain in derivative.
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